Economist's View

Bankslaughter?

Paul Collier says we should hold financial institutions responsible for reckless behavior if we want to temper their inclination to take excessive risk:

A law to tame wild bankers, by Paul Collier, Commentary, CIF: Deregulation of the banks was built on two intellectual pillars. One was that regulation was not necessary because banks would self-regulate in order to protect their reputation. Please stop laughing. The other was that regulation would not work because regulators would always be one step behind the bankers. And unfortunately we cannot laugh this one off. Indeed, the technical problems facing regulation are now compounded by political impediments. Green shoots, lobbying by the banks, and turf wars among the regulators have eroded the momentum for action. So if banks cannot effectively be regulated by the authorities, what can be done?

The Turner review came up with two solutions. One is radically to raise the capital requirements of banks so that shareholders have something to lose if management goes wrong. The other is to change incentive payments for managers so bonuses depend on the past three years of performance. The increase in capital requirements makes sense. But the three-year rule is weak. The inherent problem facing shareholders is that incentive payments cannot go negative. However much damage a manager inflicts, wiping out both shareholders and depositors, the consequences cannot be remotely commensurate. As a result, even bonuses with a three-year lag bias the system towards risk-taking. If you thought big bonuses were history you have missed BAB, the new banking mnemonic: yes, Bonuses Are Back.

So how can we avoid another Northern Rock? While shareholders cannot impose genuine penalties, governments can. Fear of jail would discourage excessive risk. Before bankers huff about blunting incentives, yes, I realise that without carrots, bankers will just sit and gaze at the office ceiling. Bankers, set your minds at rest: the introduction of penalties would permit BABEL: that is, the carrots for genuinely smart behaviour could be Even Larger.

The key problem with using the law against bankers has been the difficulty of getting a conviction: surely, the managers of Northern Rock did not intend to profit at our expense. We do not need to set the burden of proof that high. Intention misses the point. Faced with a corpse and a killer, police do not need to prove ill intent: manslaughter sets the hurdle lower than murder. It is enough to show the killer was irresponsible. That is the standard we need; we need a crime of managing a bank irresponsibly: in other words, bankslaughter.

On Turner's proposal a manager can still benefit from recklessness – as long as the bank does not blow up within three years. After that, if the bank crashes he can be off playing golf. With bankslaughter, when the bank blows up – even if it is a decade later – a criminal investigation traces back to determine whether crucial decisions were reckless. If a reasonable banker faced with the information available at the time would not have taken those risks, the person responsible is dragged off the golf course and jailed.

Once bankslaughter was on the books, bonuses would be less dangerous. Managers would have to weigh the balance between risk and return and take defensible decisions. I doubt hyper-caution would be a problem: the overly cautious would not get bonuses. Surely we can rely on our bankers to exhibit the necessary degree of greed.

Bankslaughter would target the wild fringe rather than the average banker. The wild fringe matters: sometimes it generates a crisis that becomes systemic. We now know that as early as 2004, the Bank of England anticipated that Northern Rock would implode. Its business model was so risky that other banks had not adopted it. But in the short term, reckless behaviour looks smart, and so wiser management teams were coming under pressure to emulate it. By the time of its demise, the Rock was doing a fifth of British mortgages.

By curtailing the wild fringe, bankslaughter would complement Turner's approach, which is to make the average bank behave better. Both are needed. Turner's concern about performance is manifestly necessary. But the crisis has revealed that some banks are more rotten than others. In Britain, the two Scottish banks and Northern Rock were pioneers of imprudence. In Ireland two banks run by an alliance of construction firms and politicians swept the country to ruin. Even if shareholder capital is at risk, some banks are likely to suffer because of poor corporate governance.

Had bankslaughter been on the books, the management of Northern Rock would now perhaps be in the dock. But, vengeful as we feel, the point of criminal sanction would not be to punish reckless behaviour but to discourage it. If this law had existed, would our financial knights have been so errant?

Do Tipping Points Exist?

Are tipping points "mythological"?:

The Tipping Point: Fascinating but Mythological?, by William Easterly: The “tipping point” is a popular concept covering a whole range of phenomena (and a best-selling book by Malcolm Gladwell) where individual behavior depends on the behavior of the herd.

Its original application was to racial segregation. Nobel Laureate Thomas Schelling developed a beautifully simple model for this. Suppose that whites have different degrees of racism – some would “tolerate” higher shares of nonwhites than others. Schelling showed that the less racist whites would still wind up exiting during tipping because of a chain reaction. At first only the most extreme racist whites exit. But their departure causes the white share to go down, making the second most extreme racist whites uncomfortable, so they also exit. The white share goes down some more, and so now even less racist whites will be uncomfortable being a white minority, and they will wind up exiting too. So the remarkable prediction of the tipping point model is that just a little bit of integration that directly bothered only the most racist whites wound up causing ALL of the whites to exit. So even if the typical white was perfectly happy with integrated neighborhoods, these neighborhoods would be so unstable that the final outcome would be extreme racial segregation. ...

It’s easy to imagine development applications for the tipping point idea. Suppose that people decide to get highly educated based on what is the share of highly educated people in the population. After all, it’s only worthwhile being educated if you can talk to and work with a lot of other highly educated people. If the share of educated people falls below a tipping point, a lot of people will stop getting highly educated, which decreases even further the incentive to get highly educated, and we get the same kind of chain reaction... Assuming that low education causes poverty, this is a “poverty trap” story of low education and underdevelopment.

The tipping point stories are fascinating, but do we observe them in the real world? I got intrigued with this question a while ago, and eventually published a paper testing the predictions of the tipping point story (ungated version here) for its original application: racial segregation of US neighborhoods (reminder to self: my job is not only to blog, also to be a full time academic researcher that must “publish or perish”). The basic prediction is that mixed neighborhoods are unstable but segregated neighborhoods are stable. Data on American neighborhoods from 1970 to 2000 rejected these predictions – it was the segregated neighborhoods that were unstable. There was as much “white flight” out of all-white neighborhoods as there was out of mixed neighborhoods, and there was a white influx into segregated nonwhite neighborhoods. Neighborhoods are still very segregated in the year 2000, but not because of tipping. ...

Of course, this is only one test of the tipping point for racial segregation over one time period. Maybe the tipping point is real in other contexts. But think twice and check for evidence before you accept popular stories like the Tipping Point.

Did Greenspan Make a Mistake in 2001-2004 by Keeping Too Rates Low?

David Beckworth says Brad DeLong can quit wondering, Greenspan's "low interest rate policy in the early-to-mid 2000s was truly a mistake" [Update: see Brad Delong for more]:

Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake, by David Beckworth: Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s... You ... cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity as can be seen in the figure...

Should We Pop Bubbles?

This may help Brad DeLong settle his inner conflict over whether Greenspan made an error by not moving interest rates to limit the housing boom. Guillermo Calvo and Rudy Loo-Kung argue that the benefits of bubbles almost always outweigh their costs (and thus there's no need for regulation to prevent them).

I think the authors are correct to point out that distributional issues are omitted from the analysis. Also, the assumption that social welfare depends only upon consumption is important as it rules out any utility costs associated with losing a home, a job, changing schools, etc. over and above the loss of consumption. In addition, using the aggregate consumption level of a composite commodity to index social welfare doesn't capture the costs associated with producing the subotimal mix of goods (e.g. too much housing, not enough of other goods), all that matters is the total quantity that is produced and consumed. Finally, I was surprised that the downturn and upturn phases of the cycle were assumed to be of equal length as I thought a slower return to normal growth (as compared to the downturn) - something that would increase the costs of the collapse - was the normal scenario:

Should we rush to further regulate financial institutions?, by Guillermo Calvo and Rudy Loo-Kung, Vox EU:

‘Tis better to have loved and lost,
Than never to have loved at all.
Tennyson, 1850.

In times of systemic financial distress, hunting for culprits becomes a popular sport. The Madoffs of this world are easy targets because crisis makes crookery harder to conceal. While there is no question that crooks should be sent to jail, increasing financial regulation is a different issue and requires careful analysis. Rushing to impose tighter regulations may hamper recovery and growth. Empirical evidence strongly supports the view that growth and financial development go hand in hand (Demirgüç-Kunt and Levine 2008). Although it is much harder to establish that financial development causes growth, few would doubt that, at least temporarily, financial deregulation could promote higher growth. A genuine concern, however, is that the financial sector is prone to crises, which are typically associated with serious effects on output and employment.

We cannot reach definite conclusions about the desirability of risky financial arrangements in a short column. Our objective is much more modest. We examine the welfare implications of financial deregulations that result in higher growth but end in tears and perform the exercise in the context of a benchmark case in which consumption is the ultimate source of welfare, ignoring possibly relevant behavioural finance and political economy considerations. We base our analysis on estimates of the costs of financial crises in emerging market economies (since the 1980s), a cauldron of financial crises in the last thirty years. Our results support deregulation even under those dire circumstances.¹

Rapid Resolution Plans

No disagreement with this. The failure to have dissolution plans for systemically important institutions on the shelf and ready to go turned out to be costly, so credible dissolution plans are certainly needed. However, the argument seems to assume that too big and too interconnected firms cannot be avoided, something I'm not ready to concede:

A sound funeral plan can prolong a bank’s life, by Anil Kashyap, Commentary, Financial Times: Buried within the 88-page Obama administration proposal to overhaul financial regulation is an overlooked option called a “rapid resolution plan”. It mandates that systemically important financial companies be required regularly to file a “funeral plan”: a set of instructions for how the institution could be quickly dismantled should the need to do so arise. ... It could be implemented now, without the need for legislative action. Regulators should do so immediately.

The first benefit is that regulators would gain a stronger negotiating position with a dying institution. Throughout this crisis the authorities have had to intervene without knowing exactly what hidden traps might emerge if a bank were to be closed down. The bankers know this and can exploit the fear of the unknown to press for bail-outs.

It is remarkable that such rules do not already exist. ... The crisis has shown us that the sudden unwinding of a large, complex financial institution is terrifying for the financial system. ...

A second immediate benefit would be to force bank managers to think much more carefully about the complex financial structures they have created. If bankers had to explain every single step needed (and the associated consequences) to shut down their subsidiaries in all the various jurisdictions in which they operate, they would have a big incentive to simplify their organisations. ...

Over the medium term, there would be additional benefits. The headline component of the plan would be the requirement for banks to estimate the number of days it would take to shut down. Banks that require longer to close would have to hold more capital. This would place management under serious pressure to improve their plans...

Senior members of the management team and the board would have to understand the funeral plan. Crucially, they would be forced to sign off on its accuracy. This might also lead to closer scrutiny of new products or lines of business if they jeopardised an orderly unwinding. ...

This proposal is far from a cure-all. One big problem is that resolution rules themselves, especially when multiple legal systems are involved, are quite complicated. But the plan has an extremely high benefit-to-cost ratio and could be put in place right away. ...

links for 2009-06-30

• A Quick Look Back at Waxman-Markey and the Road Ahead - Robert Stavins
• Do you know how much your home is worth? - voxeu.org
• Hybrid "Superpredator" Invading California Ponds - National Geographic
• More Signs of the Demise of Behavioral Economics? - Cheap Talk
• Why The Stimulus Isn't Working - Economic Perspectives
• Employer Health Benefits: Hawaii's Experience - FRBSF Economic Letter
• Greenspan Speaks - Models & Agents
• How to Set Greenhouse Gas Emissions Targets for All Countries - Jeff Frankel
• Why does Japan have so many elevator operator? - Daniel Gross
• Young Japanese Raise Their Voices Over Economy - NYTimes.com
• Why We Need a Second Stimulus - TNR
• New Plan Ties Lower College Loan Payments to Income - NYTimes.com
• Bucking the Banks - Chris hayes
• In Which Greg Mankiw Confesses to Remarkable Ignorance - Brad DeLong
• Debating the Public Option - The American Prospect

links for 2009-06-30

• naked capitalism - links
• Felix Salmon - links
• Matthew Yglesias - links
• Ezra Klein - links
• Credit Writedowns - links
• Free Exchange - links
• The Big Picture - links
• Chris Martenson - links
• Brad DeLong - links
• Abnormal Returns - links
• New Deal 2.0 - links
• Marginal Revolution - links

An "Ethical Dilemma" in End of Life Care

This looks at the costs of extending the end of life by a short period of time and tries to draw a boundary between those cases when treatment should be applied, and those when it is not worth it to do so (the conclusion is that "studies powered to detect a survival advantage of two months or less should test only interventions that can be marketed at a cost of less than $20,000 for a course of treatment").

How do we draw this line (and if you don't think we should, how do we avoid drawing it)? Usually, I would give the standard answer that we should employ these life-extending procedures up until the point where the marginal cost of the treatment equals the marginal benefit, and let someone else worry about how to actually measure the costs and benefits. But in this case the measurement of the benefits - life itself - seems particularly hard to quantify, and trying to account for quality of life complicates it further, and it is not clear to me that a market test is even appropriate when there may not be a tomorrow and standard opportunity cost tradeoffs are missing from the evaluation (update: thinking more, I suppose this is just "cap-T" in our models, which isn't too hard to handle in the deterministic case, i.e. where T is known in advance with certainty, but the evaluation still seems problematic due to the other reasons that are cited). So I don't think there is a good answer to this question, at least not one that standard economic models can deliver:

How much is life worth? The $440 billion question, EurekAlert: The decision to use expensive cancer therapies that typically produce only a relatively short extension of survival is a serious ethical dilemma in the U.S. that needs to be addressed by the oncology community, according to a commentary published online June 29 in the Journal of the National Cancer Institute.

Tito Fojo, M.D., Ph.D., of the Medical Oncology Branch, Center of Cancer Research at the National Cancer Institute, in Bethesda, Md., and Christine Grady, Ph.D., of the Department of Bioethics, the Clinical Center at the National Institutes of Health, ... illustrate cost-benefit relationships for several cancer drugs, including cetuximab for treatment of non-small cell lung cancer, touted as "practice changing" and new standards of care by professional societies, including the American Society of Clinical Oncology. ...

According to Fojo and Grady,... 18 weeks of cetuximab treatment for non-small cell lung cancer, which was found to extend life by 1.2 months, costs an average of $80,000, which translates into an expenditure of $800,000 to prolong the life of one patient by 1 year. At this rate, it would cost $440 billion annually ... to extend the lives of 550,000 Americans who die of cancer annually by 1 year.

To address the issue, the commentators recommend that studies powered to detect a survival advantage of two months or less should test only interventions that can be marketed at a cost of less than $20,000 for a course of treatment.

Every life is of infinite value, the authors say, but spiraling costs of cancer care makes this dilemma inescapable.

"The current situation cannot continue. We cannot ignore the cumulative costs of the tests and treatments we recommend and prescribe. As the agents of change, professional societies, including their academic and practicing oncologist members, must lead the way," the authors write. "The time to start is now."

DeLong: Sympathy for Greenspan

Brad DeLong can't decide whether or not Greenspan made a mistake when he kept interest rates low after the collapse of the dot.com bubble:

Sympathy for Greenspan, by J. Bradford DeLong, Commentary, Project Syndicate: In the circles in which I travel, there is near-universal consensus that America’s monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis. ... US policymakers erred when:

-the decision was made to eschew principles-based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government’s guarantee of the commercial banking system was enough to keep us out of trouble;

-the Fed and the Treasury decided, once we were in trouble, to nationalise AIG and pay its bills rather than to support its counterparties, which allowed financiers to pretend that their strategies were fundamentally sound;

-the Fed and the Treasury decided to let Lehman Brothers go into uncontrolled bankruptcy in order to try to teach financiers that having an ill-capitalised counterparty was not without risk, and that people should not expect the government to come to their rescue automatically.

There is, however, a lively debate about whether there was a fourth big mistake: Alan Greenspan’s decision in 2001-2004 to push and keep nominal interest rates on US Treasury securities very low in order to try to keep the economy near full employment. In other words, should Greenspan have kept interest rates higher and triggered a recession in order to avert the growth of a housing bubble? ...

Full employment is better than high unemployment if it can be accomplished without inflation, Greenspan thought. If a bubble develops, and if the bubble ... collapses, threatening to cause a depression, the Fed would have the policy tools to short-circuit that chain. In hindsight, Greenspan was wrong. But the question is: was the bet that Greenspan made a favourable one? ...

I am genuinely unsure as to which side I come down on in this debate. ... What I do know is that the way the issue is usually posed is wrong. People claim that Greenspan’s Fed “aggressively pushed interest rates below a natural level.” But what is the natural level? In the 1920’s, Swedish economist Knut Wicksell defined it as the interest rate at which, economy-wide, desired investment equals desired savings, implying no upward pressure on consumer prices, resource prices, or wages as aggregate demand outruns supply, and no downward pressure on these prices as supply exceeds demand.

On Wicksell’s definition — the best, and, in fact, the only definition I know of — the market interest rate was, if anything, above the natural interest rate in the early 2000’s: the threat was deflation, not accelerating inflation. The natural interest rate was low because, as the Fed’s current chairman Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). ...

Greenspan’s mistake — if it was a mistake — was his failure to overrule the market and aggressively push the interest rate up above its natural rate, which would have deepened and prolonged the recession that started in 2001.

But today is one of those days when I don’t think that Greenspan’s failure to raise interest rates above the natural rate to generate high unemployment and avert the growth of a mortgage-finance bubble was a mistake. There were plenty of other mistakes that generated the catastrophe that faces us today.

I have argued the Fed's decision to keep interest rates low contributed to the bubble, but was not itself the sole cause of it. As to whether the Fed made a mistake, I'll just note that the tradeoff wasn't quite as stark as Brad implies, i.e. there were other policy instruments that Fed could have used to limit the housing bubble. Regulation is certainly one means the Fed had to that end, but Fed communication could have helped too. If Greenspan had, for example, told people to stay away from mortgages because they were toxic rather than implicitly encouraging them to invest in housing, things might have been different.

Would limiting the bubble through regulation, communication, or other means have limited the employment response, the primary worry? I don't think so, at least not enough to matter. The money would have been invested somewhere, housing had an opportunity cost after all, so the next best alternatives would have been pursued to the extent that they were profitable (and many would have been, just not as profitable - apparently anyway - as investing in housing and mortgages). So people still would have been employed somewhere as the money was invested, just not in housing, and that would have helped to insulate us from the housing crash. (And a lot of them might still have those jobs, unlike the people who depended upon the housing markets for employment.)

So narrowly, keeping interest rates low and employment high was the right thing to do. The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing market in pursuit of profits based upon the misperception of risk. Those resources could have been redirected into other sectors and put to productive use rather than wasted building houses nobody wants, and achieving this result did not require the Fed to aggressively raise the target rate, it only needed to use the other tools it already had available.

Unfortunately, however, those tools were not used, and the ideology Greenspan brought to the Fed played a large role in this outcome.

Paul Krugman: Betraying the Planet

Are the arguments against the need to act to prevent climate change based upon a morally defensible position grounded in science, or, given the predicted consequences of inaction, a morally indefensible position based upon ideology and political interests?:

Betraying the Planet, by Paul Krugman, Commentary, NY Times: So the House passed the Waxman-Markey climate-change bill. In political terms, it was a remarkable achievement.

But 212 representatives voted no. A handful of these no votes came from representatives who considered the bill too weak, but most rejected the bill because they rejected the whole notion that we have to do something about greenhouse gases.

And as I watched the deniers make their arguments, I couldn’t help thinking that I was watching a form of treason — treason against the planet.

To fully appreciate the irresponsibility and immorality of climate-change denial, you need to know about the grim turn taken by the latest climate research.

The ... planet is changing faster than even pessimists expected: ice caps are shrinking, arid zones spreading, at a terrifying rate. And according to a number of recent studies, catastrophe — a rise in temperature so large as to be almost unthinkable — can no longer be considered a mere possibility. It is, instead, the most likely outcome if we continue along our present course.

Thus researchers at M.I.T., who were previously predicting a temperature rise of a little more than 4 degrees by the end of this century, are now predicting a rise of more than 9 degrees. ...

Temperature increases on the scale predicted by ... researchers ... would create huge disruptions in our lives and our economy. As a recent authoritative U.S. government report points out, by the end of this century..., Illinois may have the climate of East Texas, and ... deadly heat waves ... may become annual or biannual events.

In other words, we’re facing a clear and present danger to our way of life, perhaps even to civilization itself. How can anyone justify failing to act?

Well, sometimes even the most authoritative analyses get things wrong. And if dissenting opinion-makers and politicians ... had carefully studied the issue, consulted with experts and concluded that the overwhelming scientific consensus was misguided — they could at least claim to be acting responsibly.

But if you watched the debate..., you didn’t see people who’ve thought hard about a crucial issue, and are trying to do the right thing. What you saw, instead, were people who ... don’t like the political and policy implications of climate change, so they’ve decided not to believe in it — and they’ll grab any argument, no matter how disreputable, that feeds their denial.

Indeed, if there was a defining moment in Friday’s debate, it was the declaration by Representative Paul Broun of Georgia that climate change is nothing but a “hoax” ... “perpetrated out of the scientific community.” ... Mr. Broun’s declaration was met with a round of applause from his Republican colleagues.

Given this contempt for hard science, I’m almost reluctant to mention the deniers’ dishonesty on matters economic. But in addition to rejecting climate science, the opponents of the climate bill made a point of misrepresenting ... studies of the bill’s economic impact, which all suggest that the cost will be relatively low.

Still, is it fair to call climate denial a form of treason? Isn’t it politics as usual?

Yes, it is — and that’s why it’s unforgivable.

Do you remember ... when Bush administration officials claimed that terrorism posed an “existential threat” to America,... [so] normal rules no longer applied? That was hyperbole — but the existential threat from climate change is all too real.

Yet the deniers are choosing, willfully, to ignore that threat, placing future generations of Americans in grave danger, simply because it’s in their political interest to pretend that there’s nothing to worry about. If that’s not betrayal, I don’t know what is.

Fed Watch: A Tangled Policy Web

Tim Duy:

A Tangled Policy Web, by Tim Duy: Incoming data continues to confirm an emerging period of relative economic tranquility following the financial storm of 2008. Importantly, the bleeding in consumer spending has been staunched, despite ongoing job losses that look likely to remain a feature of the American economic landscape for months to come. But incoming data also point to America's sustained and perplexing dependence on foreign capital inflows - a dependence that suggests an underlying economic vulnerability that has yet to be addressed. Whether it needs to be addressed next month, next year, or next decade is still a question that continues to haunt the followers of global macro trends.

The most recent Personal Income and Outlays report, for May 2009, highlights many of the trends currently impacting the evolution of economic activity. The headline jump in incomes, like that of the previous month, was driven by federal stimulus. Declining private wage and salary disbursements are a more telling indicator of the health of household finances, and are consistent with ongoing labor market weakness. The best bet is the that private wage gains remain subdued, even as conditions stabilize. Although the apparent peak of initial claims is in the rearview mirror, persistent high levels of claims points to a jobless recovery.

Of course, in the absence of federal stimulus, the underlying weak income growth indicates sustained pressures on consumer spending power. Indeed, the numbers tell a clear story of stabilization, but little to suggest that a V shaped recovery for consumer spending is at hand:

In addition, the report adds further credence to the claims that American's long affair with spending has ended in a bitter divorce, with the saving rate climbing to its highest level in 15 years. To be sure, some of the increase is likely not sustainable in the short run, as it partly reflects a time lag between federal stimulus and the spending it was meant to encourage. That said, the underlying saving increase is tempering the impact of stimulus spending, as households sock some of it away for the next rainy day and/or pay down crippling debt loads, effectively turning private debt into public debt. And note that large shifts in consumer behavior are not required to have significant macroeconomic implications. Small changes across households - a little less, percentage wise, spending here and there adds up. From Bloomberg:

links for 2009-06-29

• When to Impose Fiscal Restraint and With What - pgl
• Caveat Mortgagor - James Surowiecki
• Mice run faster on high-grade oil - EurekAlert
• Obama Warns Against Trade Penalties in Energy Bill - NYT
• Obama is choosing to be weak - Clive Crook
• U.S. Plan to Stem Foreclosures Is Mired in Paper Avalanche - NYT
• Google Makes a Case That It Isn’t So Big - NYT
• Against Gerontocracy - Economic Principals
• Deficit Disorder - pgl
• How Americans spend their 24 hours - News N Economics
• Chinese Now Say "No Change" in Currency Policy - Yves Smith

links for 2009-06-29

• naked capitalism - links
• Abnormal Returns - links
• Credit Writedowns - links
• Chris Martenson - links
• Paul Kedrosky - links
• Marginal Revolution - links
• Brad DeLong - links

Old Economy/New Economy

How did people survive without Google? A colleague, Bill Harbaugh, emails:

I stink, and I needed a Laundromat in Lyon. Google translate says that's called a laverie in French. Google maps says there's one 4 blocks away. Is it open on Sunday? Laundromats don't have websites. But Google street views shows the front door - Ouvert 7 Jours.

Then the washing machine swallowed my last Euros. 

What's behind Recent Changes in Long-Term Interst Rates?

Martin Feldstein says we need to cut social programs so that we don't "weaken demand in the near term and hurt economic incentives in the long run":

The Fed must reassure markets on inflation, by Martin Feldstein, Commentary, Financial Times: The interest rate on 10-year US Treasury bonds almost doubled in six months, rising from 2.26 per cent last December to 3.98 per cent in mid-June, before decreasing slightly in recent days. This sharp rise happened despite the Federal Reserve’s ... policy aimed at lowering long-term rates by buying $300bn of Treasuries and promising to buy more than $1,000bn of mortgage securities. ...

There is no single reason for the sharp rise in rates... The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. ... The prospective decline of the dollar is also a potential source of inflation. ...

But such an explanation is deceptively easy. ... Those scared by Lehman Brothers’ collapse wanted the safety and liquidity of ordinary Treasury bonds, causing their yields to fall sharply...

Treasury yields rose this month to their level a year earlier because improving market conditions meant investors were no longer willing to pay for the extreme liquidity of Treasuries. Inflation was thus not the only, and perhaps not even the main, reason for the rise in rates.

Why did the Fed’s massive buying of long-term Treasury bonds not hold down the bond rate? The answer is that bond markets are less impressed by the $300bn of Fed purchases than by the official projection of $10,000bn of government borrowing over the next decade... The resulting crowding out of private investment will require higher future interest rates, and that is reflected in current long-term rates.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors’ concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. ...

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

Here's (my interpretation of) Paul Krugman's argument about the source of recent movements in long-term interest rates:

There are two reasons long-term rates might rise, first more worries about the debt and inflation in the future would drive rates up, and second the prospect of better economic conditions in the future would have the same effect, rates would go up.

Suppose we receive bad news about the current state of the economy. That should cause expectations of lower output growth in the future, and hence lower tax revenues and higher spending on social programs than would exist with a stronger economy. So the bad news should cause an expectation of a larger deficit and more inflation worries, and that would drive long-term interest rates up (these worries would also make foreign central banks less likely to fund US borrowing which would reinforce the increase in long-term interest rates).

But if it is future economic conditions that are driving the changes in long-term interest rates, bad news about the economy should drive rates down.

Last week, we received bad news about the economy. If the debt/inflation/foreign lending story is correct, long-term rates should have gone up. If the state of the economy story is driving rates, rates should have fallen. What did long-term rates actually do? They fell.

A Public Plan

[I'm hoping this education example will give some insight into the public health care plan, or at least give you another way to think about it.]

Suppose that education is only available from private sector schools, and that education within this system is very expensive. Because of the expense, millions of people do not have access to education. Further suppose that due to the characteristics of the education market, there is reason to believe that the private institutions are bloated with excess costs (and, in addition to all the other excess costs, 30% of their expenditures came from competition for students rather than delivering education). To make matters worse, the already too high costs are expected to escalate rapidly in the future and further limit access to education. (And there's more. If costs aren't controlled, the government's Educare program for the very young will begin to eat up a huge share of the federal budget.)

Now suppose the government decides to solve both the access and cost problems by setting up a public plan for education. Here's how it works.

The government will build schools, staff them, purchase supplies, and so on, but there's a catch. The schools will have to run without any government subsidies, none at all, not a dime (so this is different than what we actually do since some or all of the education bill is subsidized, some for college, all for lower grades).

If these schools provide exactly the same education as the private sector schools but cost less to attend, then that would either force the private sector schools to find a way to compete by bringing costs down, and they ought to be able to match the government run institution, or they would go out of business. It's true that the public institutions might have an advantage in buying books in bulk, that sort of thing, and they could probably get books and other supplies for less than individual private schools could get them, but what's wrong with scale economies? And to the extent that it is the power that comes from their size as public institutions rather than actual efficiencies, it's important to remember that the publishers aren't without their own countervailing market power, so this makes the playing field more level.

As to access, one option is to do as we do with schools now and implicitly subsidize everyone who attends, rich and poor alike, by giving government subsidies to the schools (tuition falls by the amount of the subsidy, to zero for public elementary and high schools, part way to zero for colleges). But that would violate the no government help rule we imposed above. The other way to do this is to take the money that would have been used to subsidize the schools and instead give it out to individuals who couldn't attend school otherwise (perhaps graduated by income). That avoids giving subsidies to those who don't need them, and the subsidies can then be concentrated on those who do. The additional help available to those who need it would, in turn, allow more people access to education, a key goal of the policy.

So, the idea is to build government schools that must run without any help from taxpayers, and the public schools will compete side by side with the private schools. Rather than limiting choice, this adds one more choice, and it's a choice nobody has to make if the public schools turn out to be more expensive than than the competing private schools. Then, to increase access to education, give individuals the tuition subsidies they need to make it possible for them to attend the public school. Finally, for any conservatives opposed to the public plan, notice that if individuals can use the subsidy on either a public or a private sector school, this is basically a voucher system. However, in this case the goal of the voucher system is to reduce costs in the overly expensive private sector rather than to discipline the public institutions, something the private sector shouldn't fear if, in fact, it is the least cost provider of education.

links for 2009-06-28

• Volcker Gets Less Than He Wants in Curbing Excesses - Bloomberg
• G.M., Detroit and the Fall of the Black Middle Class - NYTimes.com
• Book Review - 'The Industrial Revolutionaries - NYTimes.com
• Central banking as partisan politics - Willem Buiter
• The Lost Continent (Africa) - Robert Skidelsky
• The CRA... Still Not Causing the Meltdown - Obsidian Wings
• Most Subprime Lenders Weren’t Covered by CRA - The Big Picture

links for 2009-06-28

• naked capitalism - links
• Brad DeLong - links
• Marginal Revolution - links
• Chris Blattman - links

Are Advances in Technology the Source of Rising Medical Costs?

I'm not sure what to think of this. If it's true that medical technology increases life expectancy without increasing per capita medical expenditures, that's good news, but that result differs from other work in the area (and it leaves me wondering what is behind the actual and projected increase in health care costs if the source is something other than this):

The quality of medical care, behavioral risk factors, and longevity growth, by Frank R. Lichtenberg, Vox EU: The cost of medical care continues to rise rapidly in the US and other industrialized countries. According to a report from consulting firm PricewaterhouseCoopers, US employers who offer health insurance coverage could see a 9% cost increase between 2009 and 2010, and their workers may face an even larger increase.

Some observers argue that rapidly increasing health care expenditure is due, to an important extent, to medical innovation – the development and use of new drugs, diagnostics, and procedures. For example, the Kaiser Family Foundation (2007), citing Rettig (1994), claims that “advances in medical technology have contributed to rising overall US health care spending.”

Other observers argue that most medical innovations do not improve people’s health. Lexchin (2004), for example, claims that “at best one third of new drugs offer some additional clinical benefit and perhaps as few as 3% are major therapeutic advances.”

If both of these claims were true, medical innovation would result in the worst of both worlds – a large increase in cost and little or no increase in benefit (in the form of improved health outcomes). However, a study that I have recently performed casts considerable doubt on both of these claims. My findings indicate that medical innovation has yielded significant increases in life expectancy without increasing medical expenditure.

"Pure Political Theater, and I Don't Like It"

Jim Hamilton:

On grilling the Fed Chair, Econbrowser: I got a bit angry at accounts of the latest appearance of Federal Reserve Chair Ben Bernanke before the U.S. Congress. ...

It is one thing to have different views from those of the Fed Chair on particular decisions that have been made-- I certainly have plenty of areas of disagreement of my own. But it is another matter to question Bernanke's intellect or personal integrity. As someone who's known him for 25 years, I would place him above 99.9% of those recently in power in Washington on the integrity dimension, not to mention IQ. His actions over the past two years have been guided by one and only one motive, that being to minimize the harm caused to ordinary people by the financial turmoil. Whether you agree or disagree with all the steps he's taken, let's start with an understanding that that's been his overriding goal.

These interrogations reveal more about those doing the grilling than they reveal about Bernanke. I see this as pure political theater, and I don't like it.

If Congress wants to explore more usefully the wisdom and motives behind some of the decisions that have been made, it might want to investigate why some legislators are now pushing for Fannie and Freddie to guarantee a riskier category of mortgage condo loans.

"The Persian Bazaars"

The Persian Bazaars of 1910 (as viewed through western eyes):

Islamic History Sourcebook: Eustache de Lory: The Persian Bazaars, 1910: Like the bazaars in Constantinople and Cairo, those of Teheran consist of an immense labyrinth of streets covered with brick vaults, forming an uninterrupted row of little domes, in the middle of each of which a round hole is pierced to let in the light. Through this hole the sun darts its rays like the flash-lights of a man-of-war amid the half-lights of the vaults, which in summer keep the air so cool.

When you enter the great central artery, which starts from the south of the Sabz-Meidan, you are in the Bazaar of the Shoemakers. On both sides of the vault are stalls, from ten to fifteen feet square, with a floor about three feet above the ground. These are occupied by the makers of all sorts of shoes. Here are pahboush, yellow, or green for the mullahs; there are the tiny red slippers with turned-up toes and metal heels which the women wear. Farther on are the ugly boots of blacking leather or patent leather with elastic sides, which are intended for those who wish to enjoy the advantages of civilization. Then come the shops where you buy the giveh, the national shoes of Persia, made of very strong white linen, with soles of plaited thongs dyed green; and the yellow top-boots, with the red rolled-over tops and very turned-up toes and thick soles, like Tartar boots, which are worn by the Persians in the mountains.

links for 2009-06-27

• The American Consumer: Reforming, Or Just Resting? - Carroll and Slacalek
• The cost of medical innovation - voxeu.org
• As Incomes Rebound, Saving Hits Highest Rate in 15 Years - NYT
• Why we have both Fannie and Freddie - Richard Green
• Can Asia free itself from the IMF? - Barry Eichengreen
• Merrill Lynch Camp: Ben Bernanke Is Telling the Truth - Atlantic Business
• Bernanke Grilling May Weaken Case for Fed as Risk Regulator - Bloomberg
• Wartime China - Daniel Little
• Interview with Kevin Murphy - Federal Reserve Bank of Minneapolis
• Why we shouldn’t subsidise clean-energy technologies - voxeu.org
• Bush's court appointments emphasized ideology over diversity - EurekAlert
• Thinking of you (Theory of Mind) - MIT News

links for 2009-06-27

• naked capitalism - links
• New Deal 2.0 - links
• Felix Salmon - links
• Matthew Yglesias - links
• Brad DeLong - links
• Econbrowser - links
• Marginal Revolution - links
• Abnormal Returns - links
• Chris Martenson - links
• Paul Kedrosky - links
• FT Alphaville - links

"The Second Derivative is Bad"

John Hempton is "feeling just that little bit less certain" that the rate of deterioration in the economy has slowed:

The second derivative is bad, Bronte Capital: I have been firmly in the “second derivative is good” camp for some time. Green shoots were few and far between – but the economy no longer appeared to be in free-fall. ...

The data I considered most persuasive was the delinquency data at Fannie and Freddie. It gets worse every month, but until the last data point it was getting worse at a decreasing rate (especially if you adjusted for the foreclosure moratoriums they implemented).  

Today I am more worried. My favorite data point (rate of increase of Freddie Mac delinquency) has deteriorated – especially in their insured portfolio. Its not sharp deterioration – and it is possible – even likely – that Freddie Mac will have end credit losses considerably lower than the bears anticipate. But as a second derivative bull I am feeling just that little bit less certain.

"China Crosses the Rubicon"

According to this analysis, China's economic interests are having a big impact on its strategic plans. It also makes it sound as thought Russia and China could be be headed for conflict over border regions. I'm not sure if this will generate much discussion or not, but I'm curious what you think about this:

China Crosses the Rubicon, by Wen Liao, Commentary, Project Syndicate: For two decades, Chinese diplomacy has been guided by the concept of the country's "peaceful rise." Today, however, China needs a new strategic doctrine, because the most remarkable aspect of Sri Lanka's recent victory over the Tamil Tigers is ... the fact that China provided ... both the military supplies and diplomatic cover ... needed to prosecute the war. ...

So, not only has China become central to every aspect of the global financial and economic system, it has now demonstrated its strategic effectiveness in a region traditionally outside its orbit. ... What will this change mean in practice in the world's hot spots like North Korea, Pakistan, and Central Asia?

Paul Krugman: Not Enough Audacity

Will Obama give away too much in an attempt to get health care reform legislation through congress?:

Not Enough Audacity, by Paul Krugman, Commentary, NY Times: When it comes to domestic policy, there are two Barack Obamas.

On one side there’s Barack the Policy Wonk, whose command of the issues ... is a joy to behold. But on the other side there’s Barack the Post-Partisan, who searches for common ground where none exists, and whose negotiations with himself lead to policies that are far too weak.

Both Baracks were on display in the president’s press conference earlier this week. First, Mr. Obama offered a crystal-clear explanation of the case for health care reform, and ... a public option competing with private insurers. “If private insurers say that the marketplace provides the best quality health care, if they tell us that they’re offering a good deal,” he asked, “then why is it that the government, which they say can’t run anything, suddenly is going to drive them out of business? That’s not logical.”

But when asked whether the public option was non-negotiable he waffled, declaring that there are no “lines in the sand.” ...

The big question here is whether health care is about to go the way of the stimulus bill. At the beginning of this year,... Mr. Obama made an eloquent case for a strong economic stimulus — then delivered a proposal falling well short of what independent analysts ... considered necessary..., presumably,... to attract bipartisan support. But ... Mr. Obama was able to pick up only three Senate Republicans...

At the time, some of us warned...: if unemployment surpassed the administration’s optimistic projections, Republicans wouldn’t accept the need for more stimulus. Instead, they’d declare the whole economic policy a failure. And that’s exactly how it’s playing out. ...

The point is that ... policy has to be good enough to do the job. You might think that half a loaf is always better than none — but it isn’t if the failure of half-measures ends up discrediting your whole policy approach.

Which brings us back to health care. ...[R]eform isn’t worth having if you can only get it on terms so compromised that it’s doomed to fail. What will determine the success or failure..? Above all,... successful cost control. We really, really don’t want to get into a position a few years from now where premiums are rising rapidly, many Americans are priced out of the insurance market despite government subsidies, and the cost of health care subsidies is a growing strain on the budget.

And that’s why the public plan is an important part of reform: it would help keep costs down through a combination of low overhead and bargaining power. That’s ... a conclusion based on solid experience. Currently, Medicare has much lower administrative costs than private insurance companies, while federal health care programs ... pay much less for prescription drugs than non-federal buyers. There’s every reason to believe that a public option could achieve similar savings.

Indeed, the prospects for such savings are precisely what have the opponents of a public plan so terrified. Mr. Obama was right: if they really believed their own rhetoric about government waste and inefficiency, they wouldn’t be so worried that the public option would put private insurers out of business. Behind the boilerplate about big government, rationing and all that lies the real concern: fear that the public plan would succeed.

So Mr. Obama and Democrats in Congress have to hang tough — no more gratuitous giveaways in the attempt to sound reasonable. And reform advocates have to keep up the pressure to stay on track. Yes, the perfect is the enemy of the good; but so is the not-good-enough-to-work. Health reform has to be done right.

links for 2009-06-26

• The recession and pay: The quiet Americans - The Economist
• Estimating the Impact of Trade and Offshoring on American Workers - NBER
• Bernanke Defends His Role in Merrill Sale - NYTimes.com
• Online ethics and the bloggers' code revealed - EurekAlert
• Saving Glut Smackdown - David Beckworth
• Rationing Health Care Is Our Choice - washingtonpost.com
• The Health Care Debate in Washington has the Wrong Metrics - pgl
• So Much for "Exorbitant Privilege" and "Dark Matter" As Well - Econbrowser
• Microlending Efforts Now Active in United States - Research of Culture Blog
• The jobless recovery - Free exchange
• Rating agencies and the logic of regulatory license - voxeu.org
• Deliver us from competition - The Economist
• Will the Banks Sort Themselves Out? - Economix
• Refuted economic doctrines #9: Real Business Cycle Theory - John Quiggin
• Employment growth in Canada and the US over the longer term - Stephen Gordon

Greenspan: Equity Prices are a Key to Recovery

Maybe there was a Greenspan put after all?:

Inflation - the real threat to sustained recovery, by Alan Greenspan, Commentary, Financial Times: The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

Is this the beginning of a prolonged economic recovery or a false dawn? There are credible arguments on both sides of the issue. ...[T]he crisis will end when ...[there is] a stabilisation of home prices or a further rise in newly created equity value available to US financial intermediaries...

Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, they proceeded inexorably higher? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. Higher share prices would also lead to increased household wealth and spending, and the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. Leverage would be materially reduced. A prolonged recovery in global equity prices would thus assist in the lifting of the deflationary forces that still hover over the global economy.

I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. ...

Stock prices, to be sure, are affected by the usual economic gyrations. But ... a significant driver of stock prices is the innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it. ...

He also gives his view of the future inflation threat. I'll just note that I quite agree with Greenspan's assertion that he accords "a much larger economic role to equity prices than is the conventional wisdom."

Big Government Ben?

The GOP is targeting Bernanke as "a champion of government intrusion and an ally of President Obama":

G.O.P. to Paint Bernanke as Ally of Big Government, by Edmund L. Andrews and Louise Story, NY Times: In a peculiar role reversal, Republican lawmakers are mounting a ferocious attack on the Republican chairman of the Federal Reserve, while Democrats are coming to his defense.

Ben S. Bernanke ... will be grilled on Thursday by the House Oversight and Government Reform Committee about his role in orchestrating Bank of America’s controversial takeover of Merrill Lynch late last year.

The House investigation is heavily colored by partisanship. President Obama is proposing to give the Federal Reserve formidable new powers to regulate giant institutions, including Bank of America, that could pose risks to the financial system.

Republicans, along with some Democrats, argue that the Fed already has too much power.

Unhappy about the huge bank bailouts that the Fed arranged with the Treasury Department during the Bush administration, many Republicans are even more displeased that Mr. Bernanke is now working hand-in-glove with the Obama administration.

The result is a set of dueling narratives and agendas, all of which will be on full display when Mr. Bernanke testifies on Thursday. ...

Despite Mr. Bernanke’s Republican roots, and the fact that President Bush nominated him to be Fed chairman, the Republican memo prepared for the hearing on Thursday describes Mr. Bernanke as a champion of government intrusion and an ally of President Obama. ...

I don't think this is an attempt to negatively influence Obama's decision on Bernanke's reappointment as Fed chair as some have been hinting because that would not be in the GOP's best interest. There are open positions on the Federal Reserve Board, so even if Bernanke didn't resign as is customary in the event he was not reappointed - and nothing says he must - Obama would still be free to appoint a new Fed Chair from outside the present Board membership.

Obama would certainly appoint someone who shares his regulatory vision, and that person would likely be confirmed (e.g. someone like Janet Yellen would likely be confirmed even if there was lots of grumbling), so I don't see how the appointment of a new Fed chair would do anything but strengthen the support for the type of regulatory oversight the administration envisions. That's not what the GOP wants.

Instead, this looks much more like an attempt to by the GOP to maintain its usual anti-regulatory, anti-government stance by arguing that the Fed should not to be trusted with the powers envisioned in the proposed regulatory reform legislation. So the real goal is the Fed as an institution, Bernanke is simply the target being used to make that the point. E.g.:

The vast extent of the Fed’s actions in the past two years to commit trillions of dollars in government money to support the economy has raised significant concerns on Capitol Hill, some of which will be aired on Thursday when Bernanke testifies before the House Committee on Oversight and Government Reform.

Congressional investigators have been looking into the Fed’s role in encouraging Bank of America to purchase Merrill Lynch... Rep. Darrell Issa (R-Calif.), ranking member on the Oversight Committee, said on Wednesday that the Fed engaged in a “cover-up” and hid details about the merger, completed in January 2009, from other federal agencies.

Meanwhile, lawmakers from both parties are raising questions about Obama’s proposal to grant the Fed broad new powers to prevent another crisis.

Those concerns could make the next confirmation process far more contentious than the six that have occurred in the last two decades.

And:

Sen. Jim DeMint (R-S.C.) said, “It won’t be my decision whether he is held over or not, but right now I’m concerned that they have lost their independence and are too cozy with Treasury.”

It looks like we are going to get some version of a strategy that has the GOP saying that given what happened to the financial system, of course we need more oversight and regulation of the financial system. But any particular piece of legislation that is proposed will be fought tooth and nail by the GOP as being far too intrusive, granting the government too much power, and generally going far beyond what is needed to solve the problem. The fact that the will for reform will diminish with time works in their favor, and if they can string things out long enough with this strategy, the result will be that the legislation eventually passes in a much weaker form, or it won't ever pass at all.

Just ignore them. Altering a few words:

The Republicans, with a few possible exceptions, have decided to do all they can to make the Obama administration a failure. Their role in the financial regulation debate is purely that of spoilers who keep shouting the old slogan — Government is always the problem, never the solution! — hoping that someone still cares.

The Need for Deficit Spending

As a follow up to the post Don't "Nullify" Fiscal Policy which was part of the Romer Roundtable on fiscal policy mistakes during the Great Depression, in particular the mistake made in 1937 of giving into pressure to balance the budget before the economy had recovered sufficiently causing an economy showing signs of recovery to fall back into depression, David Cay Johnston emails this explanation of the need for deficit spending after large negative shocks from his February 18, 2009 "Johnston's Take" column at Tax Notes:

In the long run we need more savings and investment, but as Keynes famously noted, in the long run we are all dead. What we need right now is money in people's pockets to pay for mortgages so more houses do not fall into foreclosure and employers stop eliminating jobs at an accelerating pace, a rate of nearly 10,000 per day last year and 20,000 per day last month.

Borrowing our way out of this is not without risk. But imagine for a moment that you just got married, bought a house, and are expecting a baby, and your cars unexpectedly broke down. Do you take on more debt by leasing or borrowing for two new cars so you can keep getting to work to pay for the mortgage and the baby crib, or do you shun new debt because it is more prudent to do so?

links for 2009-06-25

• Taking macro-prudential regulation seriously - voxeu.org
• The leading economic index - Econbrowser
• The US is following Japan, but seven times faster - Daniel Gross
• Evolutionary Origins of Your Right and Left Brain - Scientific American
• How best to pay executives? voxeu.org

"Europeans Rely on Concessions to Save Jobs"

Some of the ways European labor markets are reacting to the economic slowdown:

Europeans Rely on a Mix of Concessions to Save Jobs, by Mathew Saltmarsh, NY Times: Rising European unemployment has business and government looking to offset the pain, and some of the solutions belie the region’s reputation for inflexibility.

A report released ... by the European Union found that some 1.9 million jobs were lost in the first quarter, the worst drop since figures were first collected starting in 1995. The unemployment rate was 8.6 percent in April, up from 6.8 percent a year earlier.

But analysts and labor experts say the figures would have been even starker without some of the job-saving measures used to combat the worst recession in decades. ...

Many countries have short-time compensation programs, tailored for the manufacturing sector, under which employers can apply for temporary assistance to lift the wages of workers working reduced hours.

France has a publicly financed partial unemployment plan, allowing companies experiencing difficulties to temporarily lay off workers and draw on state money to pay them during those periods. ... In the Netherlands,... companies ... use... a similar program...

Germany also has several measures to reduce working time, many of which are specifically framed as employment-saving measures. ... German unions have also shown some flexibility. ...

In France, as in other European countries, employers are not normally allowed to lower contracted salaries without employee consent.

But if a business with operations in France has “serious grounds” to think that its economic viability is in danger, and employees refuse a reduced salary, then a company could proceed to layoffs.

To avoid this kind of situation, some companies have tried to negotiate salary reductions. The auto rental company Hertz ... asked French management ... to swallow a pay cut of around 5 percent over three months, without offsetting time off. Slightly more than two-thirds of the 150 managers offered the deal agreed... Hewlett-Packard ... confirmed that it was engaged in similar negotiations to cut the salaries ... ranging from 2.5 to 15 percent.

The Finnish carrier Finnair announced in December plans to temporarily lay off 1,700 cabin crew members on a staggered basis this year to cut costs. The layoffs will last two to three weeks a worker.

FOMC Press Release

Not much new here, except perhaps the emphasis that the FOMC does not see inflation as a problem to be immediately concerned about. (Also, the WSJ notes that "officials deleted previous references to the risk that inflation could persist below desired rates, an indication that they don't see deflation as a risk." The Financial Times adds that the FOMC "maintained that it was moving ahead with its $300bn Treasury purchase plan and said that it would 'continue to evaluate the timing and overall amounts of its purchases of securities'. It made no changes to its previously announced plans for the total volume of purchases or for timing." Bloomberg makes the same points.):

Press Release, Release Date: June 24, 2009,  For immediate release: Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months. Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

"Obama and 'Regulatory Capture'"

Thomas Frank says the administration's regulatory overhaul plan is not putting enough emphasis on the problem of regulatory capture:

Obama and 'Regulatory Capture', by Thomas Frank, Commentary, WSJ: ...We have just come through the most wrenching financial disaster in decades, brought about in no small part by either the absence of federal regulation or the amazing indifference of the regulators.

This is the moment for a ringing reclamation of the regulatory project. President Barack Obama is clearly the sort of man who could do it. But ... a white paper his administration released on the subject last week ... uses bland, impersonal explanations for the current crisis. Regulatory agencies were ill-designed... Their jurisdictions overlapped. They had blind spots. They had been obsolete for years.

All of which is true enough. What the report leaves largely unaddressed, however, is the political problem. ... The people who filled regulatory jobs in the past administration were asleep at the switch because they were supposed to be. ...

The reason for that is simple: There are powerful institutions that don't like being regulated. Regulation sometimes cuts into their profits... So they have used the political process to sabotage, redirect, defund, undo or hijack the regulatory state since the regulatory state was first invented.

The first federal regulatory agency, the Interstate Commerce Commission, was set up to regulate railroad freight rates in the 1880s. Soon thereafter, Richard Olney, a prominent railroad lawyer, came to Washington to serve as Grover Cleveland's attorney general. Olney's former boss asked him if he would help kill off the hated ICC. Olney's reply ... should be regarded as an urtext of the regulatory state:

"The Commission . . . is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. . . . The part of wisdom is not to destroy the Commission, but to utilize it."

The George W. Bush administration elevated this strategy to a snickering, sarcastic art form. It gave us a Food and Drug Administration that sometimes looked as though it was taking orders from Big Pharma, an Environmental Protection Agency that could never rouse itself from the recliner, an energy policy that might well have been dictated by Enron, and a Consumer Product Safety Commission that moved like a rusty wind-up toy.

And it created a situation where banking regulators posed for pictures with banking lobbyists while putting a chainsaw to a pile of regulations. ...

Misgovernment of this kind is not a partisan phenomenon, of course. Democrats have been guilty of it as well as Republicans. ... Yet today we talk around this problem, with its nose-on-your-face obviousness, as though it didn't exist. It's not until page 29 of the Obama administration's densely worded white paper that you find a reference to "regulatory capture," and then it is buried in a list of items to be considered by a future Treasury working group. ...

[T]he administration must go further. ... After all, the Bush team was only able to install the dreadful regulators it did because the governance of federal agencies was rarely a topic of public debate in those days. Mr. Obama should make it an unavoidable subject, something that future politicians will be required to address. The issue cries out for it. And the nation, for once, is listening.

I see this a little bit different. I think the regulatory capture that helped to open the door for the current crisis had more to do with the adoption and promotion of free market ideology and the culture that ideology brought about within the regulatory bodies than to direct capture by regulated industries.

The financail industry certainly promoted the free market, self-healing, self-regulating approach since it coincided with their interests in shedding regulatory constraints, and they also aided politicians who promoted these ideas. Those politicians, in turn, made appointments to key positions within regulatory agencies that were designed to further this ideology and that, too, contributed to the changing culture within the regulatory bodies.

But the idea that, in almost all cases cases markets will self-correct and self-regulate, and that society is best served with a hands off approach to these markets, did not originate within industry. It came from a dominant strain of economic thought supported by theoretical models and empirical evidence. Without the support of these models, the empirical evidence, and the many economists who carried the message - and most of the profession did - it would have been much more difficult for industry to successfully promote the "deregulation is good for everybody always and everywhere" within the political and regulatory arenas.

I don't want to be mistaken here, I still believe that most markets function well with minimal regulation, and that a hands off approach is generally best. But I hope we have learned that financial markets are not among the markets for which this is true. I also hope that, as a profession, we will be more receptive to the idea that markets can fail, and can do so catastrophically, that we will build models that help us to better understand how to minimize the risk that markets will break down, and more importantly that we will interpret data with this in mind. All of the data in the world is useless if you cannot see, refuse to see, or cannot accept what it is trying to tell you.

"Critics of a Public Option for Health Care Are Wrong"

Robert Reich addresses objections to including a public plan as part of the health care reform package:

Why the Critics of a Public Option for Health Care Are Wrong, by Robert Reich [longer version]: ...Critics say the public option is really a Trojan horse for a government takeover of all of health insurance. But nothing could be further from the truth. It's an option. No one has to choose it. ...

Private insurers say a public option would have an unfair advantage..., it will have large economies of scale that will enable it to negotiate more favorable terms with pharmaceutical companies and other providers. But why, exactly, is this unfair? ... If the public plan negotiates better terms -- thereby demonstrating that ... providers can meet them -- private plans could seek similar deals.

But, say the critics, the public plan starts off with an unfair advantage because it's likely to have lower administrative costs. That may be true -- Medicare's administrative costs per enrollee are a small fraction of typical private insurance costs -- but here again, why exactly is this unfair? Isn't one of the goals ... to lower administrative costs? If the public option pushes private plans to trim their bureaucracies and become more efficient, that's fine. ...

Critics charge that the public plan will be subsidized by the government. Here they have their facts wrong. Under every plan that's being discussed on Capitol Hill, subsidies go to individuals and families who need them in order to afford health care, not to a public plan. Individuals and families use the subsidies to shop for the best care they can find. They're free to choose the public plan, but that's only one option. ... Legislation should also make crystal clear that the public plan ... may not dip into general revenues to cover its costs. It must pay for itself. And any government entity that oversees ... health-insurance ... must not favor the public plan.

Finally, critics say that because of its breadth and national reach, the public plan will be able to collect and analyze patient information on a large scale to discover the best ways to improve care. The public plan might even allow clinicians who form accountable-care organizations to keep a portion of the savings they generate. Those opposed to a public option ask how private plans can ever compete with all this. The answer is they can and should. It's the only way we have a prayer of taming health-care costs. But here's some good news for the private plans. The information gleaned by the public plan about best practices will be made available to the private plans...

As a practical matter, the choice people make between private plans and a public one is likely to function as a check on both. Such competition will encourage private plans to do better... At the same time, it will encourage the public plan to be as flexible as possible. ... [T]he president ... should come out swinging for the public option.

links for 2009-06-24

• Why We Need a Public Health-Care Plan - Robert Reich
• Modeling Everything, Public Plan Edition - The Baseline Scenario
• Building a Better Biosphere? - NYTimes.com
• Where Are The Global Problem Solvers? - Jeff Sachs
• Too big to fail is too big - FT.com
• Ben Bernanke should be reappointed - Richard Green
• Getting Incentives Right - Kevin Drum
• US launches WTO case against China - FT
• The Science of Economic Bubbles and Busts - Scientific American
• Something for Nothing - David Brooks
• Saving rates everywhere are rising - Rebecca Wilder
• Making Financial Regulation Work: A Systemic Risk Regulator - Dean baker

"A Lost Decade for Jobs"

Michael Mandel looks at job growth over the last decade, and it's not a pretty picture:

A Lost Decade for Jobs, Economics Unbound: Private sector job growth was almost non-existent over the past ten years. Take a look at this horrifying chart:

Between May 1999 and May 2009, employment in the private sector sector only rose by 1.1%, by far the lowest 10-year increase in the post-depression period.

It’s impossible to overstate how bad this is. ...

Over the past 10 years, the private sector has generated roughly 1.1 million additional jobs, or about 100K per year. The public sector created about 2.4 million jobs.

But even that gives the private sector too much credit. Remember that the private sector includes health care, social assistance, and education, all areas which receive a lot of government support. I’ve been talking about the HealthEdGov sector. ...

Most of the industries which had positive job growth over the past ten years were in the HealthEdGov sector. In fact, financial job growth was nearly nonexistent once we take out the health insurers.

Let me finish with a final chart.

Without a decade of growing government support from rising health and education spending and soaring budget deficits, the labor market would have been flat on its back.

"Incomplete Contracts and Brinkmanship"

Regulation can be roughly categorized as being one of two types, rules based and principles based. With rules based regulation, behaviors are explicitly ruled out through an extensive set of regulations, ordinances, laws, and the like, whereas with principles based regulation a broad set of guidelines outlining the principless regulators are trying to enforce is issued, then the regulators take whatever steps are needed to enforce those principles.

This post from Jeff Ely at Cheap Talk can be used to highlight a connection between complete/incomplete contracts and rules/principles based regulation:

Incomplete Contracts and Brinkmanship in the iPhone App Store, by Jeff Ely: One of the highly touted features of the iPhone is the abundance of applications...  In traditional Apple fashion,... Apple exercises strict control over which apps are made available through the app store. Short of jailbreaking your phone, there is no other way to install third-party software.

The process by which apps are submitted and reviewed strikes many as highly inefficient.  (It also strikes many as anti-competitive, but that is not the subject of this post...) Developers sink significant investment producing launch-ready versions of their software and only then learn definitively whether the app can be sold. There is no recourse if the submission is denied.

(Just recently, we witnessed an extreme example of the kind of deadweight loss that can result.  A fully licensed, full-featured Commodore64 Operating System emulator, 1 year in the making, was just rejected from the app store. )

Unfortunately, this is an inevitable inefficiency due to the ubiquitous problem of incomplete contracting.  In a first-best world, Apple would publicize an all-encompassing set of rules outlining exactly what software would be accepted and what would be rejected.  In this imaginary world of complete contracts, any developer would know in advance whether his software would be accepted and no effort would be wasted.

In reality it is impossible to conceive of all of the possibilities, let alone describe them in a contract.  Therefore, in this second-best world, at best Apple can publish a broad set of guidelines and then decide on a case-by-case basis when the final product is submitted.  This introduces inefficiencies at two levels.  First, the direct effect is that developers face uncertainty whether their software will pass muster and this is a disincentive to undertake the costly investment at the beginning.

But the more subtle inefficiency arises due to the incentive for gamesmanship that the imperfect contract creates.  First, Apple’s incentive in constructing guidelines ex ante is to err on the side of appearing more permissive than they intend to be.  Apple ... values the option to bend the (unwritten) rules a bit when a good product materializes.  ...

Second, because Apple cannot predict what software will appear it cannot make binding commitments to reject software that is good but erodes slightly their standards.  This gives developers an incentive to engage in a form of brinkmanship:  sink the cost to create a product highly valued by end users but which is questionable from Apple’s perspective.  By submitting this software the developer puts Apple in the difficult position of publicly rejecting software that end users want and the fear of bad publicity may lead Apple to accept software that they would have like to commit in advance to reject.

The iPhone app store is only a year old and many observers think of it as a short-run system that is quickly becoming overwhelmed by the surprising explosion of iPhone software.  When the app store is reinvented, it will be interesting to see how they approach this unique two-sided incentive problem.

To see the connection, here are a few sections from above rewritten so that the Fed rather than Apple is the regulator:

Unfortunately, an inevitable inefficiency arises due to the ubiquitous problem of incomplete contracting. In a first-best world, The Fed would publicize an all-encompassing set of rules outlining exactly what would be accepted and what would be rejected.  In this imaginary world of complete contracts, any financial institution would know in advance whether the new financial product they have created would be accepted and no effort would be wasted.

In reality it is impossible to conceive of all of the possibilities, let alone describe them in a contract. Therefore, in this second-best world, at best the Fed can publish a broad set of guidelines and then decide on a case-by-case basis when the financial product is submitted. This introduces inefficiencies at two levels. First, the direct effect is that financial firms face uncertainty whether their new products will pass muster and this is a disincentive to undertake the costly investment at the beginning.

Second, because the Fed cannot predict what new products will appear it cannot make binding commitments to reject a product that is good but erodes slightly their standards. This gives financial institutions an incentive to engage in a form of brinkmanship:  sink the cost to create a product highly valued by end users but which is questionable from the Fed’s perspective. By submitting this product the financial institution puts Apple in the difficult position of publicly rejecting products that end users want and the fear of bad publicity may lead the Fed to accept products that they would have liked to have committed in advance to reject.

I don't think it's one or the other, there's room for both, and principles based seems useful when it's difficult to explicate all the ways to bypass a particular rule (e.g. the designer drug issue).

But I'm not sure that the distinction between the two types of regulation is all that useful - I find it hard to draw a clear line that separates one from the other - and I doubt most of you are much interested in the topic.

So let me make a comment about Apple. The monopoly problem is set aside here, but I think it's part of the problem. If other competitors existed, it wouldn't necessarily be an all or nothing proposition for applications. If it doesn't make it at one outlet, you can always try another if the marketplace is competitive (and the competition should also help to move the regulation to an optimal configuration, at least in theory). It might take some amendments to the code, but once something is built it's usually not too hard to rewrite it in a different language. Thus, though more competition wouldn't completely eliminate the problem, it would certainly help.

But what I don't understand is why they don't allow pre-approval. Why can't you submit an idea and say something like "my app will emulate Commodore64 Operating System, will you accept that?" Apple might be worried about, say, security holes with a particular app and it may not be able to fully judge this until the code is actually written, but this condition could be written into the pre-approval, and pre-approval would encourage more development while also cutting down on their workload to approve apps after they are developed (since many wopuld be pre-screened). And I think financial regulators could do the same thing, review proposed products prior to their actual development to reduce the waste associated with the development of new products.

Bernanke, Summers, or Yellen? None of the Above?

Should Ben Bernanke be reappointed as Fed chair?:

Bernanke Set to Defend Record as Reappointment Debate Begins, by Scott Lanman, Bloomberg: Federal Reserve Chairman Ben S. Bernanke will defend his unprecedented actions to prevent a financial collapse as debate on whether he should be reappointed begins. Bernanke, whose term expires Jan. 31, faces lawmakers at a hearing this week...

President Barack Obama has said the Fed chief has done an “extraordinary job” without committing to reappoint him. ...

At stake is whether Bernanke ... pilots the Fed into an expanded financial-supervision role after overseeing the most aggressive use of the Fed’s powers since the Great Depression. ...

Bernanke has helped thaw credit markets and put the economy on a path toward recovery. Odds favor the former Princeton University economist, a Republican: Reappointment may be less disruptive to investors, and no first-term president has replaced a sitting chairman in 30 years. Many on Wall Street and in Washington view it as likely Bernanke will be reappointed.

“There’s a very strong case for reappointment,” said Douglas Lee... “Removing a Fed chairman who is generally perceived to have done an outstanding job would be an enormous problem.” ...

Still, any Obama decision may be half a year away, and the economy and financial markets could shift again. ...

Besides keeping Bernanke, Obama’s options include appointing Summers or Janet Yellen...

Summers ... is considered the front-runner should the president want a change. San Francisco Fed President Yellen ... was previously a Fed governor and chairman of the Council of Economic Advisers and would be the first female Fed chief.

Summers wants the job...

House Financial Services Committee Chairman Barney Frank said he’s “very pleased” with Bernanke. “Beyond that I wouldn’t say” anything about a renomination...

I'd reappoint him. If forced to choose between Yellen and Summers, I'd choose Yellen.

links for 2009-06-23

• Why all regulatory roads lead to the Fed - Frederic Mishkin
• Review of Akerlof and Shiller - John Quiggin
• Why is American food so popular in Japan? - Daniel Gross
• Brain represents tools as temporary body parts - EurekAlert
• How should Latvia exit its currency peg? - voxeu.org
• European public opinion, migration, and welfare benefits - voxeu.org
• A Fairer Credit Card? Priceless - NYTimes.com
• Yes Virginia, there was an international financial crisis - Brad Setser
• Is freely available research better disseminated? - voxeu.org
• Silver's flawed analysis of health care $ - Brendan Nyhan
• Don't borrowing-constrained households spend more of a tax cut?? - Nick Rowe

FRBSF: Fighting Downturns with Fiscal Policy

Sylvain Leduc of the San Francisco Fed reviews several studies on the effectiveness of fiscal policy and concludes:

The findings from the three empirical studies, particularly those of Romer and Romer and Mountford and Uhlig, suggest that the fiscal stimulus package will boost growth substantially over the next two years, partly because it includes sizeable tax cuts that can be implemented quickly and that have significant effects on output. Nevertheless, the uncertainty regarding those estimates remains high. ...

This brings up a point about tax cuts I've been meaning to make (again). The effectiveness of tax cuts depends, in part, on how hard the recession hits household balance sheets. In a recession where balance sheets are relatively unaffected, a tax cut may very well translate into spending, and do so fairly quickly.

But when balance sheets are hit hard, the result is different. In this case tax cuts may be used largely to rebuild balance sheets - to recover what was lost - rather than for new spending. Thus, in this recession the stimulative effects of tax cuts may not have as large of an immediate effect as in the past (there are also reasons to suspect the government spending multipliers shown in the table below are underestimated due to the fact that this recession is not like those in the data used to produce the estimates, e.g. for one, the historical data may overestimate the crowding out effect, but for now I want to focus on taxes).

The fact that in this recession tax cuts may not have as large of an immediate impact as in the past should not necessarily lead us to conclude that the tax cuts were a waste. That is, households will not turn back to consumption until they have saved enough to make up for what has been lost, at least in part, so how long it takes for the recession to end depends upon how quickly household balance sheets are refilled (once this is over, I expect saving rates to be higher than in the past, but I also expect that saving will fall some from where they are now once balance sheets are in better shape). The faster they are refilled, the sooner people begin to spend more, and the sooner this thing ends.

So in that sense, the tax cuts were not a waste at all. Unfortunately, however, during the time when the balance sheets are being refilled it will look like the stimulus package is not having any effect - all you see is higher savings rate - but again, the higher saving rate brings the end of the recession nearer in time, and that is important in and of itself. That's a hard effect to estimate, even if you are looking for it after the fact, but again, it shouldn't be dismissed as inconsequential.

Finally, because tax cuts are likely to be saved more than in the past, and hence have a smaller impact than tax multipliers from historical data suggest, and because there is reason to think that government spending multipliers rise as recessions get more severe (e.g. even if interest rates go up, investment is likely to be insensitive when conditions are bad), the logic of using both tax cuts and spending to stimulate the economy is sound.

Here's more:

Fighting Downturns with Fiscal Policy, by Sylvain Leduc, FRBSF Economic Letter: Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals. The main argument is that monetary policy can act quickly when output falls below an economy's potential or when inflation varies from its optimal rate, and that these actions can be reversed quickly as conditions change. By contrast, modifications to the fiscal code take a long time to enact and implement and can be very difficult to undo.

However, the current recession is clearly not a typical downturn. In particular, unlike other post-World War II U.S. recessions, monetary policy has run out of its usual ammunition to boost economic activity. The federal funds rate, the principal tool that the Federal Reserve uses to stabilize the economy, is now hovering near zero. Because interest rates cannot be negative in nominal terms, monetary policymakers are unable to lower the federal funds rate further. In this situation, the Federal Reserve has turned to unconventional tools to get around this barrier, commonly called the zero lower bound.

Because of the severity of the recession and the uncertain effects of unconventional monetary policy tools, Congress and the Obama Administration have also enacted a fiscal stimulus package. The $787 billion program approved by Congress in February includes a mix of tax and spending measures aimed at creating jobs and boosting output. Yet, economists and political leaders heatedly debate whether tax cuts or increased spending are more effective, a dispute that's hard to resolve because of the difficulty of determining the precise magnitude of fiscal policy's impact on real GDP. This Economic Letter examines some recent empirical studies analyzing data on the relative effects of higher spending and lower taxes on output.

Paul Krugman: Health Care Showdown

What's with the Blue-Cross Dogs?:

Health Care Showdown, by Paul Krugman, Commentary, NY Times: America’s political scene has changed immensely since the last time a Democratic president tried to reform health care. So has the health care picture: with costs soaring and insurance dwindling, nobody can now say with a straight face that the U.S. health care system is O.K. And if surveys ... are any indication, voters are ready for major change.

The question now is whether we will nonetheless fail to get that change, because a handful of Democratic senators are still determined to party like it’s 1993.

And yes, I mean Democratic senators. The Republicans ... role ... is ... shouting the old slogans — Government-run health care! Socialism! Europe! — hoping that someone still cares.

The polls suggest that hardly anyone does. Voters, it seems, strongly favor a universal guarantee of coverage, and they mostly accept ... that higher taxes may be needed... What’s more, they overwhelmingly favor precisely the feature ... that Republicans denounce most fiercely as “socialized medicine” —... a public health insurance option that competes with private insurers.

Or to put it another way, in effect voters support the health care plan jointly released by three House committees last week... Yet it remains all too possible that health care reform will fail...

I’m not that worried about the issue of costs ..., we can afford universal health insurance... Furthermore, Democratic leaders know that they have to pass a health care bill for the sake of their own survival. One way or another, the numbers will be brought in line.

The real risk is that health care reform will be undermined by “centrist” Democratic senators... What the balking Democrats seem most determined to do is to kill the public option, either by eliminating it or by ... replacing a true public option with something meaningless. For the record, neither regional health cooperatives nor state-level public plans, both of which have been proposed as alternatives, would have the financial stability and bargaining power needed to bring down health care costs.

Whatever may be motivating these Democrats, they don’t seem able to explain their reasons in public.

Thus Senator Ben Nelson of Nebraska initially declared that the public option — which, remember, has overwhelming popular support — was a “deal-breaker.” Why? Because he didn’t think private insurers could compete: “At the end of the day, the public plan wins the day.” Um, isn’t the purpose of health care reform to protect American citizens, not insurance companies?

Mr. Nelson softened his stand after reform advocates began a public campaign targeting him for his position on the public option.

And Senator Kent Conrad of North Dakota offers a perfectly circular argument: we can’t have the public option, because if we do, health care reform won’t get the votes of senators like him. “In a 60-vote environment,” he says (implicitly rejecting the idea, embraced by President Obama, of bypassing the filibuster if necessary), “you’ve got to attract some Republicans as well as holding virtually all the Democrats together, and that, I don’t believe, is possible with a pure public option.”

Honestly, I don’t know what these Democrats are trying to achieve. Yes, some of the balking senators receive large campaign contributions from the medical-industrial complex — but who in politics doesn’t? If I had to guess, I’d say that what’s really going on is that relatively conservative Democrats still cling to the old dream of becoming kingmakers, of recreating the bipartisan center that used to run America.

But this fantasy can’t be allowed to stand in the way of giving America the health care reform it needs. This time, the alleged center must not hold.

Mishkin: How to Get the Fed Out of Its 'Box'

Frederic Mishkin is worried about the long-run budget and how it constrains what the Fed can do:

How to Get The Fed Out Of Its 'Box', by Frederic Mishkin, Commentary, WSJ: When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma.

Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around ... 0.70%,... the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates ... has the potential to choke off economic recovery and lead to further deterioration in the housing market. ... Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?

To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause ... is the more positive economic news..., particularly in financial markets. The bad news is ... the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. ...

Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, ... be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.

The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy... The fiscal situation argues against this policy action, because it would weaken the Fed's inflation-fighting credibility.

How can the Fed get out of the box and pursue the expansionary monetary policy that is needed...? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions..., fiscal stimulus to promote economic recovery ... in a severe recession is a sensible prescription.

However, the failure to take steps to get future budgets under control is a recipe for disaster. Not only does it make it difficult for the Fed..., but it may even make the fiscal stimulus package less effective. After all, if you know that the government is issuing a lot of debt ... you can expect to pay much higher taxes in the future. With the prospect of higher taxes, you will be less likely to spend today.

How can the Obama administration and Congress help the Fed do its job and help the fiscal stimulus package work? It needs to address exploding spending on entitlements -- Social Security and particularly Medicare -- which are causing future deficit projections to be so bleak.

One possibility is to establish a nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s. ... Another is taxing health-care benefits as part of any package to reform health care. Taxing health-care benefits would ... generate large amounts of revenue. It would also increase the incentive for people to lower the costs of their health care. There are surely many other ways to promote more fiscal responsibility.

The Fed can assist this process. It could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past. In the current extremely difficult economic environment, we surely need such a deal now.

As has been pointed out here many times, the inflation and interest rate concerns are likely overblown, as is the worry that consumption will suffer significantly due to the expectation of taxes in the future, and hence the motivation to attack entitlements is not as strong as suggested. Also, there is also at least some question about the Fed's ability to control long-term interest rates.

But beyond that the projected increase in health care costs is the biggest problem with the long-run budget by far, and the Obama administration is trying to reform the health care system. So the administration is attempting to "address exploding spending on entitlements," at least the one that is actually exploding - there's no sense in which the projected increase in the deficit due to Social Security can be described as "exploding" - and if the Fed, Mishkin, or anyone else wants to assist with that effort with deals or op-eds that promote the necessary reform, I'm sure the administration would welcome their help.

links for 2009-06-22

• Risks of a double-dip, W-shaped recession may be growing - Nouriel Roubini
• How to Get The Fed Out Of Its 'Box' - Frederic Mishkln
• A thin outline of regulatory reform - Clive Crook
• Is Behavioral Economics Doomed? - Cheap Talk
• Towards a Fiscal Constitution - Economic Principals
• Don't believe the hyperinflation hype - Telegraph
• Small countries defenseless in global economic crisis - Michael Spence
• The Supply Side of Housing Markets - NBER Reporter

Productivity and the Internet

What do you think of Robert Waldmann's theory?:

The Internet and the Productivity Speedup, Angry Bear: The unexpected increase in US productivity growth in the 90's and naughties is an economic puzzle. At the time it was widely argued that investments in information and communications technology had finally finally paid off, that computers and the internet allowed vastly improved corporation wide inventory control and the increased output given inputs reflected lower work in progress inventories. ... hmmmm maybe. ...

I ... think it has to do with office workers and, in particular, middle management. ...[M]iddle managers and affiliated secretaries and janitors and such count in the denominator of labor productivity. In the 90s there was a wave of downsizing and delayering. Basically top management in many firms decided to thin the ranks of middle management on the grounds that middle managers weren't doing anything useful. The outcome says that the top managers were ruthless and right.

"How Activists Make or Break Radical Innovations"

Tom Slee reviews Hayagreeva Rao's Market Rebels: How Activists Make or Break Radical Innovations:

Review: Market Rebels, by Hayagreeva Rao, Whimsley: For decades, economists have extended their intellectual reach ... in an attempt to encompass all the social sciences in their analytical framework. But now the boot is on the other foot and it looks like even core economic observations may be better explained by other social sciences. Robert Solow apparently said that attempts to explain differences in economic growth across countries typically end in "a blaze of amateur sociology". The focus on psychology in explanations of the banking crash shows that growth is not the only area of economics where the discipline runs out of steam before reaching its destination. The rise of behavioural economics, surely a last-gasp attempt by economists to match their models to the real world without changing departments, suggests that the condition goes deep.

Despite its title, Hayagreeva Rao's Market Rebels (Open Library link, publisher's page) challenges the economic analysis of innovations. At 180 pages and full of case studies ... Rao does not hammer the reader over the head with the implications of his case studies, but for me as a non-sociologist and non-economist the implications are huge and I'll be thinking about the book for a long time.

The case studies are diverse, but are centered around a single claim: the "joined hands of activists" play an important part in the creation, diffusion, and blocking of innovations. Collective action matters. Rao describes how hobbyists were key to the cultural acceptance of the car and the development of the personal computer; how microbrewers brought diversity back to beer; how nouvelle cuisine grew from the rebellious student movements of Paris 1968; how shareholder activism has pushed large companies to change behaviours; how community activists attempted to stall the spread of chain stores and then of big-box stores; how the green movement blocked the development of biotechnology in Europe. ...

Blinder: Why Inflation isn't the Danger

Alan Blinder isn't worried about inflation:

Why Inflation Isn’t the Danger, by Alan S. Blinder, Economic View, NY Times: Some people with hypersensitive sniffers say the whiff of future inflation is in the air. ... Concluding that the Fed is leading us into inflation assumes a degree of incompetence that I simply don’t buy. Let me explain.

First, the clear and present danger, both now and for the next year or two, is not inflation but deflation. ... Core inflation near zero, or even negative, is a live possibility for 2010 or 2011.

Ben S. Bernanke ... and his colleagues have been working overtime to dodge the deflation bullet. To this end, they cut the Fed funds rate to virtually zero last December and have since relied on a variety of extraordinary policies known as quantitative easing to restore the flow of credit. ... But quantitative easing is universally agreed to be weak medicine compared with cutting interest rates. So the Fed is administering a large dose — which is where all those reserves come from.

The mountain of reserves on banks’ balance sheets has, in turn, filled the inflation hawks with apprehension. ... Will the Fed really withdraw all those reserves fast enough as the financial storm abates? If not, we could indeed experience inflation. Although the Fed is not infallible, I’d make three important points:

links for 2009-06-21

• The Global Financial Crisis: Selective Recent Research - NBER Reporter
• Reforming financial regulations in America: - The Economist
• Does unconventional monetary and fiscal policy presage inflation? - Ajay Shah
• How a Wall Street Revamp Expands the Status Quo - NYTimes.com

"Schlocky"?

Andrew Gelman:

Is it "schlocky" to compare life expectancies between countries?, by Andrew Gelman: Greg Mankiw writes:

The next time you hear someone cavalierly point to international comparisons in life expectancy as evidence against the U.S. healthcare system, you should be ready to explain how schlocky that argument really is.

He points to the following claim by Gary Becker:

National differences in life expectancies are a highly imperfect indicator of the effectiveness of health delivery systems. For example, life styles are important contributors to health, and the US fares poorly on many life style indicators, such as incidence of overweight and obese men, women, and teenagers. To get around such problems, some analysts compare not life expectancies but survival rates from different diseases. The US health system tends to look pretty good on these comparisons.

Becker cites a study that finds that the U.S. does better than Europe in cancer survival rates and in the availability of hip and knee replacements and cataract surgery.

It makes a lot of sense to think of health as multidimensional, so that some countries can do better in life expectancy while others do better in hip replacements and cancer survival.

But I disagree with Mankiw's claim that it's "schlocky" to compare life expectancy. If the U.S. really is spending lots more per person on health care and really getting less in life expectancy compared to other countries . . . that seems like relevant information.

Saving Universal Health Care

Robert Reich has some advice for the president:

Memo to the President: What You Must Do To Save Universal Health Care, by Robert Reich:  Mr. President:

Momentum for universal health care is slowing dramatically on Capitol Hill. ...[A]s you know, the worst news came days ago when the Congressional Budget Office weighed in with awful projections about how much the ... plans would cost... Yet these projections didn't include the savings that a public option would generate by negotiating lower drug prices, doctor fees, and hospital costs, and forcing private insurers to be more competitive. Projecting the future costs of universal health care without including the public option is like predicting the number of people who will get sunburns this summer if nobody is allowed to buy sun lotion. ...

If you want to save universal health care, you must do several things, and soon: