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Tuesday, March 31, 2009

"Obama Budget Reduces Deficit"

The Center on Budget and Policy Priorities says that, contrary to what you may have heard, the Obama budget "would reduce federal deficits by about $900 billion over the next ten years compared to current budget policies." Note also that, relative to their "realistic baseline," the deficit is larger in the immediate short-run than the baseline projection (but by enough?), and smaller in the longer run (any truly long-run solution to the budget problem will require us to reform health care and reduce escalating costs):

Obama Budget Reduces Deficit by $900 Billion Compared to Current Budget Policies, by Kathy Ruffing and Paul N. Van de Water, CBPP: Contrary to some claims, President Obama’s 2010 budget would reduce federal deficits by about $900 billion over the next ten years compared to current budget policies.  The $900 billion is the difference between deficits over the next decade under the President’s budget, as estimated by the Congressional Budget Office (CBO), and projected deficits under a realistic assessment of current budget policies. (See figure below.)

Some critics charge that Obama’s budget is fiscally irresponsible, and they cite CBO’s estimate that, under it, deficits would total $9.3 trillion over the next decade.  They fail to note, however, that these future deficits result from the existing budget policies that Obama inherited — not those that he is proposing.  Ironically, some of these same critics supported the large tax cuts and spending increases of recent years that helped convert the surpluses of the late 1990s into the record deficits that we face today and in the coming decades.

In fact, deficits would be $900 billion higher over the next decade under current policies than in Obama’s budget.  That’s because, in the budget plan that he released in late February, the President includes a package of spending and tax proposals that reduce future deficits by that amount.

Continue reading ""Obama Budget Reduces Deficit"" »

    Posted by on Tuesday, March 31, 2009 at 11:07 PM in Budget Deficit, Economics | Permalink  TrackBack (0)  Comments (7)


    "The End of Universal Rationality"

    Yochai Benkler discusses the use of the "assumption of universal rationality and a sub-assumption that what that rationality tries to do is maximize returns to the self" as a primary analytical foundation for our models of sociological, political, and economic behavior:

    The End of Universal Rationality, The Edge: The big question I ask myself is how we start to think much more methodically about human sharing, about the relationship between human interest and human morality and human society. The main moment at which I think you could see the end of an era was when Alan Greenspan testified before the House committee and said, "My predictions about self-interest were wrong. I relied for 40 years on self-interest to work its way up, and it was wrong." For those of us like me who have been working on the Internet for years, it was very clear you couldn't encounter free software and you couldn't encounter Wikipedia and you couldn't encounter all of the wealth of cultural materials that people create and exchange, and the valuable actual software that people create, without an understanding that something much more complex is happening than the dominant ideology of the last 40 years or so. But you could if you weren't looking there, because we were used in the industrial system to think in these terms.

    A lot of what I was spending my time on in the 90s and the 2000s was to understand why it is that these phenomena on the Net are not ephemeral. Why they're real. But I think in the process of understanding that, I had to go back and ask, where are we really in between this what's-in-it-for-me versus the great altruists and the stories of Stahanovich and the self-sacrifice for the community?

    Both of them are false. But the question is, how do we begin to build a new set of stories that will let us understand both? The stories are actually relatively easy. How we build actual, tractable analysis that allows us to convert what in some sense we all know, that some of us are selfish and some of us aren't. That actually most of us are more selfish some of the time and less selfish other of the time and in different relations. That we don't all align according to the standard economic model of selfish rationality, but that we're also not saints. Mother Teresa wouldn't be Mother Teresa if everybody were like her.

    So this is the puzzle that I'm really trying to chew on now, which is how we move from knowing this intuitively and having a folk wisdom about it to something that probably won't in any immediate future have the tractability and precision of mainstream economics. Not, by the way, that as we sit here today, mainstream economics necessarily enjoys the high status that it might have a few years ago, but nonetheless so that we will be able to start building systems in the same way that we thought about building organizational systems around compensation, like options that ties the incentives of the employees to that of the business, like we thought with regard to political science that's completely pervaded today by the understanding of, how does politics happen? Well, it depends on what the median voter wants and what the median Senator wants, and all of that.

    We have a lot of sophisticated analyses that try, with great precision, to predict and describe existing systems in terms of an assumption of universal rationality and a sub-assumption that what that rationality tries to do is maximize returns to the self. Yet we live in a world where that's not actually what we experience. The big question now is how we cover that distance between what we know very intuitively in our social relations, and what we can actually build with. ... [...continue reading or watch the video...]

      Posted by on Tuesday, March 31, 2009 at 03:33 PM in Economics, Methodology | Permalink  TrackBack (0)  Comments (22)


      Lessons from the New Deal

      The Senate committee for Banking, Housing, and Urban Affairs held a hearing today on "Lessons from the New Deal":

      Panel 1

      • Honorable Christina Romer
        Chair, Council of Economic Advisors

      Panel 2

      • Dr. James K. Galbraith
        Lloyd M. Bentsen Chair
        Lyndon B. Johnson School of Public Affairs, University of Texas at Austin
      • Dr. J. Bradford DeLong
        Professor of Economics
        University of California Berkeley
      • Dr. Allan M. Winkler
        Professor of History
        Miami (Ohio) University
      • Dr. Lee E. Ohanian
        Professor
        University of California, Los Angeles

      Here's the video:

      View archive webcast (starts at the 29:00 minute mark)

        Posted by on Tuesday, March 31, 2009 at 02:34 PM in Economics, Fiscal Policy, Monetary Policy, Video | Permalink  TrackBack (0)  Comments (5)


        DeLong: Kick-Starting Employment

        Brad DeLong:

        Kick-Starting Employment, by J. Bradford DeLong, Commentary, Project Syndicate: Unemployment is currently rising like a rocket... In response, central banks should purchase government bonds for cash in as large a quantity as needed to push their prices up as high as possible. Expensive government bonds will shift demand to mortgage or corporate bonds, pushing up their prices.

        Even after central banks have pushed government bond prices as high as they can go, they should keep buying government bonds for cash, in the hope that people whose pockets are full of cash will spend more of it...

        In addition, governments need to run extra-large deficits. Spending ... boosts employment and reduces unemployment. And government spending is as good as anybody else's.

        Finally, governments should undertake additional measures to boost financial asset prices, and so make it easier for those firms that ought to be expanding and hiring to obtain finance on terms that allow them to expand and hire.

        It is this point that brings us to US Treasury Secretary Timothy Geithner's plan to take about $465 billion of government money, combine it with $35 billion of private-sector money, and use it to buy up risky financial assets. The US Treasury is asking the private sector to put $35 billion into this $500 billion fund so that the fund managers all have some "skin in the game," and thus do not take excessive risks with the taxpayers' money.

        Private-sector investors ought to be more than willing to kick in that $35 billion, for they stand to make a fortune when financial asset prices close some of the gap between their current and normal values. ... Time alone will tell whether the financiers who invest in and run this program make a fortune. But if they do, they will make the US government an even bigger fortune. ...

        The fact that the Geithner Plan is likely to be profitable for the US government is, however, a sideshow. The aim is to reduce unemployment. The appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets that other private investors will have to hold. ... When assets are seen as less risky, their prices rise. And when there are fewer assets to be held, their prices rise, too. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms.

        The problem is that the Geithner Plan appears to me to be too small - between one-eight and one-half of what it needs to be. Even though the US government is doing other things as well -fiscal stimulus, quantitative easing, and other uses of bailout funds - it is not doing everything it should.

        My guess is that the reason that the US government is not doing all it should can be stated in three words: Senator George Voinovich, who is the 60th vote in the Senate - the vote needed to close off debate and enact a bill. To do anything that requires legislative action, the Obama administration needs Voinovich and the 59 other senators who are more inclined to support it. The administration's tacticians appear to think that they are not on board - especially after the recent AIG bonus scandal - whereas the Geithner Plan relies on authority that the administration already has. Doing more would require a legislative coalition that is not there yet.

        We're losing, roughly, 600,000 jobs per month, which is about 20,000 per day. There are many costs associated with job loss, but I wonder how many foreclosures per day are generated from the loss of 20,000 jobs? And that's in addition to the foreclosures we'd have anyway.

        The administration has an obligation to protect people from cyclical fluctuations in the economy, to help them avoid losing their jobs, their houses, and other sources of security. For example, if bank nationalization is the safer path to pursue ex-ante to stabilize the banking system, then that means convincing the 60th vote in the Senate, one way or the other, to support the action. If more fiscal stimulus, or a larger version of the Geithner plan is needed, then there should be no rest until the votes are there. If the "tacticians appear to think that they are not on board," or someone takes the time - as I hope they did - to ask them and finds out that, in fact, they aren't aboard, then do whatever it takes to change that.

        Maybe the effort was there prior to the Geithner plan, and maybe the effort is there now to try to enhance the Geithner plan through legislative authority, to set the stage for a second stimulus in case it's needed, and to change the public perception of what has been done to date. Perhaps a lot of it is behind the scenes, and all that can be done, is being done. Maybe the administration is saving political capital for other things. But prior to the announcement of the Geithner plan, I had the impression that many of the minds within the administration that counted the most were already made up, or if not fully made up that they had a preference for clever market-based solutions (that the public had no hope of understanding, which makes obtaining the public's support much more difficult), and that stood in the way of a true full court press toward nationalization. As for now, I also wonder if concerns within the administration about the deficit are causing hesitation to pursue more aggressive policies. So I'm not so sure that Voinovich was and is (or will be) the only thing standing in the way.

          Posted by on Tuesday, March 31, 2009 at 02:07 AM in Economics, Financial System, Fiscal Policy, Politics | Permalink  TrackBack (0)  Comments (87)


          links for 2009-03-31

            Posted by on Tuesday, March 31, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (36)


            Monday, March 30, 2009

            "Why Bother with Adam Smith?"

            Gavin Kennedy reacts to some of the recent criticism of economists for reading and citing the sacred texts and ancient tomes:

            Thought for the Day - 3, Adam Smith's Lost Legacy: ...There is a debate underway among historians of economic thought on whether economists really need to study the history of ideas in what we may loosely term our discipline. Those economists who take the view that the history of economic ideas really has nothing to do with modern economics, point to it being unnecessary for ‘real scientists’ to read the works of Isaac Newton, and his lesser luminaries, so why bother with Adam Smith and the rest?

            My views on this debate (I have not joined in, so far) are predictable. The physical world is fairly constant – each and every carbon atom is assumed to behave the same way, and has done so through the ages, and unless that changes in known circumstances, its properties and relationships with other atoms are not expected to change. Knowledge gains in hard sciences build upon earlier knowledge gains, and future knowledge gains continue the process.

            Turning to economics – part of human sciences – it is quite different. We hardly know about past economic history; even recent history is controversial and is well short of arriving at a settled view. There are political views of economic behaviours – as far as I know, we do not have ‘leftwing’ or ‘rightwing’ carbon atoms – and we do not have a settled view on what constitutes economic society or on what would constitute a society that could be said to be the basis for all further societies without (controversial) changes.

            Continue reading ""Why Bother with Adam Smith?"" »

              Posted by on Monday, March 30, 2009 at 09:09 PM in Economics, History of Thought, Methodology | Permalink  TrackBack (0)  Comments (16)


              Rodrik: Simon Johnson's Morality tale

              Dani Rodrik responds to Simon Johnson:

              Simon Johnson's morality tale, by Dani Rodrik: Simon Johnson tells a simple and compelling story: the U.S. has been afflicted by a version of the crony capitalism that has been the scourge of so many emerging markets, except that Wall Street has bought its influence and power not by bribery but by shaping the ideology of our times...

              The solution, to Simon, is equally clear.  Finance needs to be cut down to size.  What the U.S. needs is what the IMF would have told any country...

              As with any story built around clear villains easy solutions, there is something in this account that is quite unsatisfying.  For one thing, I think it puts the blame too narrowly on the bankers. Yes, there can be little doubt that banks badly misjudged the risks they were taking on.  But they were aided in all this by the broader economics and policymaking community--not because the latter thought the policies in question were good for bankers, but because they thought these would be good for the economy.  Simon himself says as much.  So why pick on the bankers? Surely the blame must be spread much more widely. 

              And I find it astonishing that Simon would present the IMF as the voice of wisdom on these matters--the same IMF which until recently advocated capital-account liberalization for some of the poorest countries in the world and which was totally tone deaf when it came to the cost of fiscal stringency in countries going through similar upheavals (as during the Asian financial crisis).   

              Simon's account is based on a very simple, and I believe misguided, theory of politics and economics.  It is an odd marriage of populist and technocratic visions.  Countries fail because political elites always end up in bed with economic elites.  The solution, apparently, is to let the technocrats (read the IMF) run your affairs.

              Among the many lessons from the crisis we should have learned is that economists and policy advisors need greater humility.  Too many of us thought we had the right model when it turned out that we didn't.  We pushed certain policies with much greater confidence than we should have.  Over-confidence bred hubris (and the other way around). 

              Do we really want to exhibit the same self-confidence and assurance now, as we struggle to devise solutions to the crisis caused by our own hubris?

              [Dani is generally opposed to a global financial authority. He says "the logic of global financial regulation is flawed." See his article and the discussion at the Rodrik Roundtable.]

                Posted by on Monday, March 30, 2009 at 03:15 PM in Economics, Financial System, International Finance, Regulation | Permalink  TrackBack (0)  Comments (67)


                Rogoff: Brave New Financial World

                Like Edmund Phelps, Kenneth Rogoff is also worried about regulatory overreach in response to the crisis:

                Brave New Financial World, by Kenneth Rogoff, Commentary, Project Syndicate: A huge struggle is brewing within the G-20 over the future of the global financial system. ... In all likelihood, we will see huge changes in the next few years, quite possibly in the form of an international financial regulator or treaty. ...

                The United States and Britain naturally want a system conducive to extending their hegemony..., other countries would like to see more fundamental reform. Russia and China are questioning the dollar as the pillar of the international system. ... These are the calmer critics. ...Czech Prime Minister Miroslav Topolanek, openly voiced the angry mood of many European leaders when he described America's profligate approach to fiscal policy as "the road to hell." He could just as well have said the same thing about European views on U.S. financial leadership.

                The stakes in the debate over international financial reform are huge. The dollar's role at the center of the global financial system gives the U.S. the ability to raise vast sums of capital without unduly perturbing its economy. ...

                More fundamentally, the U.S. role at the center of the global financial system gives tremendous power to U.S. courts, regulators, and politicians over global investment throughout the world. That is why ongoing dysfunction in the U.S. financial system has helped to fuel such a deep global recession. ...

                Fear of crises is understandable, yet without these new, creative approaches to financing, Silicon Valley might never have been born. Where does the balance between risk and creativity lie?

                Although much of the G-20 debate has concerned issues such as global fiscal stimulus, the real high-stakes poker involves choosing a new philosophy for the international financial system and its regulation.

                If our leaders cannot find a new approach, there is every chance that financial globalization will shift quickly into reverse, making it all the more difficult to escape the current morass.

                As I said here in response to an op-ed by Becker and Murphy where they also express concerns about regulatory overreach, my fear is the opposite, that powerful interests will prevent us from taking the steps we need to take:

                While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and [anti-regulation] Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people like Kashyap and Mishkin arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and give us the time to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

                I was talking about the U.S., but the same is true at an international level where change is even harder to coordinate, and the danger that compromise to please all will produce reform that does little to restrict behavior is even greater.

                  Posted by on Monday, March 30, 2009 at 01:17 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (11)


                  Phelps: Financing Dynamism and Inclusion

                  I was asked to post this abridged version of a letter from Edmund Phelps to G-20 leaders:

                  Financing Dynamism and Inclusion, by Edmund S. Phelps: This commentary is based on an open letter sent to Prime Minister Gordon Brown and other leaders of the G-20 ahead of their summit in London on April 2, 2009. The unabridged version of the letter is published here. The letter sums up the main recommendations presented in New York City on February 20 at a conference at Columbia University’s Center on Capitalism and Society. The conference,“Emerging from the Financial Crisis,” brought together distinguished policymakers, bankers, regulators, journalists, and scholars. The list of conference panelists, video excerpts, including Paul Volcker’s luncheon speech, can be found here.  Participants’ presentations, elaborating the conceptual foundations and policy recommendations put forth at the conference, are here.

                  When the G-20 leaders convene in London next week to propose measures to address the global economic crisis, re-regulation of the financial sector will be high on the agenda.

                  Although the need for re-regulation is clear, the key issue is how to design regulation without discouraging funding for investment in innovation in the non-financial business sector. In regulators’ understandable desire to rein in the financial sector’s excesses, there is the danger that policymakers – often pushed by the public – will adopt rules that dampen incentives and competition to the point that the sources of dynamism in the economy are weakened.

                  The need to encourage entrepreneurship and ensure that young people have the opportunity to start new businesses is acute. Even in the usually innovative American economy, dynamism has declined over the current decade, with economic inclusion – high employment rates and careers permitting ordinary people throughout society to flourish – also decreasing.

                  Continue reading "Phelps: Financing Dynamism and Inclusion" »

                    Posted by on Monday, March 30, 2009 at 11:16 AM in Economics, Financial System, International Finance, Regulation | Permalink  TrackBack (0)  Comments (15)


                    Paul Volcker on the Financial Crisis

                    Paul Volcker at the "Emerging from the Financial Crisis" Conference

                    [the video is on continuation page]

                    Continue reading "Paul Volcker on the Financial Crisis" »

                      Posted by on Monday, March 30, 2009 at 11:07 AM in Economics, Financial System, Video | Permalink  TrackBack (0)  Comments (4)


                      Paul Krugman: America the Tarnished

                      The financial crisis has damaged our global authority, credibility, and leadership, and that will make it much harder for the world to accomplish the essential task of coordinating a common response:

                      America the Tarnished, by Paul Krugman, Commentary, NY Times: Ten years ago the cover of Time magazine featured Robert Rubin,... Alan Greenspan,... and Lawrence Summers... Time dubbed the three “the committee to save the world,” crediting them with leading the global financial system through a crisis..., although it was a small blip compared with what we’re going through now.

                      All the men on that cover were Americans, but nobody considered that odd. After all, in 1999 the United States was the unquestioned leader of the global crisis response. ... The United States, everyone thought, was the country that knew how to do finance right.

                      How times have changed..., ... our claims of financial soundness — claims often invoked as we lectured other countries on the need to change their ways — have proved hollow.

                      Indeed, these days America is looking like the Bernie Madoff of economies: for many years it was held in respect, even awe, but it turns out to have been a fraud all along. ...

                      Simon Johnson..., who served as the chief economist at the IMF..., declares that America’s current difficulties are “shockingly reminiscent” of crises in places like Russia and Argentina — including the key role played by crony capitalists.

                      In America as in the third world, he writes, “elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.”

                      It’s no wonder, then, that an article in yesterday’s Times about the response President Obama will receive in Europe was titled “English-Speaking Capitalism on Trial.”

                      Now, in fairness ... the United States was far from being the only nation in which banks ran wild. Many European leaders are still in denial about the continent’s economic and financial troubles, which arguably run as deep as our own... Still, it’s a fact that the crisis has cost America much of its credibility, and with it much of its ability to lead.

                      And that’s a very bad thing... I’ve been revisiting the Great Depression,... one thing that stands out ... is the extent to which the world’s response to crisis was crippled by the inability of the world’s major economies to cooperate.

                      The details of our current crisis are very different, but the need for cooperation is no less. President Obama got it exactly right last week when he declared: “All of us are going to have to take steps in order to lift the economy. We don’t want a situation in which some countries are making extraordinary efforts and other countries aren’t.”

                      Yet that is exactly the situation we’re in. I don’t believe that even America’s economic efforts are adequate, but they’re far more than most other wealthy countries have been willing to undertake. And by rights this week’s G-20 summit ought to be an occasion for Mr. Obama to chide and chivy European leaders, in particular, into pulling their weight.

                      But these days foreign leaders are in no mood to be lectured by American officials, even when — as in this case — the Americans are right.

                      The financial crisis has had many costs. And one of those costs is the damage to America’s reputation, an asset we’ve lost just when we, and the world, need it most.

                        Posted by on Monday, March 30, 2009 at 12:42 AM in Economics, Financial System, International Finance | Permalink  TrackBack (0)  Comments (82)


                        links for 2009-03-30

                          Posted by on Monday, March 30, 2009 at 12:33 AM in Economics, Links | Permalink  TrackBack (0)  Comments (8)


                          Sunday, March 29, 2009

                          Greenspan: Equities Show Us the Way to Recovery

                          Alan Greenspan says that once stocks start to recover, all will be well with the world:

                          Equities show us the way to recovery, by Alan Greenspan, Commentary, Financial Times: Global economic policymakers are currently confronted with their most daunting challenge since the 1930s. ... Counterfactual scenarios are highly problematic to say the least. But there are intriguing possibilities that offer comfort that, if all else fails, the global economy is not on a track towards years of stagnation or worse.

                          In one credible scenario ... lie the seeds of recovery. Stock markets across the globe have to be close to a turning point. Even if a stock market recovery is quite modest, as I suspect it will be, the turnround may well have large (and positive) economic consequences. ...

                          Global losses in publicly traded corporate equities [are]... almost $35,000bn, a decline in stock market value of more than 50 per cent and an effective doubling of the degree of corporate leverage. Added to that are thousands of billions of dollars of losses of equity in homes and losses of non-listed corporate and unincorporated businesses that could easily bring the aggregate equity loss to well over $40,000bn, a staggering two-thirds of last year’s global gross domestic product.

                          This combined loss has been critically important in the disabling of global finance because equity capital serves as the fundamental support for all corporate and mortgage debt and their derivatives. These assets are the collateral that powers global intermediation, the process that directs a nation’s saving into the types of productive investment that fosters growth. ...

                          A rise in global private sector equity will tend to raise the net worth (at market prices) of virtually all business entities. ... In the current environment, new equity will open up frozen markets and provide capital across the globe to companies in general, and banks in particular. Greater equity, after addressing the shortage of bank net worth, will support more bank lending than currently available, enhance the market value of collateral (debt as well as equity), and could reopen moribund debt markets. In short, liquidity should re-emerge and solvency fears recede. ...

                          The substitution of sovereign credit for private credit has helped to fend off some of the extremes of the solvency crisis. However, when we look back on this period, I very much suspect that the force that will be seen to have been most instrumental to global economic recovery will be a partial reversal of the $35,000bn global loss in corporate equity values that has so devastated financial intermediation. A recovery of the equity market, driven largely by a receding of fear, may well be a seminal turning point of the crisis.

                          The key issue is when. Certainly by any historical measure, world stock prices are cheap... The pace of economic deterioration cannot persist indefinitely. ... The current pace of deterioration is bound to slow and with it there should come a lessening of the level of fear. ...

                          As the level of fear recedes, stock market values will rise. Even if we recover only half of the $35,000bn global equity losses, the quantity of newly created equity value and the additional debt it can support are important sources of funding for banks. As almost everyone is beginning to recognise, restoring a viable degree of financial intermediation is the key to recovery. Failure to do so will significantly reduce any positive impact from a fiscal stimulus.

                          Maybe there was a Greenspan put after all?

                            Posted by on Sunday, March 29, 2009 at 02:52 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (52)


                            "King Solomon's Dilemma and Behavioral Economics"

                            David Andolfatto uses mechanism design to help King Solomon solve his dilemma:

                            King Solomon's Dilemma and Behavioral Economics, Macromania:  When the tale of King Solomon's dilemma was first told to me as a kid, I was (like most people, no doubt) left marvelling at Solomon's brilliant solution to a rather difficult predicament.

                            But then I grew up and made the unfortunate choice of pursuing a graduate degree in economics. My mind was left rotted to the point where I could no longer appreciate what most other people continued to believe was the self-evident wisdom of Solomon.

                            The problem with Solomon's "solution" is that it adopts what in modern parlance would be labeled a "behavioral approach." In other words, the solution relies heavily on the assumption that people are "irrational" in a particular sense. It turns out to be easy to be a wise philosopher king when one assumes that everyone else is irrational. Perhaps this is why so many aspiring philosopher kings today want to replace conventional economic theory with what they call "behavioral economics."

                            Let's think about this. The "mechanism" (game) designed by Solomon proposes to split the baby in two (sounds "fair" at least). One women screams out "No! Let the other have the whole baby instead." The other woman coldly agrees to the solution. The real mother is revealed in the obvious manner. What is not so obvious is why the false mother could not have anticipated this outcome; a more clever woman would have simply mimicked the behavior of the true mother. Instead, the false mother fails to make this calculation (and instead adopts a simple "behavioral" strategy; which is just a fancy label for irrational behavior).

                            Now, perhaps there really are "irrational" people like the false mother. But would you be willing to stake a baby's life on this assumption? Even if this mechanism worked out one time, could we reasonably expect it to work in the future (would people not learn from the outcome and tailor their strategies accordingly?). If you believe that people are fundamentally irrational in this sense, then you will make a fine behavioral economist (and a poor philosopher king).

                            So what is the solution to Solomon's dilemma?... [...continue reading...]

                              Posted by on Sunday, March 29, 2009 at 12:15 PM in Economics | Permalink  TrackBack (0)  Comments (21)


                              Micromotives and Macrobehavior

                              Daniel Little on Thomas Hobbes and the microfoundations of aggregate social outcomes. This is related to the discussion below on macroeconomic modeling, though it's more about how such models ought to be constructed than about the usefulness of models per se:

                              Hobbes an institutionalist?, by Daniel Little: Here is a surprising idea: of all the modern political philosophers, Thomas Hobbes comes closest to sharing the logic and worldview of modern social science. In Leviathan (1651) he sets out the problem of understanding the social world in terms that resemble a modern institutionalist and rational-choice approach to social explanation. It is a constructive approach, proceeding from reasoning about the constituents of society, to aggregative conclusions about the wholes that are constituted by these individuals. He puts forward a theory of agency -- how individuals reason and what their most basic motives are. Individuals are rational and self-concerned; they are strategic, in that they anticipate the likely behaviors of other agents; and they are risk-averse, in that they take steps to avoid attack by other agents. And he puts forward a description of two institutional settings within which social action takes place: the state of nature, where no "overawing" political institutions exist; and the sovereign state, where a single sovereign power imposes a set of laws regulating individuals' actions.

                              Continue reading "Micromotives and Macrobehavior" »

                                Posted by on Sunday, March 29, 2009 at 11:07 AM in Economics | Permalink  TrackBack (0)  Comments (5)


                                "What Use is Economic Theory?"

                                Given the discussion below, it seems like a good time to rerun this, a post that was suggested in a comment from Hal Varian:

                                I've weighed in on this debate in this essay. My thesis is that economics should not be compared to physics but to engineering. Or, alternatively, not to biology but to medicine. That is, economics is inherently a "policy science" where the value of an economic theory should be judged according to its contribution to economic policy.

                                There are many who disagree with this view, but hey, let a thousand flowers bloom.

                                Here it is:

                                What Use is Economic Theory?, by Hal R. Varian, August, 1989: Why is economic theory a worthwhile thing to do? There can be many answers to this question. One obvious answer is that it is a challenging intellectual enterprise and interesting on its own merits. A well-constructed economic model has an aesthetic appeal well-captured by the following lines from Wordsworth:

                                Mighty is the charm
                                Of these abstractions to a mind beset
                                With images, and haunted by herself
                                And specially delightful unto me
                                Was that clear synthesis built up aloft
                                So gracefully.

                                No one complains about poetry, music, number theory, or astronomy as being ‘‘useless,’’ but one often hears complaints about economic theory as being overly esoteric. I think that one could argue a reasonable case for economic theory on purely aesthetic grounds. Indeed, when pressed, most economic theorists admit that they do economics because it is fun.

                                But I think purely aesthetic considerations would not provide a complete account of economic theory. For theory has a role in economics. It is not just an intellectual pursuit for its own sake, but it plays an essential part in economic research. The essential theme of this essay that economics is a policy science and, as such, the contribution of economic theory to economics should be measured on how well economic theory contributes to the understanding and conduct of economic policy.

                                Continue reading ""What Use is Economic Theory?"" »

                                  Posted by on Sunday, March 29, 2009 at 12:33 AM in Economics, Methodology | Permalink  TrackBack (0)  Comments (40)


                                  links for 2009-03-29

                                    Posted by on Sunday, March 29, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (23)


                                    Saturday, March 28, 2009

                                    "It Pays to Understand the Mind-Set"

                                    More on the usefulness of quantitative models:

                                    It Pays to Understand the Mind-Set, by Robert J. Shiller, Economic View, NY Times: ...[A] “theory of mind” — defined by cognitive scientists as humans’ innate ability, evolved over millions of years, to judge others’ changing thinking, their understandings, their intentions, their pretenses ... is a judgment faculty, quite different from our quantitative faculties.

                                    In October 1989, I attended a conference at the National Bureau of Economic Research ... on “The Risk of Economic Crisis.” The conference still sticks in my mind because of a paper delivered there by Lawrence H. Summers... I came away with a recognition that a severe contraction, even a depression, could indeed come again. (His and other papers from the conference are here.)

                                    Mr. Summers told a fictional but vivid story of a big financial crisis ... He said that this crisis would be preceded by an enormous stock market boom, bringing the Dow to the unimagined high... Euphoria gripped the investors of his fictional universe. “The notion that recessions were a thing of the past took hold,” Mr. Summers said. ... The popular view was that “with a reduced cyclical element, the future would be even brighter.”

                                    Furthermore, he said, “lawyers and dentists explained to one another that investing without margin was a mistake, since using margin enabled one to double one’s return, and the risks were small given that one could always sell out if it looked like the market would decline.” ...

                                    His fictional account went on to describe the early signs of the crisis, “...problems began to surface,” he said, adding that a “major Wall Street firm was forced to merge with another after a poorly supervised trader lost $500 million by failing to properly hedge a complex position in the newly developed foreign-mortgage-backed-securities market.” He went on to describe how this provocation led to a change in psychology and a market crash and problems in banks and credit markets.

                                    His fiction concluded, “The result was the worst recession since the Depression.”

                                    How did he write a story 20 years ago that sounds so much like what we are experiencing now? It seems that he was looking at factors of human psychology... Mr. Summers evidently knew that an event like our current crisis was waiting to happen, someday.

                                    Ultimately, the record bubbles in the stock market after 1994 and the housing market after 2000 were ... driven by a view of the world born of complacency about crises, driven by views about the real source of economic wealth, the efficiency of markets and the importance of speculation in our lives. It was these mental processes that pushed the economy beyond its limits, and that had to be understood to see the reasons for the crisis.

                                    Of course, forecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.

                                    Still, in our current crisis, we need to try to understand the perils we face. The motivation for a vigorous economic recovery program must come, at least in part, from our forecasts of the dangers ahead. The greatest risk is that appropriate stimulus will be derailed by doubters who still do not appreciate the true condition of our economy.

                                    Exactly how to implement this forecasting technique - one based upon a theory of the mind - is a bit vague.

                                      Posted by on Saturday, March 28, 2009 at 04:05 PM in Economics | Permalink  TrackBack (0)  Comments (17)


                                      Mathematical Formalism in Economics

                                      Roman Frydman responds to the response to the Anatole Kaletsky article, Goodbye, homo economicus:

                                      Your posting of Kaletsky’s article has led to a much overdue discussion of the usefulness of mathematical formalism for understanding market outcomes. This is particularly important as the recent discussions of failures of economic models have focused on specific assumptions, such as incompleteness of markets, contracts or nonlinearities (Willem Buiter), or neo-Keynesian versus new classical approaches (Paul Krugman).

                                      The attached note, which draws heavily on my recent book and subsequent papers with Michael Goldberg, argues that the question of whether and what type of mathematical formalism can help us understand market outcomes in modern capitalism is more subtle than Kaletsky’s critics might have realized.

                                      Here's the note:

                                      What type of mathematical formalism can help us understand market outcomes in modern capitalism?

                                      Mark Thoma reports that the article by Anatole Kaletsky Goodbye, homo economicus, calling for an intellectual revolution in economics, “did not get the best reception here and elsewhere, and there were also protests that arrived by email.”

                                      What really irked Kaletsky’s antagonists was his attack on the use of mathematical formalism in economics. But what has gone completely unnoticed in the subsequent discussion is that Kaletsky’s attack on mathematical formalism focused not on the use of mathematics in economics as such, but on the portrayal by contemporary models of the “market economy as a mechanical system.”

                                      This characterization of contemporary macro and finance models seems uncontroversial. Regardless of whether these models are based on REH or behavioral considerations, they represent the causal mechanisms that supposedly underpin change on individual and aggregate levels through mechanical rules. Thus, they ignore the key feature of modern economies: the fact that individuals and companies engage in innovative activities, discovering new ways of using existing physical and human capital and technology, as well as new technologies and new capital in which to invest.

                                      Moreover, the institutions and the broader social context within which this entrepreneurial activity takes place also change in novel ways. Innovation in turn influences future returns from economic activity in ways that no one, including economists, and market participants, can fully foresee, and thus that do not conform to any rule that can be prespecified in advance.

                                      In our recent book, Imperfect Knowledge Economics (IKE), Michael Goldberg and I trace the empirical failures and fundamental epistemological flaws within the contemporary models of “rational” or “irrational” behavior to a common source: in modeling aggregate outcomes, contemporary economists fully prespecify the causal mechanism that underpins change in real-world markets.

                                      To remedy this flaw, IKE jettisons mechanical models of change and attempts to construct economic models of individual behavior and aggregate outcomes on the basis of qualitative regularities that can be formalized with mathematical conditions. An aggregate model based on such micro-foundations generates only qualitative predictions of market outcomes.

                                      This brings us back to the key question: whether, and if so, some mathematical formalism might be useful in our quest to understand individual behavior and market outcomes.

                                      Continue reading "Mathematical Formalism in Economics" »

                                        Posted by on Saturday, March 28, 2009 at 08:46 AM in Economics, Methodology | Permalink  TrackBack (0)  Comments (25)


                                        links for 2009-03-28

                                          Posted by on Saturday, March 28, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (11)


                                          Friday, March 27, 2009

                                          Why Did Ratings Agencies Fail?

                                          The failure of ratings agencies to properly price the risky securities at the heart of the financial crisis has been attributed to conflict of interest (being paid by the issuers of the assets they are rating) and shopping for the best rating (get more than one rating, then only make public the highest one). However, an objection to these explanations is that these incentives have always existed, yet the problems did not emerge until recently. Thus, any explanation relying upon these incentives must explain why they did not cause problems until recently.

                                          This article says the answer can be found in the complexity of the assets that are being rated. When the assets are very simple, risk assessment is not very complicated and the dispersion of ratings across agencies is very low. Thus, there is no incentive to shop around. In addition, it is hard for the agencies to become beholden to asset issuers and inflate ratings because such behavior would be transparent enough so as to risk losing credibility. That is, people outside the agencies can independently check and verify the ratings easily so any manipulation of the ratings would be easy to discover, and the revelation that their ratings are inflated would damage their credibility and hence their business.

                                          But all of this changes when the assets become more complex. First, because of the complexity the dispersion of ratings across agencies will increase. Thus, even if the mean rating does not change, the variance of the ratings make it worthwhile to pay for more than one rating and cherry pick the best of the lot, i.e. to shop around. (In numerical terms, suppose assets are rated from 1, which is the highest risk category, to 10 which is the safest. A non-complex asset might have a dispersion of, say, 7.95 to 8.05 among a fixed number of ratings agencies, while a complex asset might have ratings running from 6.50 to 9.50. In both cases, assuming a symmetric distribution, the mean is 8, but the rewards to shopping around are quite different).

                                          Second, it is easier for the issuer to capture the rating agency, i.e. for the agency to produce the ratings the company is looking for, because the complexity makes such behavior harder to uncover. The ability of outside observers to uncover such behavior diminishes when the variance of the ratings goes up.

                                          To be more precise about the incentive to shop around, there is a cost to obtaining one more rating, the fee the firm must pay (though the article below implies the firm can escape the fee it if doesn't like the rating it gets). The benefit is the chance that the new, incremental rating will be higher than the ratings already in hand, and this diminishes as more ratings are collected, i.e. there is a declining marginal benefit. If the fee is relatively low, it will be worthwhile to collect many ratings, and the expected rating outcome - the maximum of the ratings - will be higher as more ratings are collected. However, issuers do not necessarily collect ratings from every ratings firm since the expected benefit of an additional rating may not cover the cost. But if the fees are sufficiently low, if the assets are sufficiently complex, and if the number of firms is sufficiently small - a case that may describe the recent market fairly well - a corner solution will emerge, i.e. it always pays - in expected terms - to collect all the ratings available and then make only the best rating public.

                                          The other side of this, though, is that the degree of distortion falls when the number of ratings agencies is small. That is, the expected maximum rating is increasing in the number of ratings collected (though the increase comes at a decreasing rate, that's why there is a declining marginal benefit to collecting another rating). It depends upon the nature of the underlying distributions, but it's possible - and I think likely - that the distortion from this factor was low due to the fact that there were only, effectively, Moody and Standard & Poor operating in these markets (do we count Fitch too?). If so, if the shopping around distortion is relatively minor because the number of firms is small (and that is highly speculative on my part, and based upon the quick reactions scribbled out above rather than days of careful thought), then the alternative explanation that the ratings agencies were beholden to asset issuers should be given more weight as the likely, predominant explanation for the problems in these markets.

                                          In any case, here's the article:

                                          The origin of bias in credit ratings, by Vasiliki Skreta and Laura Veldkamp, voxeu.org: Most market observers attribute the recent credit crunch to a confluence of factors – excess leverage, opacity, improperly estimated correlation between bundled assets, lax screening by mortgage originators, and market-distorting regulations. Credit rating agencies were supposed to create transparency, provide the basis for risk-management regulation, and discipline mortgage lenders and the creators of structured financial products by rating their assets. Understanding the origins of the crisis requires, at least in part, understanding the failures of the market for ratings. Proposed explanations for ratings bias have broadly fallen into three categories.

                                          Continue reading "Why Did Ratings Agencies Fail?" »

                                            Posted by on Friday, March 27, 2009 at 02:34 PM in Economics, Market Failure, Regulation | Permalink  TrackBack (0)  Comments (55)


                                            Paul Krugman: The Market Mystique

                                            What type of financial system should emerge from the crisis?:

                                            The Market Mystique, by Paul Krugman, Commentary, NY Times: On Monday, Lawrence Summers ... responded to criticisms of the Obama administration’s plan to subsidize private purchases of toxic assets. “I don’t know of any economist,” he declared, “who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.” ...

                                            Quite a few economists have reconsidered their favorable opinion of capital markets and asset trading in the light of the current crisis. But it has become increasingly clear ... that top officials in the Obama administration are still in the grip of the market mystique. They still believe in the magic of the financial marketplace and in the prowess of the wizards who perform that magic.

                                            The market mystique didn’t always rule financial policy. America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. ... And the financial system wasn’t just boring. It was also, by today’s standards, small. ... It all sounds primitive... Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

                                            After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. ... And finance became anything but boring. It attracted many of our sharpest minds and made a select few immensely rich.

                                            Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and pureed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

                                            But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

                                            Sooner or later, things were bound to go wrong, and eventually they did. ... Which brings us back to the Obama administration’s approach to the financial crisis.

                                            Much discussion of the toxic-asset plan has focused on the details and the arithmetic, and rightly so. Beyond that, however, what’s striking is the ... administration seems to believe that once investors calm down, securitization — and the business of finance — can resume where it left off a year or two ago.

                                            To be fair, officials are calling for more regulation. ... But the underlying vision remains that of a financial system more or less the same..., albeit somewhat tamed by new rules.

                                            As you can guess, I don’t share that vision. I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.

                                              Posted by on Friday, March 27, 2009 at 12:33 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (85)


                                              Fed Watch: The Fed Understands

                                              Tim Duy on the risks to the Fed's independence, and on whether the Fed's insistence that some actions be conducted in secret "damages the democratic process":

                                              The Fed Understands, by Tim Duy: Willem Buiter (via Yves Smith) argues that the Fed's actions over the past eighteen months has placed its independence at risk:

                                              Without a firm guarantee up front that the Federal government will fully re-capitalize the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

                                              Butier's tone suggests that the Fed is not aware of these risks. But I think the opposite is very much the case - the Fed is agonizing over this issue.  See the Fed-Treasury accord that was issued earlier this week; it is a clear effort on the part of the Fed to firmly establish its independence.  Note also that some policymakers have made clear their concerns about mixing monetary and fiscal policy.  Richmond Fed President Jeffrey Lacker hit on the point this week:

                                              Continue reading "Fed Watch: The Fed Understands" »

                                                Posted by on Friday, March 27, 2009 at 12:33 AM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (11)


                                                links for 2009-03-27

                                                  Posted by on Friday, March 27, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (27)


                                                  Thursday, March 26, 2009

                                                  "The Culture of the Financial Sector Has to Change"

                                                  Sach at The Compulsive Theorist looks at the case for behavioral reform in financial markets, and argues that fixing balance sheets without fixing norms and culture is unlikely to provide a permanent solution to the problems these markets face:

                                                  Why the culture of the financial sector has to change, the Compulsive Theorist: I want to say a little about business and cultural norms in the financial sector, how they affect tangible outcomes we all care about, and why they need to change. Norms are inherently less tangible than items on balance sheets, so it can be hard to see the role they play. I want to focus on norms in the financial sector, but to bring them out of the background I’ll start with a comparison to another field.

                                                  Doctors and bankers are alike in that they can inflict enormous damage by doing a bad job, doctors with a flick of the scalpel, bankers with a click of the mouse. Both are therefore subject to regulation which tries to trade-off costs of enforcement against risk of damage. But there’s a huge difference in the way doctors and bankers view their work. ... [...continue reading...]

                                                    Posted by on Thursday, March 26, 2009 at 06:21 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (28)


                                                    The “Zig Zag Windings of the Flowery Path of Literature”

                                                    The article by Anatole Kaletsky I posted earlier today, Goodbye, homo economicus, did not get the best reception here and elsewhere, and there were also protests that arrived by email. Here's a follow-up on one aspect of the article, the use of formal mathematical models in economics. This article is by David Colander:

                                                    Marshallian General Equilibrium Analysis, by David Colander: In an assessment of Alfred Marshall, Paul Samuelson (1967) writes that “The ambiguities of Alfred Marshall paralyzed the best brains in the Anglo-Saxon branch of our profession for three decades.“ In making this assessment he carried on a tradition of Marshall-bashing that has a long history in economics, dating back to Stanley Jevons and F. Y. Edgeworth, who accused Marshallian economists of being seduced by “zig zag windings of the flowery path of literature.” (Edgeworth, 1925)

                                                    These harsh assessments of Marshall and his approach to economics have had their influence on the modern profession and, other than historians of economic thought, few young economists know much about him. Fewer still would see themselves as Marshallians.[1]

                                                    Today, Marshall is best remembered for his contribution to partial equilibrium supply and demand analysis.[2] For the true economic theorists of the 1990s, however, this contribution is de minimus; the partial equilibrium approach is for novice economists with no stomach for real economic theory—general equilibrium. The profession’s collective view of Marshall in the 1990s is that Marshall is passé--at most a pedagogical stepping stone for undergraduate students, but otherwise quite irrelevant to modern economics.

                                                    Continue reading "The “Zig Zag Windings of the Flowery Path of Literature”" »

                                                      Posted by on Thursday, March 26, 2009 at 04:05 PM in Economics, Macroeconomics, Methodology | Permalink  TrackBack (0)  Comments (19)


                                                      Quick Note

                                                      I'll was on KPFA-FM in Berkeley from 12:00 - 12:30 p.m.(PST) today to talk about the Geithner plan and the financial crisis more generally. The show is archived here.

                                                        Posted by on Thursday, March 26, 2009 at 02:07 PM in Economics | Permalink  TrackBack (0)  Comments (6)


                                                        Fed Watch: Looking for a Bottom

                                                        Are we about to reach bottom? If and when we do, will we bounce back upward and recover, or will we bounce along the bottom in a series of fits and starts as the economy stagnates at a sub-par equilibrium?

                                                        Tim Duy:

                                                        Looking For a Bottom, by Tim Duy: Given the length and depth of the current recession, it is natural for analysts to start looking for a bottom.  In such an environment, bad news will be ignored while the seemingly good news is overblown.  For example, the most recent initial unemployment claims report indicates that labor markets continue to deteriorate; we have yet to see a turning point consistent with improved conditions.  Likewise, the durable goods report was heralded as a positive sign, but the jump in this volatile series needs to be taken in context of the severe drop the previous month.  The chart of nonair/nondefense new orders is not particularly encouraging: 

                                                        032609

                                                        That said, things will eventually get less worse, if only because some sectors, such as new residential housing, will hit a bottom.  And that bottom is not likely to be zero, and, I suspect, that bottom will be late this year or, at worst, early next year.  That should not, however, be confused with an optimistic outlook, as the durability and strength of the eventual recovery is in doubt.  I am confident that the economy will not spiral downward endlessly; I am more worried that the we will be left at a suboptimal equilibrium chiefly characterized by low growth and persistently high unemployment.

                                                        Continue reading "Fed Watch: Looking for a Bottom" »

                                                          Posted by on Thursday, March 26, 2009 at 01:26 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (31)


                                                          Fear and Greed

                                                          A "formalization of Summer's hypothesis":

                                                          Larry Summers on Fear and Greed, macromania:  I used to think that Larry Summers was a reasonable sort of fellow. By here is some evidence proving that spending too much time in administration and politics can rot even the best mind; see White House: Greed Will Help. Here are some quotes:

                                                          "In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying," Summers said Friday in a speech to the Brookings Institution. "Today, however, our problem is exactly the opposite."

                                                          Borrowing, you see, is evidently linked to greed; especially if one borrows too much. I am reminded of university students who mindlessly accumulate too much student debt. The greedy bastards. Or of poor people mindlessly borrowing to finance a home purchase. The greedy SOBs. There is too much borrowing; too much spending; there is too much greed.

                                                          Saving, on the other hand, is evidently linked to fear. Fear is a virtue (as in the fear of God). As when all those virtuous savers bid up the NASDAQ to 5000. Whoops; this doesn't sound right. Perhaps he means saving in virtuous assets, like government treasuries (backed by virtuous/coercive taxation; rather than the prospect of future cash flow from a successful enterprise). Yes, fear is a virtue...unless there is too much fear. Then fear is bad.

                                                          Continue reading "Fear and Greed" »

                                                            Posted by on Thursday, March 26, 2009 at 01:17 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (18)


                                                            What Academic Economists Do and the Need for Better Data

                                                            Let me follow-up on the post below this one with a couple of quick thoughts.

                                                            First, academic economists have taken a lot of grief for not predicting the crisis, but realize that very few academic economists do forecasting. There are two uses of economic and econometric models, one is to use the models to understand how the world works, the other is to use the models to forecast. And while, of course, one of the goals of understanding the economy is to be able to predict it, it is simply not something most academic economists do (and the best models for forecasting are not necessarily the same as the best models for learning about how the economy works). Business economists do lots of prediction and forecasting, but academic economists? Not so much. We come along long after events have occurred - e.g. we're still analyzing the Great Depression to some extent - and try to use those events (as well as data from normal times) to try to understand how the economic world works, how policy can improve performance, etc.

                                                            Second, the economists who do forecasting need better data. If we are we are going to forecast the immediate future accurately, we need data that are timely and informative. There can be big differences between forecasts made using the initial data releases, and those made once the data is revised, often months later. We simply do not have an accurate picture of aggregate activity over, say, the last month or two, even longer in some cases, due to data collection lags and other problems, and without accurate contemporaneous data, it's not possible to produce accurate forecasts (e.g. GDP data are three months old when you get them, and they are revised three months later, then again even later than that though those adjustments tend to be smaller. So we don't get a good picture of GDP until six months after it happens). It's like being asked what the weather will be like tomorrow, but only having weather data that is a month or more old.

                                                            I've been wondering if I should call for enhanced investment in data collection as part of the response to this crisis. However, much of the problem is that the data come from reports that are filed quarterly, annually, etc., and the data collection agencies must wait for those reports before they can produce initial estimates or revisions. Those delays are fairly lengthy relative to our data needs, and it's not clear to me that more money can overcome these lags in the process. Assembling these reports accurately, then interpreting them properly and then turning them into macroeconomic aggregates takes time.

                                                            But there must be some way we can get a better picture of what is going on contemporaneously than we have now, and I think we need to investigate how to make that happen. The data as they exist now are fine for academic researchers who are looking backward and do not necessarily need the very latest months worth of data, though even in this setting this is sometimes a problem, but for forecasting our data are inadequate. Maybe with some investment in the process there would be a way to go out and collect contemporaneous data from all the electronic sources of sales and other information that didn't exist in the past, or to sample more traditional data sources in a more timely fashion. Obviously, I don't have the exact answer to this problem, but I do think it's something we should put some thought into, and if there's a way to do substantially better at getting an accurate picture of the current economy than we have now, something that would be of great benefit to policymakers, forecasters, and people trying to make economic decisions in the private sector, it would be well worth pursuing.

                                                              Posted by on Thursday, March 26, 2009 at 10:44 AM in Economics | Permalink  TrackBack (0)  Comments (38)


                                                              "Goodbye, Homo Economicus"

                                                              Via an email suggestion (there's much, much more in the full version):

                                                              Goodbye, homo economicus, by Anatole Kaletsky:  Was Adam Smith an economist? Was Keynes, Ricardo or Schumpeter? By the standards of today’s academic economists, the answer is no. Smith, Ricardo and Keynes produced no mathematical models. Their work lacked the “analytical rigour” and precise deductive logic demanded by modern economics. And none of them ever produced an econometric forecast (although Keynes and Schumpeter were able mathematicians). If any of these giants of economics applied for a university job today, they would be rejected. As for their written work, it would not have a chance of acceptance in the Economic Journal or American Economic Review. The editors, if they felt charitable, might advise Smith and Keynes to try a journal of history or sociology.

                                                              If you think I exaggerate, ask yourself what role academic economists have played in the present crisis. Granted, a few mainstream economists with practical backgrounds—like Paul Krugman and Larry Summers in the US—have been helpful explaining the crisis to the public and shaping some of the response. But in general how many academic economists have had something useful to say about the greatest upheaval in 70 years? The truth is even worse than this rhetorical question suggests: not only have economists, as a profession, failed to guide the world out of the crisis, they were also primarily responsible for leading us into it. ...

                                                              Academic economists have thus far escaped much blame for the crisis. Public anger has focused on more obvious culprits: greedy bankers, venal politicians, sleepy regulators or reckless mortgage borrowers. But why did these scapegoats behave in the ways they did? Even the greediest bankers hate losing money so why did they take risks which with hindsight were obviously suicidal? The answer was beautifully expressed by Keynes 70 years ago: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

                                                              What the “madmen in authority” heard this time was the distant echo of a debate among academic economists begun in the 1970s about “rational” investors and “efficient” markets. This debate began against the backdrop of the oil shock and stagflation and was, in its time, a step forward in our understanding of the control of inflation. But, ultimately, it was a debate won by the side that happened to be wrong. And on those two reassuring adjectives, rational and efficient, the victorious academic economists erected an enormous scaffolding of theoretical models, regulatory prescriptions and computer simulations which allowed the practical bankers and politicians to build the towers of bad debt and bad policy. ...

                                                              Which brings us to the causes of the present crisis. The reckless property lending that triggered this crisis only occurred because rational investors assumed that the probability of a fall in house prices was near zero. Efficient markets then turned these assumptions into price-signals, which told the bankers that lending 100 per cent mortgages or operating with 50-to-1 leverage was safe. Similarly, regulators, who allowed banks to determine their own capital requirements and private rating agencies to establish the value at risk in mortgages and bonds, took it as axiomatic that markets would automatically generate the best possible information and create the right incentives for managing risks. ...

                                                              The scandal of modern economics is that these two false theories—rational expectations and the efficient market hypothesis—which are not only misleading but highly ideological, have become so dominant in academia (especially business schools), government and markets themselves. While neither theory was totally dominant in mainstream economics departments, both were found in every major textbook, and both were important parts of the “neo-Keynesian” orthodoxy, which was the end-result of the shake-out that followed Milton Friedman’s attempt to overthrow Keynes. The result is that these two theories have more power than even their adherents realise: yes, they underpin the thinking of the wilder fringes of the Chicago school, but also, more subtly, they underpin the analysis of sensible economists like Paul Samuelson.

                                                              The rational expectations hypothesis (REH), developed by two Chicago economists, Robert Lucas and Thomas Sargent in the 1970s, asserted that a market economy should be viewed as a mechanical system that is governed, like a physical system, by clearly-defined economic laws which are immutable and universally understood. Despite its obvious implausibility and the persistent attacks on it, especially from the left, REH has continued to be regarded by universities and funding bodies as the most acceptable foundation for serious academic research. In their recent book Imperfect Knowledge Economics, two American professors, Roman Frydman and Michael Goldberg, complain that “all graduate students of economics—and increasingly undergraduates too—are taught that to capture rational behaviour in a scientific way they must use REH.” In Britain too the REH orthodoxy has remained far more powerful than is often realised. As David Hendry, until recently head of the Oxford economics department, has noted: “Economists critical of the rational expectations based approach have had great difficulty even publishing such views, or maintaining research funding. For example, recent attempts to get ESRC funding for a project to test the flaws in rational expectations based models was rejected. I believe some of British policy failures have been due to the Bank accepting the implications [of REH models] and hence taking about a year too long to react to the credit crisis.” ...

                                                              To make matters worse, rational expectations gradually merged with the related theory of “efficient” financial markets. ... This was the efficient market hypothesis (EMH), developed by another group of Chicago-influenced academics, all of whom received Nobel prizes just as their theories came apart at the seams. EMH, like rational expectations, assumed that there was a well-defined model of economic behaviour and that rational investors would all follow it; but it added another step. In the strong version of the theory, financial markets, because they were populated by a multitude of rational and competitive players, would always set prices that reflected all available information in the most accurate possible way. Because the market price would always reflect more perfect knowledge than was available to any one individual, no investor could “beat the market”—still less could a regulator ever hope to improve on market signals by substituting his own judgment. ...

                                                              Why did such discredited theories flourish? Largely because they justified whatever outcomes the markets happened to decree—laissez-faire ideology, big salaries for top executives and billions in bonuses for traders. And, conveniently, these theories were regarded as the gold-standard by academic economists who won Nobel prizes.

                                                              So what is to be done? There are two options. Either economics has to be abandoned as an academic discipline, becoming a mere appendage to the collection of industrial and social statistics. Or it must undergo an intellectual revolution. ...

                                                              Economics today is a discipline that must either die or undergo a paradigm shift—to make itself both more broadminded, and more modest. It must broaden its horizons to recognise the insights of other social sciences and historical studies and it must return to its roots. Smith, Keynes, Hayek, Schumpeter and all the other truly great economists were interested in economic reality. They studied real human behaviour in markets that actually existed. Their insights came from historical knowledge, psychological intuition and political understanding. Their analytical tools were words, not mathematics. They persuaded with eloquence, not just formal logic. One can see why many of today’s academics may fear such a return of economics to its roots.

                                                              Academic establishments fight hard to resist such paradigm shifts, as Thomas Kuhn, the historian of science who coined the phrase in the 1960s, demonstrated. Such a shift will not be easy, despite the obvious failure of academic economics. But economists now face a clear choice: embrace new ideas or give back your public funding and your Nobel prizes, along with the bankers’ bonuses you justified and inspired.

                                                              Update: Paul Krugman comments on the use of models in Keynes' General Theory.

                                                                Posted by on Thursday, March 26, 2009 at 01:26 AM in Economics, Methodology | Permalink  TrackBack (0)  Comments (87)


                                                                links for 2009-03-26

                                                                  Posted by on Thursday, March 26, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (25)


                                                                  Wednesday, March 25, 2009

                                                                  "Has the Gaming of the Public-Private Partnership Begun?"

                                                                  Yves Smith says things are turning out every bit as badly as she feared:

                                                                  Has the Gaming of the Public-Private Partnership Begun?, Naked Capitalism: It certainly looks as if Citigroup and Bank of America are using TARP funds, not to lend, which was one of the primary goals of the program, but to scoop up secondary market dreck assets to game the public private investment partnership.

                                                                  And it fleeces the taxpayer a second way: the public has spent enough money on both banks so that in an economic sense, they ought to have been nationalized. Yet for reasons that are largely ideological and cosmetic (the banks' debt would need to be consolidated were they owned 100% by Uncle Sam), they remain private. So not only are they seeking to extract far more than was intended even with the already generous subsidies embodied in this program, but this activity is also speculating with taxpayer money.

                                                                  This sort of thing was predicted here and elsewhere. Welcome to yet more looting.

                                                                  From the New York Post (hat tip reader Hendririx):

                                                                  As Treasury Secretary Tim Geithner orchestrated a plan to help the nation's largest banks purge themselves of toxic mortgage assets, Citigroup and Bank of America have been aggressively scooping up those same securities in the secondary market, sources told The Post...

                                                                  But the banks' purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults.

                                                                  One Wall Street trader told The Post that what's been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

                                                                  Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

                                                                  The secondary market represents a key cog in the mortgage market, and serves as a platform where mortgage originators can offload mortgages in bulk that have been converted into bonds.

                                                                  Yields on such securities can be as high as 22 percent, one trader noted.

                                                                  BofA said its purchases of secondary-mortgage paper are part of its plans to breathe life back into the moribund securitization market....

                                                                  While some observers concur that the buying helps revive a frozen market, others argue the banks are gambling away taxpayer funds instead of lending.

                                                                  Moreover, the MBS market has been so volatile during the economic crisis that a number of investors who already bet a bottom had been reached have gotten whacked as things continued to slide.

                                                                  Around this same time last year some of the same distressed mortgage paper that Citi and BofA are currently snapping up was trading around 50 cents on the dollar, only to plummet to their current levels.

                                                                  One source said that the banks' purchases have helped to keep prices of these troubled securities higher than they would be otherwise.

                                                                  Both banks have launched numerous measures to help stem mortgage foreclosures, and months ago outlined to the government their intention to invest in the secondary market to expand the flow of credit.

                                                                    Posted by on Wednesday, March 25, 2009 at 08:01 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (16)


                                                                    The Recession and the Underground Economy

                                                                    How will the recession impact the underground economy?:

                                                                    The Other Chicago School, by Elisabeth Eaves, Forbes: You may think the economic meltdown is hitting bankers and Realtors hard, but spare a thought for members of the underground economy--prostitutes, drug dealers and purveyors of stolen goods, to name just a few participants. That's what sociologist Sudhir Venkatesh does, having spent much of the last 15 years studying, and sometimes living within, the underground economies of New York and Chicago.

                                                                    "The recession is engendering more violence," says Venkatesh, a professor at Columbia University. "There's far greater competition for whatever meager resources there are. The folks down on Wall Street peddling drugs, they're fighting. The sex workers are trying as hard as they can to retain their clients," he says...

                                                                    Venkatesh is watching black market workers slip into despair along with the rest of the population affected by the economy. Lest legal workers consider this a distant problem, one conclusion of Venkatesh's work is that the underground and mainstream economies are intimately entwined. "The boundaries are fluid, particularly in the global city where the black market has become instrumental--one might even say vital--to the overall economy," he says. In New York City illegal workers serve sex, drugs and takeout to the wealthiest members of society--or at least they did until financial sector layoffs began in 2008.

                                                                    The underground economy includes a vast array of people providing services that are off the books but otherwise legal. ... And as business contracts, underground workers face certain problems unique to their status. They have no unemployment insurance or other benefits, and, with little protection from law enforcement, they tend to resolve disputes by physical means. ...

                                                                    Venkatesh is struck by how much the black market resembles the wider society in which it is enmeshed. In the same Parisian banlieues that erupted in riots in 2005, he observed an "almost aristocratic," highly centralized criminal operation. In the ghettos of Chicago, by contrast, he observed underground workers convene an ad hoc court to solve a dispute. His dismisses the "culture of poverty" theory, which suggests that poor blacks in America don't work because they don't value employment. "People in America want to work," he says. They do so ever so industriously, even when they're breaking the law.

                                                                      Posted by on Wednesday, March 25, 2009 at 04:59 PM in Economics | Permalink  TrackBack (0)  Comments (13)


                                                                      Calvo: We Need a Global Lender of Last Resort

                                                                      Guillermo Calvo argues that we need to establish a global lender of last resort (see also "Central Authority Necessary" and Brad DeLong's "We Need a Hegemon Who Won't Drive Us Crazy..."):

                                                                      Lender of last resort: Put it on the agenda!, by Guillermo Calvo, Vox EU: The subprime crisis is a massive failure of the shadow banking system that has affected all corners of the capital market and triggered worldwide deleveraging. We are in a severe credit crunch. Savers distrust private-sector dissavers, which gives rise to a fall in aggregate demand and a search for safe assets (“flight to quality”).

                                                                      Therefore, the first priority should be to increase credit to the private sector. The trouble is that the process of deleveraging – partly explained by the virtual disappearance of investment banks – induces banks to lower their risk exposure. This is evident in the failure to produce noticeable credit expansion, despite bank recapitalisation and the US Federal Reserve’s absorption of commercial paper. Moreover, the credit crunch depresses asset prices and further discourages credit expansion, launching the economy into a vicious cycle.

                                                                      Fiscal stimulus packages are second-best. These packages can help restore liquidity in the private sector and consequently increase capacity utilisation and employment. But rapid effects are unlikely, because output is credit-constrained and liquidity accumulation is time-consuming. Thus, solutions should aim directly at restoring credit availability.

                                                                      Continue reading "Calvo: We Need a Global Lender of Last Resort" »

                                                                        Posted by on Wednesday, March 25, 2009 at 10:08 AM in Development, Financial System, Monetary Policy, Regulation | Permalink  TrackBack (0)  Comments (40)


                                                                        "Wage Theft"

                                                                        The Labor Department is not giving workers adequate protection against "unscrupulous employers":

                                                                        Labor Agency Is Failing Workers, Report Says, by Steven Greenhouse, NY Times: The federal agency charged with enforcing minimum wage, overtime and many other labor laws is failing in that role, leaving millions of workers vulnerable...

                                                                        In a report scheduled to be released Wednesday, the Government Accountability Office found that ... the Labor Department’s Wage and Hour Division, had mishandled 9 of the 10 cases brought by a team of undercover agents posing as aggrieved workers.

                                                                        In one case, the division failed to investigate a complaint that under-age children in Modesto, Calif., were working during school hours at a meatpacking plant with dangerous machinery...

                                                                        When an undercover agent posing as a dishwasher called four times to complain about not being paid overtime for 19 weeks, the division’s office in Miami failed to return his calls for four months, and when it did, the report said, an official told him it would take 8 to 10 months to begin investigating his case.

                                                                        “This investigation clearly shows that Labor has left thousands of actual victims of wage theft who sought federal government assistance with nowhere to turn,” the report said. “Unfortunately, far too often the result is unscrupulous employers’ taking advantage of our country’s low-wage workers.”

                                                                        The report pointed to a cavalier attitude by many Wage and Hour Division investigators... During the nine-month investigation, the report said, 5 of the 10 labor complaints that undercover agents filed were not recorded in the Wage and Hour Division’s database, and three were not investigated. In two cases, officials recorded that employers had paid back wages, even though they had not.

                                                                        The accountability office also investigated hundreds of cases that it said the Wage and Hour Division had mishandled. ...

                                                                        Secretary of Labor Hilda L. Solis said she took the report’s findings seriously. ... Ms. Solis said the Wage and Hour Division planned to increase its staff by a third by hiring 250 investigators — 100 of them as part of the federal stimulus package — “to refocus the agency on these enforcement responsibilities”...

                                                                        Ms. Solis’s predecessor, Elaine L. Chao, often defended the Wage and Hour Division, saying it had concentrated on larger, tougher cases, and secured back wages for more than 300,000 workers a year and collected more than twice as much annually as the division had done in the final years of the Clinton administration.

                                                                        The report concluded that the Wage and Hour Division had mishandled more serious cases 19 percent of the time. ...

                                                                        I don't have the data to answer it, but the obvious question is whether this was any different before the Bush administration. However, the discussion about shifting enforcement to larger employers under Chao makes it appear that it was different, and Chao's defense makes it seem like taking on big versus small employers is an either-or choice, but it's not. If Republicans had wanted to increase the budget to allow effective enforcement of labor law on behalf of workers at both large and small employers, they could have. It's not like the Democrats would have opposed more effective minimum wage enforcement, or other such proposals. It was a matter of priorities, and this wasn't deemed important enough to draw additional budgetary resources from other purposes (if they thought about it much at all). Hopefully that will change, and the additional investigators that will be hired as well as the change in leadership and direction within the agency is a start to that process.

                                                                          Posted by on Wednesday, March 25, 2009 at 02:07 AM in Economics, Regulation | Permalink  TrackBack (0)  Comments (65)


                                                                          links for 2009-03-25

                                                                            Posted by on Wednesday, March 25, 2009 at 12:24 AM in Economics, Links | Permalink  TrackBack (0)  Comments (27)


                                                                            "A Song, A Plea"

                                                                            My daughter (who's about to stimulate the Sacramento economy with the purchase of her first house) passes this along:

                                                                              Posted by on Wednesday, March 25, 2009 at 12:15 AM in Economics, Video | Permalink  TrackBack (0)  Comments (2)


                                                                              It's a Zoo Out There. Or Maybe Not.


                                                                              [via Discover]

                                                                                Posted by on Wednesday, March 25, 2009 at 12:06 AM in Economics, Fiscal Policy, Unemployment, Video | Permalink  TrackBack (0)  Comments (2)


                                                                                Tuesday, March 24, 2009

                                                                                Sachs: Will Geithner and Summers Succeed in Raiding the FDIC and Fed?

                                                                                Chris Carroll supports the Geithner plan, but I don't think we can say the same about Jeff Sachs:

                                                                                Will Geithner and Summers Succeed in Raiding the FDIC and Fed?, by Jeffrey Sachs, Vox EU: Geithner and Summers have now announced their plan to raid the Federal Deposit Insurance Corporation (FDIC) and Federal Reserve (Fed) to subsidize investors to buy toxic assets from the banks at inflated prices. If carried out, the result will be a massive transfer of wealth -- of perhaps hundreds of billions of dollars -- to bank shareholders from the taxpayers (who will absorb losses at the FDIC and Fed). Soaring bank share prices on the morning of the announcement, and in the week of leaks and hints that preceded it, are an indication of the mass bailout at work. There are much fairer and more effective ways to accomplish the goal of cleaning the bank balance sheets.

                                                                                Here’s how it works

                                                                                A major part of the plan works as follows. One or more giant investment funds will be created to buy up toxic assets from the commercial banks. The investment funds will have the following balance sheet. For every $1 of toxic assets that they buy from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the remaining balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the toxic assets purchased by private investors fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the toxic assets.

                                                                                Taxpayer giveaway explained with a numerical example

                                                                                To understand the essence of the giveaway to bank shareholders, it's useful to use a numerical illustration. Consider a portfolio of toxic assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The market value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, which sums to $360 billion. The assets therefore currently trade at 36 percent of face value.

                                                                                Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC loan. The FDIC is giving a "heads you win, tails the taxpayer loses" offer to the private investors.

                                                                                Specifically, the FDIC is lending money at a low interest rate and on a non-recourse basis even though the FDIC is likely to experience a massive default on its loans to the investment funds. The FDIC subsidy shows up as a bid price for the toxic assets that is far above $360 billion. In essence, the FDIC is transferring hundreds of billions of dollars of taxpayer wealth to the banks.

                                                                                Back of envelope calculation: $276 billion

                                                                                With a little arithmetic, we can calculate the size of that transfer. In this scenario, the private investors (who manage the investment fund) will actually be willing to bid $636 billion for the $360 billion of real market value of the toxic assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders! Here's why.

                                                                                Under the rule of the Geithner-Summers Plan, the investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion. The FDIC will loan $546 billion. (All numbers are rounded). If the toxic assets actually pay out the full $1 trillion, there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.

                                                                                Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP's expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.

                                                                                The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the toxic assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is "underwater" (holding more in FDIC debt than in payouts on the toxic assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.

                                                                                You know it’s a bank shareholder bailout when …

                                                                                Soaring bank stock prices during the last week, and then again on the day of the announcement, demonstrate the bailout in action. From March 9 to March 20, the KBW bank index rose by 33 percent, while the overall Dow Industrials rose by only 11 percent, indicating how the rumors were especially good for the banks. This morning, bank shares across the board soared in value. Citibank has tripled in value since its low in early March. The value of the bailout dwarfs the AIG and Merrill bonuses, but since the bailout is much less obvious than the bonuses, the public's reactions have been muted, at least at the start.

                                                                                A better plan

                                                                                The plan should not go forward on such unfair terms. Under the law, Congress should apply the Federal Credit Reform Act of 1990, which requires budget appropriations to cover expected losses on government loans programs, which would presumably include the expected losses on FDIC and Treasury loans under the Geithner-Summers Plan. With proper credit accounting, the entire operation in our little illustration would require a budget appropriation of $276 billion, equal to the expected losses of the FDIC and Treasury. If the Administration goes to Congress for such an appropriation it will be shot out of the water. The public will not accept overpaying for the toxic assets at taxpayers' expense. Thus, it is very likely that the Administration will attempt to avoid Congressional oversight of the plan, and to count on confusion and the evident "good news" of soaring stock market prices to justify their actions.

                                                                                The Geithner-Summers plans for the FDIC are not the only off-budget transfers to bank shareholders taking place. Other parts of the plan support subsidized loans from the Treasury and, even more, from the Fed. The Fed is already buying up hundreds of billions of dollars of toxic assets with little if any oversight or offsetting appropriations. Since the Federal Reserve profits and losses eventually show up on the budget, the Fed's purchases of toxic assets also should fall under the Federal Credit Reform Act and should be explicitly budgeted.

                                                                                There are countless preferable and more transparent courses of action. The toxic assets could be sold at market prices, not inflated prices, making the bank shareholders bear the costs of the losses of the toxic assets. If the banks then need more capital, the government could invest directly into bank shares. This would bail out the banking system without bailing out the bank shareholders. The process would be much fairer, less costly, and more transparent to the taxpayer.

                                                                                Take insolvent banks into receivership instead: a bailout needs a workout plan

                                                                                Banks that are already insolvent should be intervened directly by the FDIC, that is temporarily taken into receivership. The shareholder value would be wiped out, except perhaps for some residual claims in the event that the toxic assets vastly outperform their current market expectations.

                                                                                As I've written before, the allocation of bank shares between the taxpayers and the current bank shareholders could be make contingent on the eventual value of the toxic assets, ensuring fairness between the shareholders and the taxpayers.

                                                                                  Posted by on Tuesday, March 24, 2009 at 08:19 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (23)


                                                                                  "Why are we Bailing Out Foreigners?"

                                                                                  Ben Bernanke, via Andrew Leonard, explains why U.S. tax dollars were used to bail out foreign banks:

                                                                                  Why are we bailing out foreigners?, by Andrew Leonard: Why did American taxpayer money help AIG pay its debt to foreign counterparties? Representatives from both parties raised the question during Tuesday's House Financial Services committee hearing on AIG. On the surface, the question seems perfectly reasonable. Why are American taxpayers bailing out foreign companies? Shouldn't their own governments be taking responsibility for their welfare? ...

                                                                                  Few people seem inclined to accept that as far as the global financial system is concerned, there's really not that much difference between foreign and domestic financial institutions -- the web of interconnections tying all the big players together is so tangled and intricate that if one link in the chain goes down, everyone stands a chance of collapsing. (And yes, that's a bug, not a feature.) If the goal is preventing systemic collapse, then everybody gets bailed out, regardless of jurisdiction. But Bernanke followed up an answer along those lines with an even more effective riposte: Hey, Europe has been bailing us out too!

                                                                                  BERNANKE: ...The critical issue was, was AIG going to default and create enormous chaos in the financial markets, or was it going to meet all of its obligations, including those to foreign counterparties?

                                                                                  I would point out that the Europeans have also saved a number of major financial institutions. And the issue of whether those institutions owed American companies money has not come up. So I think that there is a sense that we all have the obligation to address the problems of companies in our own jurisdictions.

                                                                                  In particular, the Europeans could appropriately point out that it was under U.S. regulation or lack of regulation and U.S. law that AIG failed. And in their sense, we do bear some responsibility.

                                                                                  Good answer. ... All in all, I thought Ben Bernanke had a pretty good day on Monday -- he's clearly gotten more comfortable dealing with rampant Congressional irrationality over the last two years. ... And when he claimed that after learning of the AIG bonuses he wanted to file suit to stop the payments, he sounded believable.

                                                                                  This is another case (DeLong response) where having procedures worked out in advance can help with both the politics and the economics. It's best if we don't have to waste time bickering over who should pay for what while the economies of both countries are going down in flames, and policies made in the heat of the moment aren't always the best policies, particularly when they are made in combative political environments. But all of that can be avoided if the polices are thought through carefully and dispassionately in advance, and have the approval of the appropriate authorities.

                                                                                    Posted by on Tuesday, March 24, 2009 at 06:03 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (16)


                                                                                    Dissent on "Which Plan is Best": Why a Second Best Plan May not be Good Enough

                                                                                    Sach Mukherjee disagrees with my mild support of the Geithner plan. He's worried that if we let this window of opportunity for reform go by without making major changes - and going with the Geithner plan is, he believes, a step in that direction - then we are headed for an even bigger disaster than we have now at some point in the future:

                                                                                    Why a second best bailout may not be good enough, by The Compulsive Theorist: It’s not often I find myself disagreeing with Mark Thoma, but on the issue of the Geithner bailout plan I think I do. Thoma is a careful and reasoned writer, so what comes below I say cautiously, but nonetheless with some conviction.

                                                                                    Continue reading "Dissent on "Which Plan is Best": Why a Second Best Plan May not be Good Enough" »

                                                                                      Posted by on Tuesday, March 24, 2009 at 01:53 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (17)


                                                                                      "Will the Geithner Plan Work?"

                                                                                      The question is, "Will the Geithner plan work?" There are responses from Paul Krugman, Brad DeLong, Simon Johnson, and me:

                                                                                      How to Tell It’s Working, by Mark Thoma, Room for Debate, NY Times Blogs: A bailout plan must do two things to be effective. It must remove toxic assets from bank balance sheets, and it must recapitalize banks in a politically acceptable manner. I believe the Geithner plan has a chance of doing both of these things, but it’s by no means a sure bet that it will.

                                                                                      How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem. If the free insurance against downside risk that comes with the non-recourse loans the government is offering doesn’t induce sufficient private sector participation, then it will be time to end the Geithner bank bailout. Even if increasing the insurance giveaway would help, legislative approval would be unlikely and the political fight that would ensue would hurt the chances for nationalization.

                                                                                      The second factor to watch is the percentage of bad loans the government makes as part of the program. These non-recourse loans are the source of the free insurance against downside risk. Borrowers can walk away if there are large losses, and if the number of bad loans is unacceptably high (a potential political nightmare), then policymakers will need to act quickly and pull the plug on the program.

                                                                                      Unfortunately, however, the loan terms make it unlikely that we’ll have timely information on the percentage of bad loans. But there is something else we can watch to assess the health of the loans: the price of the toxic assets purchased with the loans. If the price of these assets is increasing sufficiently fast, then the loans will be safe. But if the prices do not respond to the program, then the loans will be in trouble.

                                                                                      In that case, we will need to end the program as quickly as possible and minimize losses. The next step will have to be bank nationalization, though the political climate will be difficult. Sticking with the plan until it completely crashes and burns on the hope that a little more time is all that is needed will make nationalization much more difficult.

                                                                                      [The discussion is supposed to continue through today.]

                                                                                      Update: I made similar points in a discussion at Foreign Policy (which is based upon this post):

                                                                                      There were three plans to choose from: the original Paulson plan in which the government buys bad paper directly, the Geithner plan in which the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, and outright nationalization.

                                                                                      So which plan is best? Any plan that does two things -- removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner -- has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has the two necessary features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. This option also comes with its own set of political problems -- problems that will worsen if the loans to private sector "partners" turn out to be as bad as some fear. Finally, the plan for nationalization also includes these two features, but it suffers from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives (though not everyone agrees with this assertion).

                                                                                      I am not wedded to a particular plan. Each has its good and bad points. Sure, some seem better than others, but none is so off the mark that I am filled with despair because we are following a particular course of action.

                                                                                      Thus, I am willing to get behind this plan and to try to make it work. It wasn't my first choice; I still think nationalization is better overall. But trying to change the plan now would delay the rescue for too long, and more delay is not something we dare risk at this point.

                                                                                      Update: A second entry at the NY Times blog:

                                                                                      Random Actions on Failing Banks, by Mark Thoma: Mark Thoma responds to Simon Johnson:

                                                                                      One of Simon Johnson’s points is very much worth emphasizing. When this crisis hit, we did not have the procedures in place for an orderly resolution for banks that were failing. Thus, because there were no well known procedures to follow, the actions that the government took when faced with a failing bank appeared ad hoc, almost random, because they were constructed on the fly to deal with problems at individual banks.

                                                                                      The first thing we need to do is to change the regulatory structure so that banks cannot get too big and too interconnected to fail. When they are too big, their failure puts policymakers and the public in a position where there is no resolution that can confine the costs to those who were responsible for the problem. The dynamic is bad both ways: If the bank is allowed to fail, people who did nothing to cause the crisis are hurt. But if the bank is saved the people responsible are let off the hook at taxpayer expense, at least to some degree, and that brings up issues of both moral hazard and equity.

                                                                                      But despite our best efforts, banks may become too large or too interconnected anyway, particularly if the interconnections are not transparent until trouble hits, and that’s where we need to do much, much better than we did in the present crisis. We need to have procedures available to resolve problems that are backed with a credible enforcement threat so that everyone understands in advance exactly what will happen to institutions that are deemed insolvent. We simply cannot repeat the uncertainty generating ad hoc, case by case approach that was used in the present case.

                                                                                      [And Brad DeLong has a second entry responding to Paul Krugman.]

                                                                                        Posted by on Tuesday, March 24, 2009 at 09:54 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (25)


                                                                                        Fed Watch: Fed-Treasury Accord

                                                                                        Tim Duy on the Fed's efforts to maintain its independence:

                                                                                        Fed Treasury Accord, by Tim Duy: The Fed and Treasury released a joint statement yesterday afternoon that was lost amid the official release of the Geithner Plan (hat tip Across the Curve).  Clearly, it reveals the concerns of the Federal Reserve that its expansive role in the crisis will eventually threaten monetary independence, and thus wants that right/privilege reasserted:

                                                                                        The Federal Reserve's independence with regard to monetary policy is critical for ensuring that monetary policy decisions are made with regard only to the long-term economic welfare of the nation.

                                                                                        The need for such a statement was heightened by last week's FOMC decision to expand the balance sheet via outright purchases of Treasury securities (in addition to mortgage backed securities).  Considering the massive amount of red ink fiscal authorities are expected to spill for the foreseeable future, the Fed's action could be interpreted as the first salvo in a campaign to monetize deficit spending. I do not believe that this is the interpretation the Fed intends.   Indeed, I believe this is one reason the Fed has shied away from the term "quantitative easing."  Note Bernanke & Co. always place the expansion of the balance sheet in terms of the improving the functioning of private capital markets. See Federal Reserve Chairman Ben Bernanke's speech last Friday:

                                                                                        These purchases are intended to improve conditions in private credit markets. In particular, they are helping to reduce the interest rates that the GSEs require on the mortgages that they purchase or securitize, thereby lowering the rate at which lenders, including community banks, can fund new mortgages.

                                                                                        The stated intent is not supporting fiscal stimulus, creating inflationary expectations, nor even fighting deflation.  The Fed expects they will withdraw their extraordinary liquidity operations when financial conditions stabilize (see Monday's Wall Street Journal).  They expect they will have the political freedom to do so; but the deeper they delve into financial markets, the more politicized their activities become. 

                                                                                        The broad points, with my comments:

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                                                                                          Posted by on Tuesday, March 24, 2009 at 12:42 AM in Economics, Fed Watch, Fiscal Policy, Monetary Policy | Permalink  TrackBack (0)  Comments (10)


                                                                                          Dissent on "Which Plan is Best?": Dark Musings

                                                                                          This is from Steve Waldman at Interfluidity. I have a few comments at the end:

                                                                                          Dark musings, by Steve Waldman: I often wish I were Mark Thoma. If I were Mark Thoma, I could be smart and paying attention without being bitter.

                                                                                          So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

                                                                                          Unfortunately, I have a darker temperament, a spirit less generous and optimistic than Mark's. I am filled with despair, not because what we are doing cannot "work", but because it is too unjust. This is not my country.

                                                                                          The news of today is the Geithner plan. I think this plan might work very well in terms of repairing bank balance sheets.

                                                                                          Of course the whole notion of repairing bank balance sheet is a lie and misdirection.

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                                                                                            Posted by on Tuesday, March 24, 2009 at 12:33 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (19)


                                                                                            "Neoclassical Economics: Mad, Bad, and Dangerous to Know"

                                                                                            I can't say I agree with every word of this, but given what just happened to the economy and our general failure to see the signs that it was coming, it's a good time to hear alternative viewpoints about the state of the discipline:

                                                                                            Neoclassical Economics: mad, bad, and dangerous to know, by Steven Keen: The whole of the most recent Real World Economics Review (formerly known as the Post-Autistic Economics Review) is devoted to the question of “How should the collapse of the world financial system affect economics?”. My paper, which led volume 49, is reproduced below. ...

                                                                                            The most important thing that global financial crisis has done for economic theory is to show that neoclassical economics is not merely wrong, but dangerous, by Steven Keen: Neoclassical economics contributed directly to this crisis by promoting a faith in the innate stability of a market economy, in a manner which in fact increased the tendency to instability of the financial system. With its false belief that all instability in the system can be traced to interventions in the market, rather than the market itself, it championed the deregulation of finance and a dramatic increase in income inequality. Its equilibrium vision of the functioning of finance markets led to the development of the very financial products that are now threatening the continued existence of capitalism itself.

                                                                                            Simultaneously it distracted economists from the obvious signs of an impending crisis—the asset market bubbles, and above all the rising private debt that was financing them. Paradoxically, as capitalism’s “perfect storm” approached, neoclassical macroeconomists were absorbed in smug self-congratulation over their apparent success in taming inflation and the trade cycle, in what they termed “The Great Moderation”... [...continue reading...]

                                                                                              Posted by on Tuesday, March 24, 2009 at 12:24 AM in Economics, Methodology | Permalink  TrackBack (0)  Comments (26)


                                                                                              links for 2009-03-24

                                                                                                Posted by on Tuesday, March 24, 2009 at 12:15 AM in Economics, Links | Permalink  TrackBack (0)  Comments (54)


                                                                                                Monday, March 23, 2009

                                                                                                "Which Plan is Best?" Follow-Up: Who Can At Least Tolerate the Geithner Plan?

                                                                                                James Surowiecki reacts to the post "Which Plan is Best?":

                                                                                                Who Can At Least Tolerate the Geithner Plan?, by James Surowiecki: Most of what’s been written about Tim Geithner’s plan ... has been, unsurprisingly, negative, since Geithner’s plan does not involve the preferred solution of most bloggers and pundits: nationalizing the banks. But there are some interesting exceptions. The most useful post in terms of understanding the thinking behind the plan is Brad DeLong’s FAQ. ... And Mark Thoma of Economist’s View, who is actually an advocate of nationalization, has nonetheless written two excellent posts explaining why there are problems in the market for toxic assets and why the Geithner plan, while not ideal, could work in solving them.

                                                                                                Thoma’s conclusion to his second post, which comes after his analysis of three options for dealing with the banking system (the original Paulson plan, nationalization, and now the Geithner plan) is especially interesting:

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                                                                                                  Posted by on Monday, March 23, 2009 at 06:12 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (17)


                                                                                                  "Which Plan is Best?" Follow-Up: Some Positive Comments on the Geithner Toxic Plan

                                                                                                  Calculated Risk on "Which Plan is Best?":

                                                                                                  Some Positive Comments on the Geithner Toxic Plan: From Mark Thoma at Economist's View: Which Bailout Plan is Best?

                                                                                                  ... I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear.
                                                                                                  ...
                                                                                                  I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

                                                                                                  I tend to agree with Mark on this. The Geithner plan is suboptimal, but it is probably the best we can get in the current environment. I'd add a caveat: this plan is easy for the banks to game or arb - and if a bank is caught gaming this plan, the AIG bonus flap will seem like a light Summer breeze.

                                                                                                  Continue reading ""Which Plan is Best?" Follow-Up: Some Positive Comments on the Geithner Toxic Plan " »

                                                                                                    Posted by on Monday, March 23, 2009 at 06:03 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (11)


                                                                                                    "Toxic Car" Follow-Up: The Role of Regulatory Capture and Incentives

                                                                                                    Sachi Mukherjee follows up on the toxic car analogy:

                                                                                                    On toxic cars, by The Compulsive Theorist: Mark Thoma comes up with a terrific analogy for the issues around "toxic" assets held by financial institutions. Among other things, he gives a particularly clear explanation of the Paulson, Geithner and "Swedish" plans for dealing with these assets.

                                                                                                    Thoma concludes with the important point that even if a government intervention loses the taxpayer money on the toxic assets themselves, it may still in a broader sense be a good strategy, once we account in our risk function for the high probability of very severe economic disruption absent any intervention.

                                                                                                    Suppose we agree, on these grounds, that some intervention is better than no intervention, even if it loses the taxpayer money in the narrow sense of a book loss on the toxic assets. The question then shifts to which of the plans on offer is best (or least bad)?

                                                                                                    Continue reading ""Toxic Car" Follow-Up: The Role of Regulatory Capture and Incentives" »

                                                                                                      Posted by on Monday, March 23, 2009 at 02:43 PM in Economics, Financial System, Policy, Regulation | Permalink  TrackBack (0)  Comments (6)