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Friday, July 31, 2009

"Forecasts vs. Mechanisms in Economics"

Putting up another post all too quickly between conference sessions:

Forecasts vs mechanisms in economics, by Chris Dillow: This discussion between Edmund Conway and Andrew Lilico on the Today programme on the alleged crisis in economics seems to me to rest upon a misunderstanding of what economics is.

Conway says the crisis has been “an earthquake for economic thought” and Lilico says we need “new theories.“  This, though, seems to regard economics as a settled but inadequate body of knowledge and theory. It’s not. It is instead a vast number of diverse insights. What’s more, all of the insights that help explain the current economic crisis were, in truth, well known to economists before 2007, for example:

  1. Risk cannot be simply described by a bell curve. But we learnt about tail risk on October 19 1987. And we learnt from the collapse of LTCM in 1998 that correlation risk, liquidity risk and counterparty risk are all significant.
  2. Assets can be mispriced. But we’ve known about bubbles for centuries - since at least 1637. Their existence does not disprove the efficient market hypothesis; as I’ve said, the EMH is not the rational investor hypothesis. Nor, contrary to Conway’s implicit claim, is the EMH inconsistent with the possibility that behaviour can be swayed by emotions; the EMH allows for the possibility of time-varying risk premia*
  3.  Long periods of economic stability can lead to greater risk-taking. We’ve known this since (at least) Hyman Minsky.
  4.  Banks can suffer catastrophic losses - which are correlated across banks. We learnt this - not for the first time - in the Latin American debt crisis of the early 80s and in the crises in Japan and the Nordic countries in the early 90s. Banking crises are a regular feature of even developed economies.
  5.  Institutions, such as banks, can be undermined by badly designed incentives.  But there’s a huge literature on the principal-agent problem.
  6. The current crisis, then, has not thrown up much that economists didn’t know.

    Instead, our problem is a different one. It’s that what we have are lots of mechanisms, capable of explaining why things happen and the links between them. What we don’t have are laws which generate predictions. In his book, Nuts and Bolts for the Social Sciences, Jon Elster stressed this distinction. The social sciences, he said:

Can isolate tendencies, propensities and mechanisms and show that they have implications for behaviour that are often surprising and counter-intuitive. What they are more able to do is to state necessary and sufficient conditions under which the various mechanisms are switched on.

This is precisely the problem economists had in 2007. We knew that there were mechanisms capable of generating disaster. What we didn’t know is whether these were switched on. The upshot is that, although we didn’t predict the crisis, we can more or less explain it after the fact. As Elster wrote:

Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. True, in many cases one and the same theory will enable us to do both, but I believe that in the social sciences this is the exception rather than rule.

The interesting question is: will it remain the exception? My hunch is that it will; economists will never be able to produce laws which yield systemically successful forecasts.  

What’s more, I am utterly untroubled by this. The desire for such laws is as barmy as the medieval search for the philosopher’s stone. If you need to foresee the future, you are doing something badly wrong.

* The basic insight of efficient market theory is that you cannot out-perform the market except by taking extra risk. I am sick and tired of hearing people who still have to work for a living trying to deny this.

I think the statements on prediction are overly broad. If you raise the price of a good, in all but a few cases such as when price is interpreted as a signal of quality, we can predict what will happen, quantity demanded will fall. By exactly how much will quantity demanded fall? In some microeconomic applications, the bounds can be fairly tight. For example, I suspect Hal Varian at Google - who has access to vast amounts of data and the ability to conduct all else equal type experiments - has a fairly tight estimate of important parameters that indicate how, say, changing the price of an ad will impact Google's revenue stream. He has also been doing some interesting work on prediction, e.g. see Predicting Initial Claims for Unemployment Benefits. But in other cases, particularly in macroeconomics and the prediction of turning points, success has been much more modest (or absent altogether). However, I am not as pessimistic as Chris that we will never be able to do predict the course of the economy, but it will require that we begin to better understand how pressures build within the macroeconomic system, how to measure and monitor these pressures (e.g. measures such global and sectoral imbalances or price rent ratios, but those are hardly sufficient in and of themselves), and ultimately how to relieve the pressures when they begin to build to threatening levels.

    Posted by on Friday, July 31, 2009 at 11:31 AM in Economics, Methodology | Permalink  Comments (21)


    Paul Krugman: Health Care Realities

    When it comes to health care, "government involvement is the only reason our system works at all":

    Health Care Realities, by Paul Krugman, Commentary, NY Times: At a recent town hall meeting, a man stood up and told Representative Bob Inglis to “keep your government hands off my Medicare.” The congressman, a Republican from South Carolina, tried to explain that Medicare is already a government program — but the voter, Mr. Inglis said, “wasn’t having any of it.”

    It’s a funny story — but it illustrates the extent to which health reform must climb a wall of misinformation. It’s not just that many Americans don’t understand what President Obama is proposing; many people don’t understand the way American health care works right now. They don’t understand, in particular, that getting the government involved in health care wouldn’t be a radical step: the government is already deeply involved, even in private insurance.

    And that government involvement is the only reason our system works at all.

    The key thing you need to know about health care is that it depends crucially on insurance. You don’t know when or whether you’ll need treatment — but if you do, treatment can be extremely expensive, well beyond what most people can pay... Triple coronary bypasses, not routine doctor’s visits, are where the real money is, so insurance is essential.

    Yet private markets for health insurance, left to their own devices, work very badly: insurers deny as many claims as possible, and they also try to avoid covering people who are likely to need care. Horror stories are legion...

    And in their efforts to avoid ... paying medical bills, insurers spend much of the money taken in through premiums ... on “underwriting” — screening out people likely to make insurance claims. In the individual insurance market,... so much money goes into underwriting and other expenses that only around 70 cents of each premium dollar actually goes to care.

    Still, most Americans do have health insurance, and are reasonably satisfied... How is that possible, when insurance markets work so badly? The answer is government intervention.

    Most obviously, the government directly provides insurance via Medicare and other programs. ... Medicare — which is ... one of those “single payer” systems conservatives love to demonize — covers everyone 65 and older. And surveys show that Medicare recipients are much more satisfied with their coverage than Americans with private insurance.

    Still, most Americans under 65 do have some form of private insurance. The vast majority, however, don’t buy it directly: they get it through their employers. There’s a big tax advantage to doing it that way... But to get that tax advantage employers have to follow a number of rules; roughly speaking, they can’t discriminate based on pre-existing medical conditions or restrict benefits to highly paid employees.

    And it’s thanks to these rules that employment-based insurance more or less works, at least in the sense that horror stories are a lot less common than they are in the individual insurance market.

    So here’s the bottom line: if you currently have decent health insurance, thank the government. ...

    Which brings us to the current debate over reform.

    Right-wing opponents of reform would have you believe that President Obama is a wild-eyed socialist, attacking the free market. But unregulated markets don’t work for health care — never have, never will. To the extent we have a working health care system at all right now it’s only because the government covers the elderly, while a combination of regulation and tax subsidies makes it possible for many, but not all, nonelderly Americans to get decent private coverage.

    Now Mr. Obama basically proposes using additional regulation and subsidies to make decent insurance available to all of us. That’s not radical; it’s as American as, well, Medicare.

      Posted by on Friday, July 31, 2009 at 12:36 AM in Economics, Health Care | Permalink  Comments (117)


      The Courage to Click

      Brad DeLong asks Do I Dare Click Through on This article by Jonah Goldberg? He then answers "No. I do not. I will remain forever ignorant..."

      I dared to click through. Next time, I won't bother, and let me save you the trouble. The argument is that we don't spend enough to fight the threat of asteroids, so we must be spending too much fighting global warming, but one doesn't follow from the other. I see now why I can't remember the last time I read an article by Goldberg.

      Maybe this sudden bout of timidity from Brad DeLong is my fault (though there is a sign he is recovering). Last night, I was the one who didn't dare click through on an article, so I sent the link to Brad saying "I just couldn’t read this. Maybe tomorrow." Looks like that may have sent him over the edge:

      Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal, by Brad DeLong: Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal!

      My friend Mark Thoma is trying to diminish my quality of life by emailing me links to Donald Luskin writing in the Wall Street Journal:

      Luskin: President Barack Obama proposed last month that the Fed act as an overall “systemic risk” regulator, with consolidated supervisory responsibility over “large, interconnected firms whose failure could threaten the stability of the system.” Now William C. Dudley, the ex-Goldman Sachs economist just appointed president of the New York Federal Reserve, has upped the ante.... Mr. Dudley is effectively asking for the power to control asset prices...

      Sigh.

      Sigh.

      Sigh.

      The Federal Reserve is not "asking for the power to control asset prices." It already has the power to control--or, rather, profoundly influence--asset prices already. When the Federal Reserve carries out an expansionary open-market operation, the whole point of the exercise is that it boosts bond and stock prices. The Federal Reserve buys bonds for cash. There are then fewer bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes up, and their yields--the interest rates quoted in the financial press--go down. Also by supply and demand, when bonds are yielding less investors are willing to pay more for substitute assets like equities and real estate, and their prices go up as well.

      When the Federal Reserve carries out a contractionary open market operation, the same process works in reverse: the whole point of the exercise is that it lowers bond and stock prices. The Federal Reserve sells bonds for cash. There are then more bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes down, and their yields--the interest rates quoted in the financial press--go up. Also by supply and demand, when bonds are yielding more investors are willing to pay less for substitute assets like equities and real estate, and their prices go down as well.

      For Luskin to claim that Dudley is asking for something new--that there is an extraordinary increase in the big, bad government's power to regulate financial markets contained in Dudley's "effectively asking for the power to control asset prices" is to demonstrate a degree of cluelessness that takes my breath away. The Federal Reserve already has the power to control asset prices. It has had this power since its founding in 1913. That's the point. That's what a central bank does. That's what it's for: it's an island of central planning power seated in the middle of the market economy.

      If you don't like it, call for its abolition. But don't pretend that it isn't there--don't pretend that "Mr. Dudley... asking for the power to control asset prices" is some wild change in our current system.

      Jeebus save us...

      Continue reading "The Courage to Click" »

        Posted by on Friday, July 31, 2009 at 12:33 AM in Economics, Financial System, Monetary Policy, Regulation | Permalink  Comments (7)


        "Savings Rate Could Stay High"

        Andy Harless explains why he believes that much of the recent increase in the savings rate will be permanent, while Brad DeLong thinks "only a small part" will be permanent. My own view is somewhere between Andy's "much" and Brad's "small part": 

        Savings Rate Could Stay High, by Andy Harless: Mark Thoma shows us a historical chart of the personal savings rate since 1960 and asks how much of the recent increase (from an average of about 0.5% from 2005 through 2007 to a peak of almost 7% in May of this year) is permanent? One must, of course, take the May figure with a grain of salt: the savings rate rose in May largely because tax withholding was reduced; unless that attempt at a stimulus is completely ineffective, we should expect the savings rate to decline as people start taking advantage of the new disposable income. But even before May the savings rate this year was running consistently above 4%, which is a dramatic change from a few years ago. Let’s use the April figure – 5.6% – as a guesstimate of what the “true” savings rate is right now and ask how much of that will be permanent.

        Not much, thinks Brad DeLong:

        I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.

        I’m inclined to disagree. Undoubtedly the savings rate will fall somewhat as the degree of financial distress declines, but I think there’s a good case to be made that much of the increase is permanent.

        For one thing, from the point of view of households, “financial distress” may be extremely slow to lift. If the Japanese experience is any guide, it is a very slow process to get a severely distressed banking system to start lending normally again, and it’s not clear that things are going to be any easier for the US. Meanwhile, most forecasts expect the unemployment rate to remain quite high for several years. It could take 3 years, or 5 years, or 10 years, or 20 years before the financial distress lifts.

        Granted, even 20 years is not forever, and 3 years is certainly not forever, but it’s long enough to stop thinking about household behavior as being continuous over time. We can reasonably surmise that, even without so much financial distress, the savings rate would have trended upward over time. Presumably households would gradually have come to recognize that they weren’t saving enough. (Can zero be anywhere near enough?) And as baby boomers’ children settle into their own careers, they would cease to be a drag on their parents’ savings, and at the same time those parents would have to start worrying seriously about retirement. The financial distress messed up this scenario (or maybe just speeded it up), but the underlying trend should still be going on “beneath the surface.” By the time the distress lifts, there will be other reasons for the savings rate to be higher than it was in 2006.

        That argument is rather speculative, I admit, but there are more solid reasons to expect the savings rate to remain high.

        Continue reading ""Savings Rate Could Stay High"" »

          Posted by on Friday, July 31, 2009 at 12:23 AM in Economics, Saving | Permalink  Comments (11)


          Why Wasn't an RTC-like Institution Set up for TARP?

          Where are the technocratic institutions?:

          Why wasn't an RTC-like institution set up for TARP?, by Economics of Contempt: Brad DeLong asks...:

          I do have one big question. The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930’s Reconstruction Finance Corporation and the 1990’s RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial guts of the economy to turn out relatively well, without an overwhelming degree of corruption and rent seeking. ...

          So I wonder: why didn’t the US Congress follow the RFC/RTC model when authorising George W. Bush’s and Barack Obama’s industrial and financial policies?

          ...I think it's an interesting question..., so I'll take this chance to offer my response. With regard to TARP, I think Congress didn't set up an RTC-like institution because the feeling was that there simply wasn't enough time. Neither the RTC nor the RFC were set up during market panics. By the time the RTC was set up in 1989, the S&L crisis had been raging for several years, and the 1987 stock market crash had come and gone. Similarly, the RFC was created in January 1932—over 2 years after the stock market crash of '29.

          Time was of the essence back in September, and in order to respond with the necessary speed and force, more discretion had to be given to the executive branch. The RTC, for example, was run by a board of directors and a separate oversight board. In a crisis, policy-by-committee doesn't work. The market had to be confident that help was coming soon, and wouldn't be held up by internal government bickering (think Sheila Bair).

          Why wasn't an RTC-like institution created once the financial markets more or less stabilized, and time was no longer of the essence? That's easy: because Congress already gave the executive branch the money. In the administration's view (which I largely share), there's no real benefit from creating a separate "technocratic" institution to administer TARP. Treasury is a highly "technocratic" institution itself, as DeLong no doubt knows, having worked in the Clinton Treasury. I have great confidence in Tim Geithner's competence—in fact, I don't think there's anyone I'd rather have in charge of TARP.

            Posted by on Friday, July 31, 2009 at 12:10 AM in Economics, Financial System | Permalink  Comments (4)


            links for 2009-07-31

              Posted by on Friday, July 31, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (21)


              Thursday, July 30, 2009

              What Caused Foreclosures?

              Richard Green:

              Michael Lacour-Little says it's all about the refinances, by Rickard Green: He points me to:

              Why are so many homeowners underwater on their mortgages?

              In crafting programs to prevent foreclosures, policymakers have assumed that the primary reason homeowners owe more on their home than it is worth is that they bought at the top of the market. In other words, they’ve lost equity primarily through forces beyond their control.

              A new study challenges this premise and finds that excessive borrowing may have played as great a role.

              Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn’t purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.

              The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.

              Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.

              “[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage,” writes Mr. LaCour-Little. “Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes.”

              If other housing markets across the country offer similar findings, then the study argues that current “policies aimed at protecting homeowners from foreclosure are misguided” because lenders, and not borrowers, have born the lion’s share of economic losses.

              Borrowers that bought homes without ever putting any or little equity in their homes could have seen huge returns on investment simply by extracting cash through refinancing. “Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear,” the authors write.

              Michael is a co-author of mine (and was a student at Wisconsin while I taught there), and has a gift for slicing up mortgage data. On the policy question, we might think about treating the half who did not refinance differently, as they were drowned by the flood.

                Posted by on Thursday, July 30, 2009 at 02:24 PM in Economics, Housing | Permalink  Comments (38)


                To Page this Person, Press Five Now...

                From my son Paul:

                Take Back the Beep Campaign, Pogue's Posts: ...I’ve been ranting about one particularly blatant money-grab by U.S. cellphone carriers: the mandatory 15-second voicemail instructions.

                Suppose you call my cell to leave me a message. First you hear my own voice: “Hi, it’s David Pogue. Leave a message, and I’ll get back to you”–and THEN you hear a 15-second canned carrier message.

                • Sprint: “[Phone number] is not available right now. Please leave a detailed message after the tone. When you have finished recording, you may hang up, or press pound for more options.”
                • Verizon: “At the tone, please record your message. When you have finished recording, you may hang up, or press 1 for more options. To leave a callback number, press 5. (Beep)”
                • AT&T: “To page this person, press five now. At the tone, please record your message. When you are finished, you may hang up, or press one for more options.”
                • T-Mobile: “Record your message after the tone. To send a numeric page, press five. When you are finished recording, hang up, or for delivery options, press pound.”

                (You hear a similar message when you call in to hear your own messages...)...

                [UPDATE: iPhone owners' voicemail doesn't have these instructions--Apple insisted that AT&T remove them. And Sprint already DOES let you turn off the instructions message, although it's a buried, multi-step procedure...]

                These messages are outrageous for two reasons. First, they waste your time. Good heavens: it’s 2009. WE KNOW WHAT TO DO AT THE BEEP.

                Do we really need to be told to hang up when we’re finished!? Would anyone, ever, want to “send a numeric page?” Who still carries a pager, for heaven’s sake? Or what about “leave a callback number?” We can SEE the callback number right on our phones!

                Second, we’re PAYING for these messages. These little 15-second waits add up–bigtime. If Verizon’s 70 million customers leave or check messages twice a weekday, Verizon rakes in about $620 million a year. That’s your money. And your time: three hours of your time a year, just sitting there listening to the same message over and over again every year.

                In 2007, I spoke at an international cellular conference in Italy. The big buzzword was ARPU–Average Revenue Per User. The seminars all had titles like, “Maximizing ARPU In a Digital Age.” And yes, several attendees (cell executives) admitted to me, point-blank, that the voicemail instructions exist primarily to make you use up airtime, thereby maximizing ARPU.

                Right now, the carriers continue to enjoy their billion-dollar scam only because we’re not organized enough to do anything about it. But it doesn’t have to be this way. ... Let’s push back... Send them a complaint, politely but firmly. Together, we’ll send them a LOT of complaints. [List of addresses for complaints in full post.] If enough of us make our unhappiness known, I’ll bet they’ll change. ... I have a feeling that the volume of complaints will be too big for them to ignore. ...

                  Posted by on Thursday, July 30, 2009 at 12:38 PM in Economics | Permalink  Comments (10)


                  Fed Watch: More Confirmation of Steady Monetary Policy

                  Tim Duy sees, among other things, the possibility of another bubble:

                  More Confirmation of Steady Monetary Policy, by Tim Duy: Green shoots - or, as President Obama says - the beginning of the end of the recession aside, the Fed will not be ready to reverse their accommodative policy stance anytime soon. New York Federal Reserve  President William Dudley said as much in a speech today:

                  If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

                  The Fed continues to expect that low levels of resource utilization will keep a lid on inflation. While some might object that emerging market economies can have both weak growth and high inflation, those economies still have an important transmission mechanism between higher prices and higher wages that appears to be missing in the US. Indeed, while the press focused on the old news "recession is ending" angle of the Beige Book, the money quote for policymakers was:

                  The weakness of labor markets has virtually eliminated upward wage pressure, and wages and compensation are steady or falling in most Districts; however, Boston cited some manufacturing and business services firms raising pay selectively, and Minneapolis said wage increases were moderate. Boston, Cleveland, Richmond, Chicago, Dallas, and San Francisco cited a range of methods firms are using to limit compensation, including cutting or freezing wages or benefit contributions, deferral of future salary increases, trimming bonuses and travel allowances, reducing hours, temporary shutdowns, periodic furloughs, and unpaid vacations.

                  Until economic growth is sufficient to propel wages upward, any residual price pressures are likely to be snuffed out by deteriorating real wage growth. Will the job market improve anytime soon? We get a fresh look at initial unemployment claims tomorrow morning, but the July consumer confidence report from the Conference Board indicates that households see a deteriorating jobs picture:

                  The share of consumers who said jobs are plentiful dropped to 3.6 percent, the lowest level since February 1983. The proportion of people who said jobs are hard to get climbed to 48.1 percent from 44.8 percent.

                  Lacking a story that leads to strong wage growth in the near - or even medium - term, the Fed is almost certainly on hold at least through this year and likely well into 2010, allowing the size of the balance sheet to adjust according to the needs of the financial markets while keeping interest rates at rock bottom levels. That doesn't mean all that easy money will not show up somewhere - technical analysts are looking for US equities to explode on the basis of recent market action. But will the Fed lean against such an explosion without clear and convincing evidence that the labor market is poised for strong, sustainable improvement? I doubt it - and for those looking for it, therein lies the ingredients for making the next big bubble.

                    Posted by on Thursday, July 30, 2009 at 12:06 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (11)


                    Sluggish Wages and Employment

                    Following up briefly on part of Tim's post, once the economy turns the corner, for wages to increase two things must happen. First, there is a lot of expansion that can come from currently employed workers through expanded hours, reversing temporary shutdowns, eliminating forced furloughs, no longer allowing unpaid vacations, those sorts of things. These bring hours and other work conditions back to normal and hence do not place much if any upward pressure on wages. There is a lot of slack in hours alone that can be taken up before the existing workforce is fully utilized, and adding back hours that have been taken away does not require an increase in wages. (There are some cases where the wage rate was cut instead of hours, and even some cases where both happened, but because the proportion of firms that cut wages is relatively small, even if those wage cuts are reversed it would not have much of an effect on the overall wage rate, and it would be a one-time change in wages in any case, not continuous upward wage pressure).

                    Second, even if the existing workforce reaches normal (full) employment conditions, there are still a lot of workers who are unemployed, and they can be hired at the existing wage rate. It is not until the existing workforce returns to normal and the unemployed find new jobs that wages come under pressure. When the economy is at full employment, expanding the number of workers in a particular firm requires that they be bid away from other opportunities, and that pushes wages up. But when there is unemployment, there are no alternative opportunities and hence no upward pressure on wage rates.

                    Finally, note that when there is slack in the existing labor force due to a decline in hours worked, etc., there will be a delay between the time the economy turns around and the time when employment begins increasing. This isn't the only reason there is a delay in the response of employment, but it contributes to it.

                      Posted by on Thursday, July 30, 2009 at 12:05 AM in Economics, Unemployment | Permalink  Comments (64)


                      "Some Thoughts on Wages and Competitiveness"

                      Another follow-up to Tim's post gleaned from a post by Karl Whelan at The Irish Economy:

                      Some Thoughts on Wages and Competitiveness, by Karl Whelan: There’s a lively debate going on about ... competitiveness and recovery...

                      Despite what seems to me to be an exceptionally strong attitude in this country [Ireland] of calling on the government to solve every possible problem, we are largely a market economy and wage rates are set in a relatively decentralised fashion compared with other European countries.  And despite the faith of many that unregulated labour markets should always clear to produce full employment, we have plenty of macroeconomic evidence that this is not the case.

                      The reality is that, in all economies, negative macroeconomic shocks tend to raise unemployment because wages never adjust quickly enough to get the labour market back to full employment.  This has been a mainstream theme in macroeconomics since, at least, the General Theory. 

                      In more recent decades, New Keynesian macroeconomic theorists have put forward a plethora of models to explain why the labour market does not operate according to the simple market-clearing  fashion (efficiency wages, implicit contract theory, bargaining models based on “holdups”).  More recently, behavioural economists have documented the importance of “money illusion’’ which makes workers particularly resistant to cuts in nominal wages. The result is a significant amount of empirical evidence demonstrating the existence of nominal and real wage rigidity.

                      This is not to argue that wages are completely rigid or that the labour market does not have mechanisms to bring unemployment down after a negative shock.  Macroeconomic data generally show good fits for Phillips Curve relationships such that wage growth is low when unemployment is high.  But governments will generally not want to rely only on this mechanism to restore macroeconomic equilibrium because the pace of recovery will be too slow. Instead, they prefer, where possible, to use countercyclical fiscal and monetary policy. ...

                      I should note that the argument in the full post gives more credence to wage cuts as a recession fighting strategy that I would. Here's Paul Krugman on the topic:

                      [W]e may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.

                      Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

                      But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

                      In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.

                      Things get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: “The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period.” And a rise in the effective interest rate is the last thing this economy needs.

                      Concern about falling wages isn’t just theory. Japan — where private-sector wages fell an average of more than 1 percent a year from 1997 to 2003 — is an object lesson in how wage deflation can contribute to economic stagnation.

                        Posted by on Thursday, July 30, 2009 at 12:04 AM in Economics, Unemployment | Permalink  Comments (34)


                        "Surprising Comparative Properties of Monetary Models"

                        I need to read this paper:

                        Surprising Comparative Properties of Monetary Models: Results from a New Data Base, by John B. Taylor and Volker Wieland, May 2009 [open link]: Abstract: In this paper we investigate the comparative properties of empirically-estimated monetary models of the U.S. economy. We make use of a new data base of models designed for such investigations. We focus on three representative models: the Christiano, Eichenbaum, Evans (2005) model, the Smets and Wouters (2007) model, and the Taylor (1993a) model. Although the three models differ in terms of structure, estimation method, sample period, and data vintage, we find surprisingly similar economic impacts of unanticipated changes in the federal funds rate. However, the optimal monetary policy responses to other sources of economic fluctuations are widely different in the different models. We show that simple optimal policy rules that respond to the growth rate of output and smooth the interest rate are not robust. In contrast, policy rules with no interest rate smoothing and no response to the growth rate, as distinct from the level, of output are more robust. Robustness can be improved further by optimizing rules with respect to the average loss across the three models.

                          Posted by on Thursday, July 30, 2009 at 12:03 AM in Academic Papers, Environment, Monetary Policy | Permalink  Comments (5)


                          links for 2009-07-30

                            Posted by on Thursday, July 30, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (11)


                            Wednesday, July 29, 2009

                            "How Wars, Plagues, and Urban Disease Propelled Europe’s Rise to Riches"

                            [Note: Travel day today, so I am letting things that are posted do most of the talking. I'll add what I can along the way. Update: Off to a great start - left my iPhone at the last airport ... grrr. Update: Sitting in Detroit airport, hungry, and just dropped my sandwich on the floor. I really want to eat it anyway, but won't. ... grrr. Update: I made it to Ithaca, someone found my phone and turned it in to lost and found, and I got another sandwich. Plus, amazingly, the shuttle to the hotel was waiting when I walked out to get a taxi. Yeah!  Now the only problem is that I usually go to sleep pretty late - 3 a.m. is not unusual - and that's about when I have to get up given the time change. Hmmm. That won't help my talk. ... grrr.]

                            "This column explains why Europe’s rise to riches in the early modern period owed much to exceptionally bellicose international politics, urban overcrowding, and frequent epidemics."

                            Cruel windfall: How wars, plagues, and urban disease propelled Europe’s rise to riches, by Nico Voigtländer and Hans-Joachim Voth, Vox EU: In a pre-modern economy, incomes typically stagnate in the long run. Malthusian regimes are characterised by strongly declining marginal returns to labour. One-off improvements in technology can temporarily raise output per head. The additional income is spent on more (surviving) children, and population grows. As a result, output per head declines, and eventually labour productivity returns to its previous level. That is why, in HG Wells' phrase, earlier generations "spent the great gifts of science as rapidly as it got them in a mere insensate multiplication of the common life" (Wells, 1905).

                            How could an economy ever escape from this trap? To learn more about this question, we should look more closely at the continent that managed to overcome stagnation first. Long before growth accelerated for good in most countries, a first divergence occurred. European incomes by 1700 exceeded those in the rest of the world by a large margin. We explain the emergence of this income gap by a number of uniquely European features – an unusually high frequency of war, particularly unhealthy cities, and numerous deadly disease outbreaks.

                            Continue reading ""How Wars, Plagues, and Urban Disease Propelled Europe’s Rise to Riches"" »

                              Posted by on Wednesday, July 29, 2009 at 01:21 AM in Economics | Permalink  Comments (42)


                              "Why had Nobody Noticed that the Credit Crunch Was on its Way?"

                              A letter to the Queen attempting to explain why economists missed the financial crisis:

                              Her Majesty The Queen
                              Buckingham Palace
                              London
                              SW1A 1AA

                              MADAM,

                              When Your Majesty visited the London School of Economics last November, you quite rightly asked: why had nobody noticed that the credit crunch was on its way? The British Academy convened a forum on 17 June 2009 to debate your question... This letter summarises the views of the participants ... and we hope that it offers an answer to your question.

                              Many people did foresee the crisis. However, the exact form that it would take and the timing of its onset and ferocity were foreseen by nobody. ...

                              There were many warnings about imbalances in financial markets... But the difficulty was seeing the risk to the system as a whole rather than to any specific financial instrument or loan. Risk calculations were most often confined to slices of financial activity, using some of the best mathematical minds in our country and abroad. But they frequently lost sight of the bigger picture.

                              Many were also concerned about imbalances in the global economy ... known as the ‘global savings glut’. ... This ... fuelled the increase in house prices both here and in the USA. There were many who warned of the dangers of this.

                              But against those who warned, most were convinced that ... the financial wizards had found new and clever ways of managing risks. Indeed, some claimed to have so dispersed them through an array of novel financial instruments that they had virtually removed them. It is difficult to recall a greater example of wishful thinking combined with hubris. There was a firm belief, too, that financial markets had changed. ... A generation of bankers and financiers deceived themselves and those who thought that they were the pace-making engineers of advanced economies.

                              All this exposed the difficulties of slowing the progression of such developments in the presence of a general ‘feel-good’ factor. Households benefited from low unemployment, cheap consumer goods and ready credit. Businesses benefited from lower borrowing costs. Bankers were earning bumper bonuses... The government benefited from high tax revenues... This was bound to create a psychology of denial. It was a cycle fuelled, in significant measure, ... by delusion.

                              Among the authorities charged with managing these risks, there were difficulties too. ... General pressure was for more lax regulation – a light touch. ...

                              There was a broad consensus that it was better to deal with the aftermath of bubbles ... than to try to head them off in advance. Credence was given to this view by the experience, especially in the USA ... when a recession was more or less avoided after the ‘dot com’ bubble burst. This fuelled the view that we could bail out the economy after the event.

                              Inflation remained low and created no warning sign of an economy that was overheating. ... But this meant that interest rates were low by historical standards. And some said that policy was therefore not sufficiently geared towards heading off ... risks. ... But on the whole, the prevailing view was that monetary policy was best used to prevent inflation and not to control wider imbalances in the economy.

                              So where was the problem? Everyone seemed to be doing their own job properly... And according to standard measures of success, they were often doing it well. The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction. This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe. Individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast.

                              So in summary, Your Majesty, the failure..., while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole. ...

                              We have the honour to remain, Madam,
                              Your Majesty’s most humble and obedient servants

                              Professor Tim Besley, FBA
                              Professor Peter Hennessy, FBA

                              [See also At your own risk and Economists were beholden to the long boom.]

                                Posted by on Wednesday, July 29, 2009 at 12:51 AM in Economics, Financial System | Permalink  Comments (49)


                                Exchequer Tallies

                                The "first experiment with derivative financial instruments":

                                Theory of Games and Economic Misbehavior, by George Dyson, Edge: ...There are numerous precedents for [the derivatives now haunting us].

                                As early as the twelfth century it was realized that money ... can be made to exist in more than one place at a single time. An early embodiment of this principle, preceding the Bank of England by more than five hundred years, were Exchequer tallies — notched wooden sticks issued as receipts for money deposited with the Exchequer for the use of the king. "As a financial instrument and evidence it was at once adaptable, light in weight and small in size, easy to understand and practically incapable of fraud," wrote Hilary Jenkinson in 1911. ...

                                A precise description was given by Alfred Smee... "The tally-sticks were made of hazel, willow, or alder wood, differing in length according to the sum required to be expressed upon them. They were roughly squared, and one end was pointed; and on two sides of that extremity, the proper notches, showing the sum for which the tally was a receipt, were cut across the wood." 11

                                On the other two sides of the tally were written, in ink and in duplicate, the name of the party paying the money, the account for which it was paid, and the date of payment. The tally was then split in two, with each half retaining the notched information as well as one copy of the inscription. "One piece was then given to the party who had paid the money, for which it was a sufficient discharge," Smee continues, "and the other was preserved in the Exchequer. Rude and simple as was this very ancient method of keeping accounts, it appears to have been completely effectual in preventing both fraud and forgery for a space of seven hundred years. No two sticks could be found so exactly similar ... when split in the coarse manner of cutting tallies; and certainly no alteration of the ... notches and inscription could remain undiscovered when the two parts were again brought together. ..." 12

                                Exchequer tallies were ordered replaced in 1782 by an "indented cheque receipt," but the Act of Parliament (23 Geo. 3, c. 82) thereby abolishing "several useless, expensive and unnecessary offices" was to take effect only on the death of the incumbent who, being "vigorous," continued to cut tallies until 1826. "After the further statute of 4 and 5 William IV the destruction of the official collection of old tallies was ordered," noted Hilary Jenkinson. "The imprudent zeal with which this order was carried out caused the fire which destroyed the Houses of Parliament in 1834." 13

                                The notches were of various sizes and shapes corresponding to the tallied amount: a 1.5-inch notch for £1000, a 1-inch notch for £100, a half-inch notch for £20, with smaller notches indicating pounds, shillings, and pence, down to a halfpenny, indicated by a pierced dot. The code was similar to bar-coding... And the self-authentication achieved by distributing the information across two halves of a unique piece of wood is analogous to the way large numbers, split into two prime factors, are used to authenticate digital financial instruments today. Money was being duplicated: the King gathered real gold and silver into the treasury through the Exchequer, yet the tally given in return allowed the holder to enter into trade, manufacturing, or other ventures, producing real wealth with nothing more than a wooden stick.

                                Until the Restoration tallies did not bear interest, but in 1660, on the accession of Charles II, interest-bearing tallies were introduced. They were accompanied by written orders of loan which, being made assignable by endorsement, became the first negotiable interest-bearing securities in the English-speaking world. Under pressure of spiraling government expenditures the order of loan was soon joined by an instrument called an order of the Exchequer, drawn not against actual holdings but against future revenue and sold at a discount to the private goldsmith bankers whose hard currency was needed to prop things up. In January 1672, unable to meet its obligations, Charles II declared a stop on the Exchequer. At the expense of the private bankers, this first experiment with derivative financial instruments came to an end. ...

                                  Posted by on Wednesday, July 29, 2009 at 12:51 AM in Economics, Financial System | Permalink  Comments (5)


                                  Wealth Inequality

                                  Daniel Little on wealth inequality:

                                  Wealth inequality, by Daniel Little: When we talk about inequality in the United States, we usually have a couple of different things in mind. We think immediately of income inequality. Inequalities of important life outcomes come to mind (health, housing, education), and, of course, we think of the inequalities of opportunity that are created by a group's social location (race, urban poverty, gender). But a fundamental form of inequality in our society is a factor that influences each of these: inequalities of wealth across social groups. Wealth refers to the ownership of property, tangible and intangible: for example, real estate, stocks and bonds, savings accounts, businesses, factories, mines, forests, and natural resources. Two facts are particularly important when it comes to wealth: first, that wealth is in general very unevenly distributed in the United States, and second, that there are very striking inequalities when we look at the average wealth of major social groups.

                                  Edward Wolff has written quite a bit about the facts and causes of wealth inequality in the United States. A recent book, Top Heavy: The Increasing Inequality of Wealth in America and What Can Be Done About It, Second Edition, is particularly timely; also of interest is Assets for the Poor: The Benefits of Spreading Asset Ownership. Wolff summarizes his conclusion in these stark terms:

                                  The gap between haves and have-nots is greater now--at the start of the twenty-first century--than at anytime since 1929. The sharp increase in inequality since the late 1970s has made wealth distribution in the United States more unequal than it is in what used to be perceived as the class-ridden societies of northwestern Europe. ... The number of households worth $1,000,000 or more grew by almost 60 percent; the number worth $10,000,000 or more almost quadrupled. (2-3)

                                  The international comparison of wealth inequality is particularly interesting. Wolff provides a chart of the share of marketable wealth held by the top percentile in the UK, Sweden, and the US, from 1920 to 1992. The graph is striking. Sweden starts off in 1920 with 40% of wealth in the hands of the top one percent, and falls fairly steadily to just under 20% in 1992. UK starts at a staggering 60% (!) in the hands of the top 1 percent in 1920, and again, falls steadily to a 1992 level of just over 20%. The US shows a different pattern. It starts at 35% in 1920 (lowest of all three countries); then rises and falls slowly around the 30% level. The US then begins a downward trend in the mid-1960s, falling to a low of 20% in the 1970s; and then, during the Reagan years and following, the percent of wealth rises to roughly 35%. So we are roughly back to where we were in 1920 when it comes to wealth inequalities in the United States, by this measure.

                                  Why does this kind of inequality matter?

                                  Continue reading "Wealth Inequality" »

                                    Posted by on Wednesday, July 29, 2009 at 12:50 AM in Economics, Equity | Permalink  Comments (17)


                                    links for 2009-07-29

                                      Posted by on Wednesday, July 29, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (5)


                                      Tuesday, July 28, 2009

                                      Where are the Technocratic Institutions?

                                      Brad DeLong wonders why the response to the financial crisis hasn't included technocratic institutions to limit executive power:

                                      Conservative Interventionism, by J. Bradford DeLong, Commentary, Project Syndicate: At this stage in the worldwide fight against depression, it is useful to stop and consider just how conservative the policies implemented by the world’s central banks, treasuries, and government budget offices have been. Almost everything that they have done – spending increases, tax cuts, bank recapitalisation, purchases of risky assets,... and ... money-supply expansions – has followed a policy path that is nearly 200 years old...

                                      The place to start is 1825, when panicked investors wanted their money invested in safe cash rather than risky enterprises. Robert Banks Jenkinson, Second Earl of Liverpool and First Lord of the Treasury for King George IV, begged Cornelius Buller, Governor of the Bank of England, to act to prevent financial-asset prices from collapsing. “We believe in a market economy,” Lord Liverpool’s reasoning went, “but not when the prices a market economy produces lead to mass unemployment on the streets of London, Bristol, Liverpool, and Manchester.”

                                      The Bank of England acted: it intervened in the market and bought bonds for cash, pushing up the prices of financial assets and expanding the money supply. It loaned on little collateral to shaky banks. It announced its intention to stabilize the market – and that bearish speculators should beware.

                                      Ever since, whenever governments largely ... let financial markets work their way out of a panic out by themselves – 1873 and 1929 in the United States come to mind – things turned out badly. But whenever government stepped in or deputized a private investment bank to support the market, things appear to have gone far less badly. ... [F]ew modern governments are now willing to let financial market heal themselves. To do so would be a truly radical step indeed. The Obama administration and other central bankers and fiscal authorities around the globe are thus, in a sense, acting very conservatively... I ... am somewhat reluctant to second-guess them.  ...

                                      Nevertheless, I do have one big question. The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930’s Reconstruction Finance Corporation and the 1990’s RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial ... economy ... without an overwhelming degree of corruption and rent seeking. The discretionary power of executives, in past crises, was curbed by new interventionist institutions constructed on the fly by legislative action.

                                      That is how America’s founders ... envisioned that things would work. They were suspicious of executive power, and thought that the president should have rather less discretionary power than the various King Georges of the time. ...

                                      So I wonder: why didn’t the US Congress follow the RFC/RTC model when authorising George W. Bush’s and Barack Obama’s industrial and financial policies? Why haven’t the technocratic institutions that we do have, like the IMF, been given a broader role in this crisis? And what can we do to rebuild international financial-management institutions on the fly to make them the best possible?

                                        Posted by on Tuesday, July 28, 2009 at 01:54 PM in Economics, Financial System, Policy | Permalink  Comments (23)


                                        Equity and Efficiency in Health Care Markets

                                        This is an attempt to clarify a few of the remarks I've made over the last several days regarding the need for government intervention in health care markets.

                                        There are two separate reasons to intervene, market failure and equity. Taking market failure first, there are a variety of failures in health care and insurance markets such as asymmetric information, market power, and principal agent problems. These can be solved by the private sector in some cases, but in others government intervention is required.

                                        But even if the private sector or the government can solve the market failure problems adequately, there's no guarantee that the resulting distribution of health care services will be equitable. We don't expect the private sector to, for example, make sure that everyone can live on the coast and have an ocean view if they so desire, we use market prices to ration those goods, but we may want to make sure that everyone can get health care when they have serious illnesses. So equity considerations may prompt the government to intervene and bring about a different distribution of health care services than would occur with an efficient market.

                                        I believe that economists have something to offer in both cases. In the first, economic theory offers solutions to market failures, and though not every market failure can be completely overcome, the solutions can guide effective policy responses. I prefer market-based regulation to command and control solutions whenever possible, i.e. I prefer that government create the conditions for markets to function rather than direct intervention. But sometimes the only solution is to intervene directly and forcefully.

                                        In the second case, the idea is a bit different. Here, equity is the issue so somehow society must first designate the outcome it is trying to produce before economists can help to achieve it. Right now, it is my perception that the majority of people want to expand to universal or near universal coverage if we can do so without breaking the bank, and without reducing the care they are used to. If we can find a way to do that, the majority will come on board. If that's the case, if that's what we have collectively decided we want, then the job of the economists is to find the best possible way of achieving that outcome (or whatever outcome is desired) given whatever constraints bind the process (whether political realities should be part of the set of constraints is a point of contention, so I'll stay silent on that).

                                        So if we are only concerned about efficiency, we do our best to resolve the market failures and leave it at that. We make sure, for example, that people have the information they need to make informed decisions about their care, that there aren't incentives that cause doctors to order too much or too little of some type of care or test, that monopoly power is checked, etc., etc. There's no guarantee that everyone will receive care, or that the distribution of care among those who do receive care will be as desired.

                                        But if we are concerned with equity too - and most of us aren't comfortable watching people suffer when we know that help is readily available (perhaps nature imposes this externality upon us purposefully) - if we won't let people die on the street or suffer needlessly due to our sense of fairness and equity - then we will want to intervene to achieve broad based coverage in the least cost and fairest manner we can find (and there may be other equity issue that are important too).

                                        Both reasons, equity and efficiency, can justify government intervention into health care markets. I think equity is of paramount importance when it comes to health care, so for me that is enough to justify government intervention, and the existence of market failure simply adds to the case that government intervention is needed.

                                        So those opposed to government involvement in health care markets have to first argue that there is no market failure significant enough to justify intervention, a tough argument in and of itself, and also argue that people who, for example, go without insurance or cannot afford the basic care they need deserve no compassion whatsoever from society more generally. That's an argument I could never make even for those who could have paid for insurance but chose to take a chance they wouldn't need care, let alone for those who cannot afford it under any circumstances. I want everyone to be covered as efficiently as possible, and to be required to pay their fair share of the bill, whatever that might be, for the care that's made available to them.

                                          Posted by on Tuesday, July 28, 2009 at 01:08 AM in Economics, Equity, Health Care, Market Failure | Permalink  Comments (84)


                                          What's the Matter with the Blue Dogs?

                                          Jacob Hacker wonders why the Blue Dogs oppose health care reform that could provide significant help to their constituents:

                                          Health Care for the Blue Dogs, by Jacob S. Hacker, Commentary, Washington Post: The fate of health-care reform ... hinges on ... the ... "Blue Dogs" -- who are threatening to jump ship.

                                          The main worry expressed by the Blue Dogs is that the ... leading bills ... won't bring down medical inflation. The irony is that the Blue Dogs' argument -- that a new public insurance plan designed to compete with private insurers should be smaller and less powerful, and that Medicare and this new plan should pay more generous rates to rural providers -- would make reform more expensive, not less. The further irony is that the federal premium assistance that the Blue Dogs worry is too costly ... would make health-care affordable for a large share of their constituents. ...

                                          Increasing what doctors and hospitals are paid by the new public plan, as the Blue Dogs desire, would only raise premiums and health costs for their constituents. It would also fail to address excessive payments to hospitals and specialists...

                                          Many Blue Dogs fret that a new public health insurance plan will become too large... Their concern should be that a public plan will be too weak. A public health plan will be particularly vital for Americans in the rural areas that many Blue Dogs represent. ...

                                          Yet the Blue Dogs have mostly ignored the huge benefits of a new public plan for their districts. ... Right now, large swaths of farmers, ranchers and self-employed workers can barely afford a policy ... or are uninsured. They will benefit greatly from the premium assistance in the House legislation..., from additional subsidies for small businesses to cover their workers, and from a new national purchasing pool, or "exchange," giving those employers access to low-cost group health insurance that's now out of reach.

                                          And given that Blue Dogs are worried about the ... cost of reform, they should applaud the House bill's requirement that all but the smallest of employers make a meaningful contribution to the cost of coverage. This will not just raise much-needed revenue..., it will also reduce the incentive for employers to drop coverage and let their workers go into the pool, increasing the size of the exchange and the public plan.

                                          Blue Dogs have the future of health-care reform in their hands. If they hold firm to their principles of fiscal responsibility and effective relief for workers and employers in their districts, what's good for Blue Dogs will also be good for America.

                                          Maybe their most important constituents aren't the voters in their districts?

                                            Posted by on Tuesday, July 28, 2009 at 12:43 AM in Economics, Health Care, Politics | Permalink  Comments (21)


                                            Interconnectedness and the Distribution of Default Risk

                                            I was asked what went wrong that caused economists to miss the financial crisis. For me, a key part of it was the belief in the risk distribution model. Let me give a simple example of how risk distribution works:

                                            There are 100 people, each has $1,000 saved, and those balances are sitting idle, they have not been loaned out.

                                            There are 100 different people who have loan projects that promise to pay more than simply putting the money in the bank (for simplicity, assume bank deposits earn no interest, but if they do, that won't change any of the conclusions drawn below). However, the default rate on these loans is 10%.

                                            Suppose that the individuals with the accumulated savings are very risk averse. In particular, suppose that they only have this money temporarily, they will have their own bills to pay in the future (e.g. they will need to repay other types of loans), and they are just looking to put the money to work safely in the interim. If they lose any principal, they will go into default on the loans they need to repay in the future, and that's not a risk they are willing to take.

                                            But this means no loans will be made. With a default rate of 10%, 10 of the 100 people will, in fact, lose everything, and that would mean going into default. Thus, without some means of sharing risk, none of them are not willing to risk losing all of their savings, at least not at an interest rate anyone would be willing to pay, and the market will not exist.

                                            Now suppose that there are financial market intermediaries who come up with the following innovation to distribute risk. They will accept the deposits and pay 3.5% on them, and they will make loans at 15% (I'm assuming that the demand for these loans exists to avoid complicating things unnecessarily).

                                            Let's see what happens if the savers take them up on their 3.5% offer, and then the deposits are lent at 15%. First, let's look at the original principal. There are 100 loans of $1,000 for a total value of (100)*($1,000) = $100,000. But not all of it is paid back. Subtract off the 10% of loans that default, i.e. subtract $10,000 leaving a payback of $90,000. So the original principal falls from $100,000 to $90,000 due to defaults (assuming a zero scrap value).

                                            But the 15% interest rate is more than sufficient to cover the $10,000 loss so that nobody actually loses anything. To see this, the next step is to add interest to the $90,000 in good loans. Since 90 people pay back $150 in interest each, the interest return is $13,500, more than the $10,000 loss. Thus, the total amount paid back, with interest, is $103,500. Now divide this among the lenders, i.e. divide this by 100 to get $1,035 returned to each person who made a loan. Thus, with the risks distributed across all the lenders, instead of 10 people losing everything, everyone makes 3.5% (I didn't build bank profit into the example, but that's easy to do).

                                            So in this example, rather than 10% of the lenders losing everything, a risk they won't take, they all make 3.5% on their investment. So long as the 10% default rate is accurate, this is a fairly certain return and they will be willing to enter the market.

                                            (Note however that if the default rate turns out to be, say, 25% instead of 10%, then the lenders will lose principal, e.g. at 25% they are only repaid $8,625 each leaving an $1,375 shortage. This could cause them to default on their own loan payments, and that could in turn bring about more defaults in a spreading, domino style collapse.)

                                            Before moving on to what I missed - I'm in no hurry to point that out - note one thing about this example. Risk distribution does not reduce risks overall. It does reduce the size of the risk that an individual faces - nobody loses everything unless every single loan defaults (with zero repayment in every case) - but overall the losses are still $10,000 whether individuals or intermediaries make the loans. There are ways in which financial intermediation can reduce overall risk, e.g. the expertise of the intermediaries at assessing risk is supposed to reduce the 10% default rate, and generally it would, I just didn't build this in. But the point is that risk distribution does what it says, it distributes risk, it does not reduce it. Many people misunderstood this.

                                            O.K., here's where I went wrong, or one place anyway. I thought that default in the mortgage market would be like the default of these loans. The defaults would be distributed through complex financial products not just among U.S. lenders, but throughout the world, and that meant nobody would lose very much, certainly not enough to cause big problems. If problems developed, everyone would lose a little bit just like above. This belief was widespread among economists. The financial innovation driven by fancy mathematical models was supposed to assure that risk was widely distributed, and the insiders in these markets repeatedly reassured everyone that if problems did develop, they would be so widely dispersed that there was nothing to worry about.

                                            But that's not what happened. Why? One reason is simple. The default rate was higher than expected, and that brought about unexpected losses. For example, above a 25% default rate means losses of $1,375 on the $10,000 investment leaving a shortage as this money is needed to repay other loans. But those losses still should have been widely dispersed, widely enough to avoid big problems.

                                            But there's something else that explains how these losses spread to create such a big problem. The degree to which the people making the loans and taking out the loans were interconnected was misunderstood (that is, risks were more concentrated than we thought). The people borrowing and lending the money had far more financial interconnections than we noticed or knew about - there was a lot of borrowing and lending among them that was hidden or ignored - and when the higher than expected number of borrowers defaulted, that meant some of the people expecting payments from the lenders were forced into default as well. In the example above, remember that the lenders only had the money short-term, they would need the money later to repay their debts and were just trying to make something on the accumulated balances in the intervening period. But with losses of $1,375 rather than the anticipated gain, they are short on funds and hence must sell assets, call in loans, reduce consumption, etc. to try to accumulate sufficient cash balances to pay what they owe. But not everyone will be able to come up with the money they need, especially as asset prices fall as they are put up for sale, loans dry up, etc., and that will cause more defaults and the problems will spread. Thus, as lenders and everyone else try to rebuild what was lost so they can pay their own bills, that causes even more difficulty, and the result is more defaults on loans, and a process that feeds on itself in a downward spiral of defaults and further problems.

                                            So a key thing I missed was the degree to which these markets are interconnected, and that may explain why I've emphasized finding better measures of interconnectedness, and then insulating markets against it as part of the reform process (and leverage is a key factor driving the interconnections).

                                            *****

                                            Update: As a follow-up to some of the discussion in comments, here are some past posts on the cause of crisis:

                                              Posted by on Tuesday, July 28, 2009 at 12:34 AM in Economics, Financial System | Permalink  Comments (36)


                                              links for 2009-07-28

                                                Posted by on Tuesday, July 28, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (23)


                                                Monday, July 27, 2009

                                                Update to "A Breakthrough in the Fight against Hunger"

                                                The post "A Breakthrough in the Fight against Hunger" summarizes Jeff Sachs' favorable view of the G-8’s $20bn initiative on smallholder agriculture (e.g. to provide assistance buying seed and fertilizer), and also gives Murat Iyigun's view of the type of developmental assistance advocated by many economists. Since Iyigun mentions Bill Easterly explicitly, and since Easterly and Sachs have an ongoing debate on this (and many other) issues, I promised an update if Bill Easterly responded. I just received this email:

                                                Sachs mentions the lessons of history, but doesn't acknowledge the nearly universal agreement that past efforts at African Green Revolutions (with the same list of interventions that Sachs lists) have failed (see the documentation in my recent JEL article -- ungated version here). That doesn't mean giving up, but it does mean learning from history, trying to figure out why it failed in the past and correcting it -- why does Sachs find this idea so threatening?

                                                On Iyigun's blog, I'm so happy to finally find somebody who gets it, that you shouldn't invade countries based on economists' crappy econometrics, that I have nothing else to add. I have had a lot more difficulty convincing people of this than I expected.

                                                  Posted by on Monday, July 27, 2009 at 01:41 PM in Economics, Market Failure | Permalink  Comments (12)


                                                  Adverse Selection

                                                  With health care reform in the news, there's been quite a bit of talk about adverse selection and the degree to which it is actually a problem in health care and health insurance markets. Some people have even gone so far as to question whether significant adverse selection effects exist at all outside of textbooks since when they look at the marketplace, they have a hard time finding it.

                                                  But the thing is, if you go looking for it in the marketplace, you aren't likely to find it. Unless the problem has been largely overcome either the government intervention or the through private sector institutions constructed to fix the problem (generally intermediaries who can solve the information problem that generates the market failure), the market will fail to exist at all. So you will either observe a fairly well-functioning market that has overcome the problem, or you won't see a market at all.

                                                  So if you want evidence of adverse selection, you should look for the institutions designed to overcome the problem - e.g. used car dealers with the expertise needed to  overcome the one-sided information problem on car quality, and then issue quality guarantees (or develop a reputation for quality) acting as intermediaries, that sort of thing - and those types of intermediaries are easy to find. Evidence of the institutions needed to overcome adverse selection - and evidence that the problem exists - aren't hard to find. Furthermore, very often government intervention isn't needed, the market can solve this on its own.

                                                  And the market will solve it on its own in the case of health care, but we may not like the solution the market comes up with. First, it violates our sense of equity since the solution will be to prevent people likely to have high health costs from getting insurance (or the price of insurance will be so high that they are effectively excluded). But we will still have to provide for them, we can't just abandon them to suffer when help can be provided. It's one thing if someone cannot sell their car due to market failure, it's quite another if they cannot get the medicine or care they need to maintain their health. So the private sector solution may not be morally acceptable. Second, because we have to provide for the sick in any case, the resources that are devoted to excluding people are wasted resources, all that happens is that the problem is shunted off to a generally more expensive option.

                                                  So it's not that the private sector cannot solve this problem at all, that's not why we need government to intervene, it's that the solution the market imposes violates our moral sensibilities and wastes resources that could be used more productively.

                                                  [On the run today and writing this sitting in my car in a parking lot. Mobility is getting better.]

                                                  Update: Thinking about this a bit more, I don't think I want to stand behind the claim that finding evidence of adverse selection is unlikely, for example the consequences of missing markets may be evident in the data (technically the search is then outside of the marketplace, but I still don't want to push this). And I also overstated the extent to which the private sector can solve the adverse selection problem, there are problems that I think the private sector cannot resolve, problems that require government involvement (e.g. mandates). But I do want to comment on this from Megan McArdle:

                                                  Of course, it's also true that the population of the uninsured is correlated with something that's also correlated with good health:  being young.  But then, this sort of undercuts the adverse selection argument, and also the moral imperative of giving them health insurance.  If you could reasonably afford health insurance by dropping down to a lower-priced cell phone plan and cutting back on your bar tab, you are not a national emergency.

                                                  But this is, in fact, a good example of market failure and why government intervention is sometimes needed. So long as people know that they can get care for life threatening illnesses, broken bones, that sort of thing, and even for less threatening ailments, they have no incentive to cut back on these other expenditures. They get roughly the same care whether they drop their cell plan and the bar tab or not, so why bother? That's why the government has to mandate coverage, so they are forced to pay their share. Sure, we can say it's a moral issue, that they shouldn't do this, but if they do it anyway then it's all of us, not the people choosing to forgo insurance, who end up picking up the tab. If we are willing to say "let them suffer for their choices, even die for them" then sure, there's no market failure here, they will know that and get insurance (maybe - it's rational to do so, but will they behave rationally?). But I am going to help if I can when health is significantly threatened (even if just to save them from themselves in some cases) - I think most people would - and that leaves the market failure door wide open (I'm not addressing the presumption that people without insurance have cell phones and bar tabs rather than necessities they can cut out in order to afford insurance - that's not, of course, always true).

                                                    Posted by on Monday, July 27, 2009 at 11:58 AM in Economics, Market Failure | Permalink  Comments (25)


                                                    Paul Krugman: An Incoherent Truth

                                                    Paul Krugman rubs Blue Dog noses in the pile of incoherence they left in the House:

                                                    An Incoherent Truth, by Paul Krugman, Commentary, NY Times: Right now the fate of health care reform seems to rest in the hands of relatively conservative Democrats — mainly members of the Blue Dog Coalition, created in 1995. And you might be tempted to say that President Obama needs to give those Democrats what they want. But he can’t — because the Blue Dogs aren’t making sense. ...

                                                    Reform, if it happens, will rest on four main pillars: regulation, mandates, subsidies and competition. ... The subsidy portion of health reform would cost around a trillion dollars over the next decade..., this expense would be offset with a combination of cost savings elsewhere and additional taxes, so that there would be no overall effect on the federal deficit.

                                                    So what are the objections of the Blue Dogs? Well, they talk a lot about fiscal responsibility, which basically boils down to worrying about the cost of those subsidies. And it’s tempting to stop right there, and cry foul. After all, where were those concerns about fiscal responsibility back in 2001, when most conservative Democrats voted enthusiastically for that year’s big Bush tax cut — a tax cut that added $1.35 trillion to the deficit?

                                                    But it’s actually much worse than that — because even as they complain about the plan’s cost, the Blue Dogs are making demands that would greatly increase that cost.

                                                    There has been a lot of publicity about Blue Dog opposition to the public option, and rightly so: a plan without a public option ... would cost taxpayers more...

                                                    But Blue Dogs have also been complaining about the employer mandate, which is even more at odds with their supposed concern about spending. The Congressional Budget Office has already weighed in on this issue: without an employer mandate, health care reform would be undermined as many companies dropped their existing insurance plans, forcing workers to seek federal aid — and causing the cost of subsidies to balloon. It makes no sense at all to complain about the cost of subsidies and at the same time oppose an employer mandate.

                                                    So what do the Blue Dogs want?

                                                    Maybe they’re just being complete hypocrites. It’s worth remembering the history of one of the Blue Dog Coalition’s founders: former Representative Billy Tauzin of Louisiana. Mr. Tauzin switched to the Republicans soon after the group’s creation; eight years later he pushed through the 2003 Medicare Modernization Act, a deeply irresponsible bill that included huge giveaways to drug and insurance companies. And then he left Congress to become, yes, the lavishly paid president of PhRMA, the pharmaceutical industry lobby.

                                                    One interpretation, then, is that the Blue Dogs are basically following in Mr. Tauzin’s footsteps: if their position is incoherent, it’s because they’re nothing but corporate tools, defending special interests. And as the Center for Responsive Politics pointed out in a recent report, drug and insurance companies have lately been pouring money into Blue Dog coffers.

                                                    But I guess I’m not quite that cynical. After all, today’s Blue Dogs are politicians who didn’t ... switch parties even when the G.O.P. seemed to hold all the cards and pundits were declaring the Republican majority permanent. So these are Democrats who, despite their relative conservatism, have shown some commitment to their party and its values.

                                                    Now, however, they face their moment of truth. For they can’t extract major concessions on the shape of health care reform without dooming the whole project: knock away any of the four main pillars of reform, and the whole thing will collapse — and probably take the Obama presidency down with it.

                                                    Is that what the Blue Dogs really want to see happen? We’ll soon find out.

                                                      Posted by on Monday, July 27, 2009 at 01:17 AM in Economics, Health Care, Politics | Permalink  Comments (84)


                                                      links for 2009-07-27

                                                        Posted by on Monday, July 27, 2009 at 12:09 AM in Economics, Links | Permalink  Comments (20)


                                                        Sunday, July 26, 2009

                                                        "A Breakthrough in the Fight against Hunger"

                                                        Jeff Sachs seems relatively pleased and cautiously optimistic:

                                                        A breakthrough in the fight against hunger, by Jeffrey D Sachs, Commentary, Project Syndicate: The G-8’s $20bn initiative on smallholder agriculture, launched at the group’s recent summit in L’Aquila, Italy, is a potentially historic breakthrough in the fight against hunger and extreme poverty. With serious management of the new funds, food production in Africa will soar.

                                                        Indeed, the new initiative, combined with others in health, education, and infrastructure, could be the greatest step so far toward achieving the Millennium Development Goals, the internationally agreed effort to reduce extreme poverty, disease, and hunger by half by 2015. ... One cornerstone of the project was “smallholder farmers”, meaning peasant farm families in Africa, Latin America, and Asia – working farms of around one hectare (2.5 acres) or less. These are some of the poorest households in the world, and, ironically, some of the hungriest as well, despite being food producers.

                                                        They are hungry because they lack the ability to buy high-yield seeds, fertiliser, irrigation equipment, and other tools needed to increase productivity. As a result, their output is meagre and insufficient for their subsistence. ...

                                                        The Millennium Project recommended a big increase in global funding for this purpose. ... Now the key is to make this effort work. The lessons of history are clear. ... Not only will food yields rise in the short term, but farm households will use their higher incomes and better health to accumulate all sorts of assets: cash balances, soil nutrients, farm animals, and their children’s health and education. ...

                                                        Continue reading ""A Breakthrough in the Fight against Hunger"" »

                                                          Posted by on Sunday, July 26, 2009 at 03:56 PM in Development, Economics | Permalink  Comments (23)


                                                          One Dog, Two Dog, Red Dog, Blue Dog

                                                          Robert Waldmann explains Basic Football Terminology:

                                                          To Red Dog (alternative phrase for to blitz):

                                                          Linebacker crosses line of scrimmage attempting to sack opposing quarterback.

                                                          Often works, sometimes risky. Shows that player (and/or defensive coordinator) has guts.

                                                          To Blue Dog (alternative phrase for To Benedict Arnold):

                                                          Linebacker crosses own goal line and spikes own helmet.

                                                          Shows that player forgot which team he is on.

                                                            Posted by on Sunday, July 26, 2009 at 01:35 AM in Economics, Politics | Permalink  Comments (10)


                                                            Should Bernanke Be Reappointed?

                                                            Nouriel Roubini says:

                                                            Ben Bernanke ... deserves to be reappointed. Both the conventional and unconventional decisions made by this scholar of the Great Depression prevented the Great Recession of 2008-2009 from turning into the Great Depression 2.0.

                                                            Anna Schwartz has a different perspective:

                                                            As Federal Reserve chairman, Ben Bernanke has committed serious sins of commission and omission — and for those many sins, he does not deserve reappointment.

                                                            Here's how I see it. It's true that we failed to notice that the patient was getting sick. The signs of disease were there, but we either didn't see the signs or they were misdiagnosed. In fact, there's a case to be made that we saw some of the changes in the patient as signs of improving health. Had we made the correct diagnosis early enough, maybe we could have prevented the patient from getting sick (though it's not clear the patient would have taken our advice, so stronger measures than mere advice may have been required).

                                                            And once the patient showed up in the office and was clearly sick, we didn't get it right initially either. We thought the patient needed fluids - liquidity as they say - and the patient did need some of that, but we didn't immediately see that there were also some key nutrient deficiencies and chemical imbalances that were threatening to cause further problems.

                                                            Bu we kept at it with tests and other diagnostics, and eventually got a handle on the problem. Once we did, we began to administer the medicine the patient needed. The patient will get better, the deterioration was rapid and turning it around will be difficult - it won't happen fast enough to suit any of us - but what has been done prevented a complete collapse, and is helping to move the patient towards recovery.

                                                            So I'm with Nouriel, Bernanke should be reappointed. It's true that the progression of the underlying disease was largely missed, but that's pretty much true across the board, all the doctors missed it. It's also true that there was some dispute over how to interpret the initial symptoms and test results, and what to do to cure the patient. But again that was largely true across the board in the tumultuous period just after the patient began to exhibit clear and serious problems. It's not like everyone except the patient's doctors knew exactly what to do. The uncertainty in that initial period created fear, and the fear made the patient - who needed calm above all else - even worse off.

                                                            But as just noted, the doctors who were put in charge - Bernanke in particular - persevered and began to understand more precisely what was going wrong and what was needed, and that allowed them to save the patient from a much, much worse fate. They deserve credit for that. The patient will live, and that wasn't always so clear. In the initial confusion they did what you need to do - they administered wide spectrum drugs and other procedures that were known to abate the symptoms they were observing, and these did help, and that gave them time to find more targeted remedies. They used the time wisely to find and structure better remedies, and once those remedies were ready they used them to attack the various ways in which the disease was shutting down vital systems (not everything they tried worked, but the things that did work helped quite a bit).

                                                            There was one scary point, however, and that was when they thought the patient had become strong enough to go without the medicine, and they withdrew it too soon (the Lehman episode). The result was that they almost lost the patient completely, and only quick action saved the day. That's the one point where I think the doctors could have done better. I understand the concerns over the side effects of this medicine, but it was too soon and it created too much unnecessary uncertainty and fear.

                                                            But overall, they did the things that needed to be done to make sure the patient did not suffer an even worse, prolonged, debilitating collapse, and those efforts were successful. Failing to diagnose a disease is different from not knowing what to do once you figure it out. The disease was a difficult one to diagnose or it wouldn't have missed so widely, and it wasn't clear at first precisely what was wrong, but in every case, once they understood the problem, they took the proper course of action.

                                                            Here's the question I ask myself. If I were to suddenly come down with the same disease, would I want the current group with it's current leadership in charge of bringing me back to health, or would I want a different group led by someone new who thinks they know what to do, but has never actually been through it? I'd want this group, the one with experience. They're likely to have learned enough to spot the disease the next time and head it off all together, one hopes so. But if not and I get the disease, they are also likely to know just what to do - while avoiding the missteps they took the first time - to get me back on my feet as fast as possible (and please don't let politicians second guess them).

                                                              Posted by on Sunday, July 26, 2009 at 01:08 AM in Economics, Financial System, Monetary Policy | Permalink  Comments (85)


                                                              links for 2009-07-26

                                                                Posted by on Sunday, July 26, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (17)


                                                                Saturday, July 25, 2009

                                                                The Fed as Systemic Risk Regulator?

                                                                Alan Blinder favors making the Fed the systemic risk regulator for the U.S.:

                                                                An Early-Warning System, Run by the Fed, by Alan Blinder, Commentary, NY Times: ...[T]wo contradictory crosscurrents are swirling in Washington — one that would enhance the Fed’s powers and one that would curtail them.

                                                                The Treasury’s recent white paper on financial regulatory reform would have the Fed “supervise all firms that could pose a threat to financial stability,” even if they are not banks, turning the Fed into what some people are calling the nation’s “systemic-risk regulator.” Doing so would expand the Fed’s reach...

                                                                On the other hand, some members of Congress are grumbling that the Fed has already overreached, usurping Congressional authority. Others contend that it has performed so poorly as a regulator that it hardly deserves more power. Representative Ron Paul, the Texas Republican, has even introduced a bill that would have the Government Accountability Office audit the Fed’s monetary policy — a truly terrible idea that could quickly undermine the Fed’s independence. ...

                                                                The main task of a systemic-risk regulator is to serve as an early-warning-and-prevention system, on the prowl for looming risks that extend across traditional boundaries and are becoming large enough to have systemic consequences. Can this job be done perfectly? No. Is it worth trying? I think so. ...

                                                                Some people would end the systemic-risk regulator’s role there, making it an investigative body and whistle-blower whose job is to alert other agencies to mounting hazards. But if systemic problems are uncovered, someone must take steps to remedy or ameliorate them.

                                                                Under one model, the regulator would be like the family doctor ... making a general diagnosis and then referring the patient to appropriate specialists for treatment: to the Securities and Exchange Commission for securities problems, to the banking agencies for safety and soundness issues... But if multiple agencies are involved, their actions would need coordination. Would a systemic-risk regulator ... find itself herding cats?

                                                                An alternative model would work more like a full-service H.M.O., where an internist refers patients to in-house specialists as necessary. To make that work, the systemic-risk regulator would need more power — not just to diagnose problems, but also to fix them. And it would need a huge range of in-house expertise.

                                                                Crucially, when truly systemic problems arise, a lender of last resort is almost certain to be part of the solution — and that means the central bank. So if there is to be a systemic-risk regulator in the United States, it should be the Fed.

                                                                Furthermore, unlike any other agency, the Fed would not be starting from scratch... The Fed already has the eyes and ears (though not enough of them) to do this job, and has the broad view (though, again, not broad enough) over the entire financial landscape. It must have such a view to handle monetary policy properly.

                                                                I am also deeply skeptical that a consortium or a committee would succeed at systemic-risk regulation. Creating a hydra-headed regulator, as some have proposed, invites delays, disagreements and turf wars — and dilutes accountability. So the Treasury plan sensibly puts the Fed in the driver’s seat, with the others playing advisory roles.

                                                                Now to the final question. Critics who worry about the Fed accumulating too much power have a point. But the Treasury proposal already clips the Fed’s wings by stripping away its authority over consumer protection, and further wing-clippings are possible. But when it comes to dealing with systemic risk, Treasury Secretary Timothy F. Geithner said last month, “I do not believe there is a plausible alternative.” Neither do I.

                                                                Here's Alice Rivlin with a more space to write and hence a more nuanced view of the issues. This is from her testimony before the House Committee on Financial Services and the Senate Committee on Banking, Housing and Urban Affairs. I agree with most of what she says, but not point three where she argues that "it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed." One of her arguments is that we can't necessarily identify systemically risky institutions until problems actually develop, but I believe it is possible to do this. It may require that we develop some new measures of connectedness, size isn't the only determining factor, but it seems quite feasible and desirable to develop ways of characterizing risk from interconnectedness. And once the risk is identified, it needs to be controlled and I see the Fed as the best agency to do this for the reasons Blinder outlines (point three is the main focal point in the extracts below, but there's quite a bit more in the original, e.g. sections on the need for regulation to fix the perverse incentives in the mortgage and financial industries, and a discussion of controlling leverage):

                                                                Reducing Systemic Risk in the Financial Sector, by Alice M. Rivlin:  July 21, 2009 — Mr. Chairman and members of the Committee:

                                                                I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. ...

                                                                It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic wellbeing and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and over-borrowing, excessive risk taking, and out-sized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world’s economic wellbeing.

                                                                Approaches to Reducing Systemic Risk

                                                                The crisis was a financial “perfect storm” with multiple causes. Different explanations of why the system failed—each with some validity—point to at least three different approaches to reducing systemic risk in the future.

                                                                • The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system... The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.
                                                                • The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.
                                                                • The system crashed because large inter-connected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms—or even break them up—and to expedited resolution authority for large financial firms... Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier One Financial Institutions. I believe it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.

                                                                The Case for a Macro System Stabilizer

                                                                One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, anti-regulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. ...

                                                                Systemically Important Institutions

                                                                The Obama Administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier One Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go.

                                                                Continue reading "The Fed as Systemic Risk Regulator?" »

                                                                  Posted by on Saturday, July 25, 2009 at 04:09 PM in Economics, Financial System, Regulation | Permalink  Comments (15)


                                                                  How Much of the Increase is Permanent?


                                                                  [pop-up]

                                                                  Update: Brad DeLong answers:

                                                                  I would guess that only a small part of the rise in the savings rate is permanent. Financial distress was and is much greater than in past post-WWII recessions, and financial distress is associated with transitory rises in the savings rate.

                                                                  Update: Since we're on the topic, Martin Feldstein thinks the saving rate will be higher in the future, but not high enough to avoid increases in the real interest rate:

                                                                  US saving rate & the dollar's future, by Martin Feldstein, Commentary, Project Syndicate: ...The saving rate of American households has risen sharply since the beginning of the year, reaching 6.9 per cent of after-tax personal income in May, the highest rate since 1992. In today’s economy, that is equivalent to annual savings of $750 billion.

                                                                  While a 6.9 per cent saving rate is not high in comparison to that of many other countries, it is a dramatic shift from the household-saving rate... Dramatically lower share prices and a 35 per cent fall in home prices reduced household wealth by $14 trillion... Individuals now have to save more to prepare for retirement, and retirees have less wealth to spend. Looking ahead, the saving rate may rise even further, and will, in any case, remain high for many years.

                                                                  The increase in the household saving rate reduces America’s need for foreign funds to finance its business investment and residential construction. Taken by itself, today’s $750 billion annual rate of household saving could replace that amount in capital inflows from the rest of the world. Since the peak annual rate of capital inflow was $803 billion (in 2006), the increased household saving has the potential to eliminate almost all of America’s dependence on foreign capital. ...

                                                                  Without a fall in the dollar and the resulting rise in net exports, a higher saving rate and reduced consumer spending could push the US economy into a deep recession. By contrast, the lower dollar makes reduced consumption consistent with full employment by shifting consumer spending from imports to domestic goods and services, and by supplementing this rise in domestic demand with increased exports.

                                                                  But this direct link between higher household saving and a lower dollar will only be forged if higher household saving is not outweighed by a rise in ... government deficit. A large fiscal deficit increases the need for foreign funds to avoid crowding out private investment. Put differently, the value of the dollar reflects total national saving, not just savings in the household sector.

                                                                  Unfortunately, the US fiscal deficit is projected to remain high for many years. ... If that high level of government borrowing occurs, it will absorb all of the available household savings even at the current elevated level. That would mean that the US would continue to need substantial inflows of foreign capital to fund business investment and housing construction. So the dollar would have to stay at its current level to continue to create the large trade deficit and resulting capital inflow.

                                                                  It is, of course, possible — I would say likely — that China and other foreign lenders will not be willing to continue to provide the current volume of lending to the US. Their reduced demand for dollars will cause the dollar to decline and the trade deficit to shrink. That reduced trade deficit and the resulting decline in capital inflows will lead to higher real interest rates in the US. The higher interest rate will reduce the level of business investment and residential construction until they can be financed with the smaller volume of national saving plus the reduced capital inflows.

                                                                  Although the higher level of household saving will limit the rise in US interest rates, it will not change the fact that the combination of large future fiscal deficits and foreign lenders’ reduced willingness to buy US securities will lead to both a lower dollar and higher US interest rates.

                                                                  Since the increase in the long-term fiscal deficit Feldstein is worried about is mostly due to the expectation of rapidly increasing health care costs, this points to the need for health care reform that can (compassionately) control escalating health care costs.

                                                                  Update: Speaking of health care reform, Ezra Klein looks at the lessons to be learned from Clinton's attempt to reform health care:

                                                                  The Ghosts of Clintoncare, by Ezra Klein, Commentary, Washington Post: Barack Obama's strategy to pass health-care reform seems based on a simple principle: Whatever Bill Clinton did, do the opposite. ... Few legislative failures have been as catastrophic as Clinton's on health-care reform. ... Yet there are aspects of Clinton's approach that could, and should, inform Obama's effort -- and not just as examples of what not to do. ... Clinton got the politics of reform wrong, but in important ways, he got the policy right. He just got it right too soon.

                                                                  By the time Clinton and his team took office, the insurance market was changing. American consumers had traditionally relied on the most straightforward of insurance products: indemnity insurance. You went to the doctor or hospital of your choice, and that doctor or hospital sent your insurer the bill. Hopefully, your insurer paid it. That was that. The plans weren't confined to networks tangled in deductibles and co-pays. But they weren't holding down costs, either, and the system was becoming unaffordable. Managed care, a new system that ... envisioned a more central role for insurers ... was rapidly emerging... But this was a dangerous change. Insurers make money by denying claims. Money they spend on health care is money they lose...

                                                                  So Clinton sought to cage managed care inside managed competition, which would regulate the behavior of insurers and force them to compete for patients. This would give consumers more power against their insurance companies, drive the bad actors from the market and generally protect against the excesses of managed care. Clinton's plan also included a handful of other safeguards, like out-of-pocket caps and an independent appeals process, designed to protect consumers from deficient insurance. ...

                                                                  But if Clinton's team of enlightened wonks could glimpse managed care over the horizon, the public wasn't as farsighted. Bill and Hillary weren't seen as meeting and taming the managed-care revolution. The act of writing legislation that included managed care made it seem as if they were proposing it. And there was no political margin in that. Managed care, after all, means less choice. It means provider networks and insurance bureaucrats and complexity. It would have been a hard sell under any circumstances... The plan died a painful and public death...

                                                                  But then a funny thing happened: Managed care came anyway ... HMOs and PPOs and HDHPs. We're all in networks now. We don't get our choice of doctor. There's no appeals process. No out-of-pocket caps. Nothing to stop insurers from rejecting ... coverage... And if we don't like our insurer? Tough. "We got managed care," says Chris Jennings,... one of Clinton's top health-care staffers. "But we didn't get the things that would protect us from managed care. We got the Wild West version of it."

                                                                  In the modern health-care system,... the insurers who populate that market have grown all the stronger..., 94 percent of statewide insurance markets are highly concentrated. ... Clinton had promised us managed care within managed competition. Instead, the insurers took control of our care and managed to effectively end competition. Neat trick. ...

                                                                  All of this has led to an interesting reversal in this year's health-care debate. In 1994, people feared that Clinton would restrict their choices. In 2009, people want Obama to bring their choices back. ... A ... poll last month showed that 62 percent of Americans support the choice of a public insurance option. ... But if the public option would drive private insurers out of business and reduce consumer choice, the numbers flip, with 58 percent opposing it. What people support, in other words, is not public or private insurance, but choice in insurance. That, along with protection from escalating costs, is the inviolable principle of health-care reform. ...

                                                                  The lesson of Clintoncare was that even if the American people want reform, they do not necessarily want change. And so Obama's health-care strategy involves a delicate effort to ... reform the health-care system without substantially changing it... But this is not the early 1990s. The indemnity insurance that most Americans enjoyed then is virtually nonexistent today. The mergers and takeovers and consolidations in the insurance market have given people less choice and thus less power. Today, the cost issue is more acute, the president is more popular, the Democrats have more seats in Congress, and the Republicans are more fractured. Obama ... was right to dismiss those who would "dust off that old playbook."

                                                                  But the ghosts still hover. Republicans are fixated on what worked for them in the last health-care battle, and Democrats are overly concerned with what contributed to their failure. Just as Clinton's plan was weighed down by the impression that it would change too much, history may leave Obama's effort vulnerable to the charge that it is changing too little.

                                                                  The claim that reform will give people more rather than less choice will hard to sell. Politically, I think the focus has to be on how the increase in concentration and power within the insurance industry and the control that gives the industry over the delivery of health care limits choice in undesirable ways.

                                                                    Posted by on Saturday, July 25, 2009 at 12:37 AM in Economics, Saving | Permalink  Comments (54)


                                                                    links for 2009-07-25

                                                                      Posted by on Saturday, July 25, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (11)


                                                                      Friday, July 24, 2009

                                                                      From 1983: Health Care Reform in Canada

                                                                      This is an article on health care reform in Canada from February 15, 1983. As the article explains, "The Canadian health system is really nothing more than an insurance plan for all citizens. The Federal Government and each of the 10 provincial governments put up the money, which comes from income taxes, sales taxes and, in the case of three provinces, premiums. Doctors bill the province for medical services." The issue the Canadian system faced was that some doctors had begun charging the government insurance plans more than the mandated fees, something many saw as a movement toward a private or two-tiered system and hence a threat to public health care in Canada. I was struck by how many similarities there are in the arguments to what we are hearing today. It's also interesting to look back and determine which of the scary stories about the future have come true:

                                                                      Health Care in Canada: Popular System now Rocked by Criticism, by Douglas Martin, NY Times, 2/15/1983: Toronto - When Tommy Douglas was a boy, a Winnipeg doctor told him that he was suffering from a bone disease called osteomyelitis and that his leg would have to be cut off. Only because a brilliant young orthopedic surgeon decided to use the young charity patient for a teaching demonstration was he lucky enough to avoid the amputation. ''Had I been a rich man's son,'' Mr. Douglas says, ''the services of the finest surgeons would have been available. As an iron molder's boy, I almost had my leg amputated before chance intervened and a specialist cured me without thought of a fee.'' Mr. Douglas grew up to become the Premier of Saskatchewan, head of one of the first socialist governments in North America. In 1962, his party established a comprehensive medical insurance system, providing, in his words, ''complete medical care without a price tag.'' By 1971, such a system, administered by individual provinces and financed partly by the Federal Government, had been extended to cover every Canadian.

                                                                      But now this comprehensive medical insurance system - which provides health care at substantially lower cost than the American system and has been closely watched by United States policy makers as a possible model for imitation - is confronted by wrenching pressures. The Canadian medical system lies somewhere between the American entrepreneurial approach and British nationalization.

                                                                      A growing number of critics say that Canadian medicine has become bloated and inefficient, and they assert that the Federal and provincial governments no longer have effective control. Doctors point to mounting evidence of inadequate financing, including yearlong waits for operations, hospitals so overcrowded that beds and obsolete equipment jam hallways. Most visibly, the physicians ... complain that they are not paid enough and have gone on strike in several provinces to demand higher fee scales. And patients are increasingly asked to pay amounts above the insured fee, a contradiction to the system's founding philosophy.

                                                                      At issue, analysts say, is the whole public nature of the system and how much of a new or expanded role, if any, private enterprise should play. ''We have a great chance of losing our health system the way we know it,'' said Ginette Rodger, executive director of the Canadian Nurses Association.

                                                                      The Canadian health system is really nothing more than an insurance plan for all citizens. The Federal Government and each of the 10 provincial governments put up the money, which comes from income taxes, sales taxes and, in the case of three provinces, premiums. Doctors bill the province for medical services. The theory behind the system is that the healthy, not the sick, should pay for medicine.

                                                                      Differences From U.S.

                                                                      Canada's public monopolization of medical insurance, and the guarantee of medical care to all, are the chief differences from the United States, where Government-financed health programs are limited to veterans, the elderly and the poor. Most analysts agree that national health insurance has been a dead letter in Washington for nearly a decade. There have been new expressions of interest in recent months, however, because 10 million Americans have lost health coverage since 1981 as a result of losing their jobs.

                                                                      The relevance of Canada's health system to Americans appears to be its success in providing what analysts and doctors generally agree is good care for less money. Canada spends roughly 8 percent of its gross national product for medical services, as against the United States' 10 percent. If the United States could reduce its proportion to 8 percent, the saving would be about $60 billion. Analysts say much of Canada's lower cost stems from the absence of a complex maze of private insurers who have to earn a profit to stay in business.

                                                                      ''Almost nobody thinks that for our 10 percent we're getting value for our money,'' said Theodore Marmor, a professor of political science at Yale who has extensively studied the Canadian health apparatus. ''In Canada, some do, some don't.''

                                                                      Continue reading "From 1983: Health Care Reform in Canada" »

                                                                        Posted by on Friday, July 24, 2009 at 04:42 PM in Economics, Health Care | Permalink  Comments (18)


                                                                        "Who Is Killing America's Millionaires?"

                                                                        Sneaking in a quick post between new student advising appointments, does recent evidence support that claim that wealthy individuals have been fleeing high tax jurisdictions?:

                                                                        Who Is Killing America's Millionaires?, by Daniel Gross, Slate: It hasn't been a good recession for the rich. The ... boom was extraordinarily top-heavy..., these are tough times for the wealthy.

                                                                        As if market forces and malevolent actors weren't enough, the rich are now finding themselves targeted by politicians. Strapped for cash, states, cities, and the federal government are seeking to soak the rich—or at least to make them pay taxes at the same marginal rates as they did in the Reagan years, which many on the right regard as an act equivalent to executing landed gentry. Some politicians have even suggested that we fund health care by slapping a surtax on people with annual incomes of more than $1 million.

                                                                        This tactic isn't likely to work, in large part because people who make a lot of money are quite effective at swaying public policy. What's more, the wealthy have many defenders who argue that taxing the golden geese will cause them to fly away. In May, the Wall Street Journal op-ed page argued that millionaires fled Maryland after the state legislature boosted the top marginal state income tax rate to 6.25 percent on the top 0.3 percent of filers. ... The Journal uses this ... to warn the federal government and states with progressive tax structures and lots of rich people—New York, New Jersey, California—to heed the lesson. Tax the wealthy too much, and they'll leave.

                                                                        Such logic makes sense to the Journal's op-ed page staffers, who inhabit an alternative universe in which people wake up in the morning and decide whether to go to work, innovate, or buy a bagel based on marginal tax rates. But if people were motivated to choose residences based solely on high state income taxes, then California and New York wouldn't have any wealthy entrepreneurs, venture capitalists, or investment bankers—and the several states that have no state income tax, which include South Dakota, Alaska, and Wyoming, would be really crowded with rich people. Maybe Maryland's rich folks just had a crappy year in 2008. Robert Frank..., citing data from the Institute on Taxation and Economic Policy, that there's "evidence that [the state's] millionaires didn't disappear because they moved, they disappeared because they are no longer millionaires." ...

                                                                        Consulting firm CapGemini conducts an annual census of high-net-worth individuals, defined as people with at least $1 million in investable assets, excluding primary residences. "We've been doing this report for 13 years and haven't seen this kind of loss of wealth since we started," said Ileana van der Linde ... at CapGemini... North America saw an 18.5 percent decline in its high-net-worth population, from 3.02 million in 2007 to 2.46 million in 2008. ...

                                                                        CapGemini's survey contains some interesting geographic wrinkles. High-tax areas like New York and California—places where politicians have been talking about potentially raising taxes on the rich to deal with budget crises—held up better than the national average. ...

                                                                        Comparative tax havens like Florida, Nevada, and Arizona didn't see an influx of millionaires in 2008. Far from it. In 2008, Las Vegas lost 38 percent of its HNWIs, and Phoenix lost 34 percent. Florida, which has no state income tax and hasn't been talking about one, was a killing field for the rich. The three major metro areas that lost more than 40 percent of millionaires in 2008 were all in no-income-tax Florida—Orlando (42 percent), Miami (42 percent), and Tampa (51 percent). The decline has nothing to do with taxes and everything to do with bursting asset bubbles. ...

                                                                        Of course, there's evidence that some millionaires have moved out of high-tax states. Bernie Madoff, for example, recently left New York to take up residence in North Carolina.

                                                                          Posted by on Friday, July 24, 2009 at 12:20 PM in Economics, Taxes | Permalink  Comments (25)


                                                                          Paul Krugman: Costs and Compassion

                                                                          Controlling costs is essential if we want to guarantee health care for all:

                                                                          Costs and Compassion, by Paul Krugman, Commentary, NY Times: The talking heads on cable TV panned President Obama’s Wednesday press conference. You see, he didn’t offer a lot of folksy anecdotes.

                                                                          Shame on them. The health care system is in crisis. The fate of America’s middle class hangs in the balance. And there on our TVs was a president with an impressive command of the issues... Mr. Obama was especially good when he talked about controlling medical costs. And there’s a crucial lesson there — namely, that when it comes to reforming health care, compassion and cost-effectiveness go hand in hand. ...

                                                                          President Obama is trying to provide every American with access to health insurance — and he’s also doing more to control health care costs than any previous president.

                                                                          I don’t know how many people understand the significance of Mr. Obama’s proposal to give MedPAC, the expert advisory board to Medicare, real power. But it’s a major step toward reducing the useless spending — the proliferation of procedures with no medical benefits — that bloats American health care costs.

                                                                          And both the Obama administration and Congressional Democrats have also been emphasizing the importance of “comparative effectiveness research” — seeing which medical procedures actually work. ...

                                                                          Many health care experts believe that one main reason we spend far more on health than any other advanced nation, without better health outcomes, is the fee-for-service system in which hospitals and doctors are paid for procedures, not results. As the president said Wednesday, this creates an incentive for health providers to do more tests, more operations, and so on, whether or not these procedures actually help patients.

                                                                          So where in America is there serious consideration of moving away from fee-for-service to a more comprehensive, integrated approach to health care? The answer is: Massachusetts — which introduced a health-care plan three years ago that was, in some respects, a dress rehearsal for national health reform, and is now looking for ways to help control costs.

                                                                          Why does meaningful action on medical costs go along with compassion? ... When health insurance premiums doubled during the Bush years, our health care system “controlled costs” by dropping coverage for many workers — but as far as the Bush administration was concerned, that wasn’t a problem. If you believe in universal coverage, on the other hand, it is a problem, and demands a solution.

                                                                          I’d suggest that would-be health reformers won’t have the moral authority to confront our system’s inefficiency unless they’re also prepared to end its cruelty. If President Bush had tried to rein in Medicare spending, he would have been accused, with considerable justice, of cutting benefits so that he could give the wealthy even more tax cuts. President Obama, by contrast, can link Medicare reform with the goal of protecting less fortunate Americans and making the middle class more secure.

                                                                          As a practical, political matter, then, controlling health care costs and expanding health care access aren’t opposing alternatives — you have to do both, or neither.

                                                                          At one point in his remarks Mr. Obama talked about a red pill and a blue pill. I suspect, though I’m not sure, that he was alluding to the scene in the movie “The Matrix” in which one pill brings ignorance and the other knowledge.

                                                                          Well, in the case of health care, one pill means continuing on our current path — a path along which health care premiums will continue to soar, the number of uninsured Americans will skyrocket and Medicare costs will break the federal budget. The other pill means reforming our system, guaranteeing health care for all Americans at the same time we make medicine more cost-effective.

                                                                          Which pill would you choose?

                                                                            Posted by on Friday, July 24, 2009 at 12:24 AM in Economics, Health Care | Permalink  Comments (84)


                                                                            Fed Watch: The Debate Continues

                                                                            Tim Duy looks at the shape of things to come:

                                                                            The Debate Continues, by Tim Duy: The debate over the shape of the  recovery continues unabated.  Equities, at least this week, are voting in favor of the V-shaped recovery, with the Dow pushing past the 9,000 mark for the first time since January.  Never one to accept good news at face value, Nouriel Roubini predictably took the opposite position:

                                                                            A “perfect storm” of fiscal deficits, rising bond yields, “soaring” oil prices, weak profits and a stagnant labor market could “blow the recovering world economy back into a double-dip recession,” he wrote in a research note today. “It is getting more likely unless a clear exit strategy from the massive monetary and fiscal stimulus is outlined even before it is implemented.”

                                                                            Roubini, chairman of Roubini Global Economics and a professor at NYU’s Stern School of Business, predicted that the global economy will begin recovering near the end of 2009. The U.S. economy is likely to grow about 1 percent in the next two years, less than the 3 percent “trend,” he said.

                                                                            Roubini based his short-term outlook on the worsening condition of the U.S. housing and labor markets, which he called “inextricably linked.” He said a “weak” job market will contribute to another 13 percent to 18 percent drop in house prices, bringing total declines nationally to as much as 45 percent from their peak.

                                                                            I would add to Roubini's pessimism that  bond market investors as of yet do not share the optimism of their brethren in the equity side of the industry.  The run up in yields that brought a 4-handle to the 10 year Treasury appears to have been stopped dead in its tracks, and that maturity has pulled back to the mid threes.  If the run-up in yields foreshadowed a burst of optimism in equities, the pull back would suggest that this rally has nearly run its course.

                                                                             The challenge here is two-fold.  The first challenge is to determine how much of the recent equity run is attributable to the weight of evidence that indicates the worst of the downturn is behind us.  With the Armageddon trade off the table, some gains were inevitable, just as was the rise in Treasury yields.  The more difficult challenge is the strength and pattern of the subsequent recovery.  To be sure, one should not ignore the possibility of a blowout quarter here and there, as GDP data can bounce quickly to bounces in underlying data such as a stabilization in auto sales.  But will such a bounce reflect fundamental underlying strength?  A slow, jobless recovery - my dominant scenario - would most likely produce the seesaw trading we saw in the wake of the tech bubble crash, a pattern that held until the housing bubble gained full traction.  Such an outcome looks consistent with the sentiment of Federal Reserve Chairman Ben Bernanke in this weeks Congressional testimony:

                                                                            Continue reading "Fed Watch: The Debate Continues" »

                                                                              Posted by on Friday, July 24, 2009 at 12:12 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (9)


                                                                              "All Stimulus Roads Lead to China"

                                                                              Should emerging countries, China in particular, intentionally spend more on imports from the U.S.?:

                                                                              All stimulus roads lead to China, by Barry Eichengreen, Commentary, Project Syndicate: Now that the “green shoots” of recovery have withered, the debate over fiscal stimulus is back with a vengeance. ... It is possible to argue the economics both ways, but the politics all point in one direction. The US Congress lacks the stomach for another stimulus package. ... A second stimulus simply is not in the cards.

                                                                              If there is going to be more aggregate demand, it can come from only one place. That place is not Europe or Japan, where debts are even higher than in the US – and the demographic preconditions for servicing them less favorable. Rather, it is emerging markets like China.

                                                                              The problem is that China has already done a lot to stimulate domestic demand... As a result, its stock market is frothy, and it is experiencing an alarming property boom. ... Understandably, Chinese officials worry about bubble trouble.

                                                                              The obvious way to square this circle is to spend more on imports. China can purchase more industrial machinery, transport equipment, and steelmaking material, which are among its leading imports from the US. Directing spending toward imports of capital equipment would avoid overheating China’s own markets, boost the economy’s productive capacity (and thus its ability to grow in the future), and support demand for US, European, and Japanese products just when such support is needed most.

                                                                              This strategy is not without risks. Allowing the renminbi to appreciate as a way of encouraging imports may also discourage exports, the traditional motor of Chinese growth. And lowering administrative barriers to imports might redirect more spending toward foreign goods than the authorities intend. But these are risks worth taking if China is serious about assuming a global leadership role.

                                                                              The question is what China will get in return. And the answer brings us back, full circle, to ... US fiscal policy. China is worried that its more than $1tn investment in US Treasury securities will not hold its value. It wants reassurance that the US will stand behind its debts. It therefore wants to see a credible program for balancing the US budget once the recession ends.

                                                                              And, tough talk notwithstanding, the Obama administration has yet to offer a credible roadmap for fiscal consolidation. ... We live in a multipolar world where neither the US nor China is large enough to exercise global economic leadership on its own. ... Only by working together can the two countries lead the world economy out of its current doldrums.

                                                                              I don't think we should count on this happening.

                                                                                Posted by on Friday, July 24, 2009 at 12:06 AM in China, Economics, Fiscal Policy | Permalink  Comments (16)


                                                                                links for 2009-07-24

                                                                                  Posted by on Friday, July 24, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (3)


                                                                                  Thursday, July 23, 2009

                                                                                  Macroeconomic Models

                                                                                  Robert Skidelsky doesn't always get things completely right. For example, he often talks about "New Classical economics" as if that is the dominant paradigm today, but that term has a very specific meaning and refers to a class of models that is no longer popular in macroeconomics.

                                                                                  Let's back up. The New Classical model had four important elements, the assumption of rational expectations, the assumption of the natural rate hypothesis, the assumption of continuous market clearing that Skidelsky refers to below, and an assumption that agents have imperfect information. The imperfect information assumption was quite clever in that it allowed proponents of this model to explain correlations between money and income without acknowledging that systematic, predictable policy based upon something like a Taylor rule would have any effect at all (put another way, only unexpected changes in monetary policy matter, expected changes are fully neutralized by private sector responses to the policy).

                                                                                  The New Classical model did contribute to the movement in macroeconomics toward microeconomic foundations and to the use of rational agents within macro models, but the model itself could not simultaneously explain both the duration and magnitude of actual cycles, it had difficulty explaining some key correlations among macroeconomic variables, and it was difficult to understand why a market for the absent information did not develop if the consequences of imperfect information were as large as the New Classical model implied. In addition, one of the model's key results that only unexpected changes in money can affect real variables did not hold up when taken to the data (though there are still a few die-hards on this). So the profession moved on.

                                                                                  The New Classical model had replaced the old Keynesian model after it became widely believed that the models' shortcomings were partly responsible for the problems we had in the 1970s, and for the theoretical reasons that will be described in a moment. But while the New Classical economists were having their day in the sun, the Keynesians were quietly working behind the scenes to fix the problems that caused the old Keynesian model to go out of favor (or not so quietly in a few cases). The old Keynesian model had a poor model of expectations - if expectations were considered at all they were usually modeled as a naive adaptive process - and in addition, it was not clear that the relationships embedded within the old Keynesian model were consistent with optimizing behavior on behalf of households and firms. The New Keynesian model solved this by deriving macroeconomic relationships from microeconomic optimizing behavior, and by adopting the rational expectations framework. And they made one other change important change. In order for systematic monetary policy such as following a Taylor rule to affect real variables such as output and employment, there must be some type of friction that prevents the economy from immediately moving to it long run equilibrium value. The friction in the New Classical model is informational, agents optimize given the information that they have, but because the information is imperfect the decisions they make take the economy away from its optimal long-run path.

                                                                                  In the New Keynesian model the friction that gives monetary policy its power to affect output and employment is sluggish movement of prices and wages (generally modeled through something called the Calvo pricing rule, a source of controversy because there are questions about the extent to which this rule is consistent with micro-founded optimizing behavior, though others assert there are rationales for the Calvo structure that are sufficient - to some - to overcome these concerns).

                                                                                  To me, the New Keynesian model is about as mainstream as they get, so I'm puzzled by the opening to this column that claims modern macro completely embraces fully flexible prices. I think what he has in mind is some version of a Real Business Cycle model where prices are, in fact, assumed to be fully flexible, agents are rational etc. so that actual output is always equal to potential (so there's no need for policy to do anything but maximize the growth of potential output, hence the supply-side orientation of advocates of this approach). And I'm sure we could have a lively debate about which model has more proponents, but to say that mainstream economics subscribes fully to the notion of continuous market clearing when price rigidities are at the heart of a major class of modern models seems to miss the mark (and the assertion that agents are assumed to have perfect information is equally puzzling, they optimize given what they know, but they are not assumed to know everything and the efficient market hypothesis he discusses does not require this).

                                                                                  I don't disagree with the main message of the column that prevention of financial crashes through regulation is better than trying to cure them with policy, though I might quibble with particulars, but as someone who has been an advocate of the New Keynesian model, and quite resistant to pure Real Business Cycle approaches, I wanted to make clear that not all of us believe that assuming fully flexible prices and continuous market clearing is the proper way to model the economy. (A synthesis of the New Keynesian and Real Business Cycle models is what I have pushed in the past, though I'm now reconsidering the types of frictions that ought to be embedded in these models given recent events, and whether the mechanisms for generating bubbles in these structures are sufficient. I am also quite sympathetic to learning models as a replacement for the assumption of strict rationality):

                                                                                  Risky Risk Management, by Robert Skidelsky, Project Syndicate: Mainstream economics subscribes to the theory that markets "clear" continuously. The theory's big idea is that if wages and prices are completely flexible, resources will be fully employed, so that any shock to the system will result in instantaneous adjustment of wages and prices to the new situation.

                                                                                  This system-wide responsiveness depends on economic agents having perfect information about the future, which is manifestly absurd. Nevertheless, mainstream economists believe that economic actors possess enough information to lend their theorizing a sufficient dose of reality.

                                                                                  The aspect of the theory that applies particularly to financial markets is called the "efficient market theory," which should have blown sky-high by last autumn's financial breakdown. But I doubt that it has. Seventy years ago, John Maynard Keynes pointed out its fallacy. When shocks to the system occur, agents do not know what will happen next.

                                                                                  In the face of this uncertainty, they do not readjust their spending; instead, they refrain from spending until the mists clear, sending the economy into a tailspin. It is the shock, not the adjustments to it, that spreads throughout the system. The inescapable information deficit obstructs all those smoothly working adjustment mechanisms ― i.e., flexible wages and flexible interest rates ― posited by mainstream economic theory.

                                                                                  An economy hit by a shock does not maintain its buoyancy; rather, it becomes a leaky balloon. Hence Keynes gave governments two tasks: to pump up the economy with air when it starts to deflate, and to minimize the chances of serious shocks happening in the first place.

                                                                                  Today, that first lesson appears to have been learned... But, judging from recent proposals in the United States, the United Kingdom, and the European Union to reform the financial system, it is far from clear that the second lesson has been learned.

                                                                                  Admittedly, there are some good things in these proposals. For example, the U.S. Treasury suggests that originators of mortgages should retain a "material" financial interest in the loans they make, in contrast to the recent practice of securitizing them. This would, among other things, reduce the role of credit rating agencies. ... The underlying problem, though, is that both regulators and bankers continue to rely on mathematical models that promise more than they can deliver for managing financial risks.

                                                                                  Although regulators now place their faith in "macro-prudential" models to manage "systemic" risk, rather than leaving financial institutions to manage their own risks, both sides lumber on in the untenable belief that all risk is measurable (and therefore controllable), ignoring Keynes's crucial distinction between "risk" and "uncertainty."

                                                                                  Salvation does not lie in better "risk management" by either regulators or banks, but, as Keynes believed, in taking adequate precautions against uncertainty.

                                                                                  As long as policies and institutions to do this were in place, Keynes argued, risk could be let to look after itself. Treasury reformers have shirked the challenge of working out the implications of this crucial insight.

                                                                                    Posted by on Thursday, July 23, 2009 at 12:55 PM in Economics, Macroeconomics, Methodology | Permalink  Comments (19)


                                                                                    "The Fed is Lending to 'Foreigners' instead of Americans!"

                                                                                    All of the people praising Alan Grayson for his gotcha questioning of Ben Bernanke might want to reconsider. Some deserved Economics of Contempt:

                                                                                    Dear God, Alan Grayson is a Tool, Economics of Contempt:  I just saw this video, which shows Rep. Alan Grayson questioning Ben Bernanke during his Humphrey-Hawkins testimony, and was being promoted by Zero Hedge and others a couple days ago. It's embarrassing....for Grayson.

                                                                                    He asks Bernanke about the currency swap lines that the Fed established with other central banks during the financial crisis, which he clearly doesn't understand (although he obviously thinks he does). He harps on the fact that Bernanke doesn't know which foreign financial institutions "got the money." Of course Bernanke doesn't know that. The Fed entered into currency swaps with foreign central banks, like the ECB and the BoE. Who those central banks then lent the dollars to is irrelevant—the Fed doesn't bear the credit risk of loans made by other central banks. The Fed only bears the credit risk of the central banks it established swap lines with, which, obviously, is vanishingly small.

                                                                                    Grayson then focuses on the Fed's swap line with New Zealand's central bank, which is where the wheels really come off the wagon. He apparently thinks a swap is the same thing as a loan, and that the Fed extended $9bn of credit to New Zealanders, which he considers an outrage (the Fed is lending to "foreigners" instead of Americans!). Of course, he doesn't even get his facts right (which is what happens when you hire people with no experience on Capitol Hill as Senior Policy Advisors). The Fed's swap facility with New Zealand central bank is $15bn, not $9bn, and more importantly, NZ's central bank never even drew on its swap line, which has $0 outstanding (pdf):


                                                                                    Grayson arrogantly laughs when Bernanke denies that the expansion of the swap lines on September 18th caused the dollar to rise 20%, which is amusing because the swap lines relieved the extraordinarily high demand for dollars from foreign financial institutions.

                                                                                    The best part of the video is when Barney Frank (easily my favorite Congressman) cuts Grayson off, which draws another of his arrogant laughs. Maybe Grayson should go back to losing millions in Ponzi schemes.

                                                                                      Posted by on Thursday, July 23, 2009 at 11:04 AM in Economics, Monetary Policy, Politics | Permalink  Comments (61)


                                                                                      "Carbon Sequestration from Forestry and Agriculture"

                                                                                      Michael Roberts responds to Rob Stavins post on the potential benefits from sequestering carbon:

                                                                                      Carbon sequestration from forestry and agriculture, Greed, Green, and Grains: Rob Stavins writes about curbing potential climate change by sequestering carbon rather than, or in addition to, reducing emissions from fossil fuel consumption. Stavins focuses mainly on preserving and increasing forest coverage. There are two good reasons for this focus: (1) deforestation is responsible for about 20% of CO2 emissions worldwide and (2) preventing deforestation and planting new forests appear to be low-cost ways of reducing total emissions.

                                                                                      Within the Waxman-Markey bill, CO2 emissions can be offset from agriculture and forestry activities. I'm not convinced much sequestration gains are to be had from agriculture. But farmer interests smell an opportunity, and with 80 years of rent-seeking under their collective belts, they are quite good at capitalizing on them. Under the bill (at least some versions of it) USDA will run the offset program, not EPA. That's probably essential given political constraints.

                                                                                      Some environmentalists smell a rat in the offset provision. They seem to see offsets as a loophole to avoid actual emissions reductions. There may be some truth to this.

                                                                                      My view is a little different (see earlier post). The problem is that by restricting emissions from carbon-based fuels and ultimately increasing the price of energy, there will be increased demand for other resources, including those from agriculture and forestry. Instead of using oil and gas people will use wood and ethanol. If carbon emissions from wood and ethanol are not counted they will be under-priced in a cap-and-trade world. Besides wood and ethanol, there are surely a zillion other indirect market implications we are unlikely to imagine.

                                                                                      So, in the end, we must at least try to count all the carbon. Otherwise we'll be squeezing a balloon--reducing emissions in one part of the global economy just to have them pop out somewhere else. It's not much different from having cap-and-trade in the U.S. and then buying Chinese goods produced using their uncapped carbon emissions. Eventually, we'll need to get China, India, and the rest of the developing world on board. Everyone knows this. But not everyone seems to recognize that we need to count all the carbon.

                                                                                      An offset policy doesn't capture these indirect effects. Even a painfully complicated offset policy that attempts to trace market impacts far and wide to make sure they are "additive." Even if there are no offsets, energy price changes will shift demand for all kinds of resources, from firewood to ethanol, all which affect the carbon balance.

                                                                                      I don't think many are yet willing to seriously consider the difficulty of this problem. It almost surely won't get into the first bill. But sooner or later we'll see fewer emission reductions than we expected. Maybe then we'll start counting all the carbon. Hopefully it won't be too late.

                                                                                      Reliable and transparent measurement of carbon emissions and sequestrations from forestry and agriculture will be key. While current [proposed] offset policies may do little in the way of actually influencing the carbon balance, they will spur research and debate about measurement issues. That's a good first step.

                                                                                      In comments to this post, Richard Serlin adds:

                                                                                      A fascinating and potentially very powerful idea for ramping this up greatly is genetically engineered super carbon eating trees. The best short article I've been able to find so far on this is a recent New York Times guest column by science journalist Oliver Morton.

                                                                                        Posted by on Thursday, July 23, 2009 at 02:43 AM in Economics, Environment, Policy | Permalink  Comments (25)


                                                                                        "The Power Elite"

                                                                                        Are the boards of major corporations, and the elite and powerful more generally, too interconnected to fail?:

                                                                                        Power elites after fifty years, by Daniel Little: When C. Wright Mills wrote The Power Elite in 1956, we lived in a simpler time. And yet, with a few important exceptions, the concentration of power that he described continues to seem familiar by today's standards. The central idea is that the United States democracy -- in spite of the reality of political parties, separation of powers, contested elections, and elected representation -- actually embodied a hidden system of power and influence that negated many of these democratic ideals. The first words of the book are evocative:

                                                                                        The powers of ordinary men are circumscribed by the everyday worlds in which they live, yet even in these rounds of job, family, and neighborhood they often seem driven by forces they can neither understand nor govern. 'Great changes' are beyond their control, but affect their conduct and outlook none the less. The very framework of modern society confines them to projects not their own, but from every side, such changes now press upon the men and women of the mass society, who accordingly feel that they are without purpose in an epoch in which they are without power.

                                                                                        And a page or two later, here is how he describes the "power elite":

                                                                                        The power elite is composed of men whose positions enable them to transcend the ordinary environments of ordinary men and women; they are in positions to make decisions having major consequences. Whether they do or do not make such decisions is less important than the fact that they do occupy such pivotal positions: their failure to act, their failure to make decisions, is itself an act that is often of greater consequence than the decisions they do make. For they are in command of the major hierarchies and organizations of modern society. They rule the big corporations. They run the machinery of the state and claim its prerogatives. They direct the military establishment. They occupy the strategic command posts of the social structure, in which are now centered the effective means of the power and the wealth and the celebrity which they enjoy.

                                                                                        Mills offers a sort of middle-level sociology of power in America. He believes that power in the America of the 1950s centers in the economic, political, and military domains -- corporations, the state, and the military are all organized around networks of influence at the top of which stands a relatively small number of extremely powerful people. (It seems that Mills's description of the military is less apt today; perhaps not surprising, given that Mills was writing in the middle of the Cold War.) Power is defined as the ability to achieve what one wants over the opposition of others; and the levers of power are the great institutions in society -- corporations, political institutions, and the military. And the thesis is that a relatively compact group of people exercise hegemony in each of these areas. Moreover, power leads often to wealth, in that power permits firms and individuals to gain access to society's wealth. So a power elite is often also an economic elite.

                                                                                        The central thrust of the book stands in sharp opposition to the fundamental assumption of then-current democratic theory: the idea that American democracy is a pluralist system of interest groups in which no single group is able to dominate all the others (Robert Dahl (1959), A Preface to Democratic Theory). Against this pluralistic view, Mills postulates that members of mass society are dominated, more or less visibly, by a small group of powerful people in the elite. (See an earlier posting on power as influence for discussion of how power works.)

                                                                                        So what is Mills's theory, exactly? It is that there is a small subset of the American population that (1) possess a number of social characteristics in common (for example, elite university educations, membership in certain civic organizations); (2) are socially interconnected with each other through marriage, friendship, and business relationship; (3) occupy social positions that give them a durable ability to make a large number of the most momentous decisions for American society; (4) are largely insulated from effective oversight from democratic institutions (press, regulatory system, political constraint). They are an elite; they are a socially interconnected group; they possess durable power; and they are little constrained by open and democratic processes.

                                                                                        And, of course, there needs to be a theory about recruitment and the social mechanisms of steering given individuals into the elite group. Is it family background? Is it the accident of attendance at Yale? Is it a meritocracy through which talented young people eventually grasp the sinews of power through their own achievement in the organizations of power? We need to have an account of the social means of reproduction through which a set of power relations is preserved and reproduced throughout generational change.

                                                                                        Continue reading ""The Power Elite"" »

                                                                                          Posted by on Thursday, July 23, 2009 at 02:34 AM in Economics, Politics | Permalink  Comments (47)


                                                                                          links for 2009-07-23

                                                                                            Posted by on Thursday, July 23, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (8)


                                                                                            Wednesday, July 22, 2009

                                                                                            "Ten Myths about the Subprime Crisis"

                                                                                            The Cleveland Fed's Yuliya Demyanyk says "most popular explanations for the subprime crisis turn out to be myths." I disagree on Myth 8, perhaps the crisis wasn't "totally" 100% unexpected, but it was generally unexpected and very few people got this right. As for Myth 10, I don't think anyone still believes that the "subprime mortgage market was too small to cause big problems," though that was believed at one time. Also, I'm not completely convinced that Myth 4 that "Declines in mortgage underwriting standards triggered the subprime crisis" is a myth, though that seems to be partly acknowledged in the discussion:

                                                                                            Ten Myths about Subprime Mortgages, by Yuliya Demyanyk: Subprime mortgages have been getting a lot of attention in the United States since 2000, when the number of subprime loans being originated and refinanced shot up rapidly. The attention intensified in 2007, when defaults on subprime loans began to skyrocket. Researchers, policymakers, and the public have tried to identify the factors that explained these defaults.

                                                                                            Unfortunately, many of the most popular explanations that have emerged for the subprime crisis are, to a large extent, myths. On close inspection, these explanations are not supported by empirical research.

                                                                                            Continue reading ""Ten Myths about the Subprime Crisis"" »

                                                                                              Posted by on Wednesday, July 22, 2009 at 12:14 PM in Economics, Financial System, Housing | Permalink  Comments (56)


                                                                                              Commercial Real Estate "Does Appear to be Headed Further South"

                                                                                              Calculated Risk has me convinced that this is something we ought to be worried about:

                                                                                              Bernanke: CRE May Pose Risk, by Calculated Risk: From Bloomberg: Bernanke Says Commercial Property May Pose Risk for Economy

                                                                                              Federal Reserve Chairman Ben S. Bernanke said a potential wave of defaults in commercial real estate may present a “difficult” challenge for the economy, without committing to additional steps to aid the market. ...

                                                                                              It “may be appropriate” for the government and Congress to consider “fiscal” steps to support the industry, Bernanke said today. Ideas for fresh support for the market could include government guarantees for commercial mortgages, Bernanke also said today ...

                                                                                              “As the recession’s gotten worse in the last six months or so, we’re seeing increased vacancy, declining rents, falling prices -- and so, more pressure on commercial real estate,” Bernanke said yesterday. “We are somewhat concerned about that sector and are paying very close attention to it. We’re taking the steps that we can through the banking system and through the securitization markets to try to address it.”

                                                                                              A few key CRE stories this month...[list of news items] ...And a comment from the USG (building materials supplier) conference call this morning:

                                                                                              "Nonresidential construction does appear to be headed further south, perhaps significantly so."

                                                                                              No kidding.

                                                                                                Posted by on Wednesday, July 22, 2009 at 12:01 PM in Economics, Financial System | Permalink  Comments (45)


                                                                                                Fed Independence

                                                                                                Continuing the recent discussion here and elsewhere on Fed independence, this is not the first time audits and other threats to independence have been seriously considered:

                                                                                                On the mend, The Economist: It has been a long time since comments on the economy by an official of America’s Federal Reserve comments could be described as cheerful. Yet there was no denying the upbeat tone of Ben Bernanke’s testimony to Congress on Tuesday... His fingers may be crossed but it is clear that Mr. Bernanke thinks the recession, if not over now, soon will be.

                                                                                                That is a far cry, though, from seeing a threat from inflation and Mr. Bernanke made it clear that the federal funds target rate, now near zero, will remain there for a long time. On Wall Street, most reckon that means until well into 2010 at least.

                                                                                                Yet the Fed is already under pressure to explain how it intends to tighten monetary policy, even by congressmen who usually want nothing of the sort. ... Whether inflation [occurs] depends on if the Fed raises interest rates in time and thereby curbs the appetite for credit. Mr. Bernanke spent much of his testimony explaining how he can do just that. ...

                                                                                                Politics could ... interfere with the Fed’s willingness to tighten monetary policy in time. Congress’s nonpartisan investigative arm, the Government Accountability Office, can now audit the Fed with the exception of its monetary policy, lending programs or relations with foreign central banks. A bill in Congress would lift those prohibitions. Mr. Bernanke argued that the threat of such audits would lead investors to question the Fed’s willingness to do unpopular things, like tighten monetary policy, unsettling them and driving up long-term interest rates.

                                                                                                This is not idle speculation. Anti-Fed sentiment was also strong in the 1970s, when Congress first sought to have the GAO audit the central bank. Arthur Burns, chairman at the time, fought back, and a compromise was struck to allow audits, but with the current prohibitions. Mr. Burns later reflected that the effort of “warding off legislation that could destroy any hope of ending inflation” involved “political judgments” that may have weakened his anti-inflationary resolve.

                                                                                                For all the discussion, any tightening of policy is a long way off. ... 

                                                                                                I think one of the problems that people are trying to get at when they want to take away the Fed's independence is the concentration of power within the Board of Governors (the view by some that the Board represents special rather than public interests, e.g. Wall street, also plays a role), and they see devices such as audits from the GAO as a check on that concentration of power. Here's an edited version of part of an old post:

                                                                                                While the Fed was initially structured to balance competing interests and to share power, the system has evolved into an institution with centralized rather than shared power. The intent to share power and balance competing interests is evident in the structure of the Federal Reserve system. For example, individual district banks are overseen by a board of nine part-time directors. These directors come in three types. Three of the nine are type A and are bankers, and three are type B and represent the business community. Legislation prohibits type B board members from being bankers. In a further attempt to make the process representative, type A and type B directors representing banking and business interests are elected by member banks within each of the twelve Federal Reserve districts. Type C directors are appointed by the Board of governors and are intended to represent the public interest within the district banks.

                                                                                                Thus, the districts themselves provide geographic representation that is population based, while control of the district banks balances public, banking, and business interests. Initially, the district banks functioned as twelve cooperating banks and each district had considerable control of monetary conditions within the district. It was very much a shared power arrangement. As one example of the power district banks had, each bank had full control of the discount rate for its district (the discount rate was the only tool available for controlling the money supply when the Fed was formed, open-market operations were not well understood until later and there was no provision for the Federal Reserve system to control reserve requirements, another way to affect the money supply).

                                                                                                The shared power arrangement within the Federal Reserve system changed after the Great Depression when monetary authorities failed to respond adequately to crisis condition. The problem, or so it seemed, was the shared power nature of the system. The deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances, it was mostly equipped to deal with problems at individual banks (the discount window is well-suited to help individual banks, but not system wide disruptions; on the other hand, open-market operations can inject reserves system-wide and hence is a better tool for systemic problems).

                                                                                                The solution to this was to concentrate power into the hands of the central bank so that should a crisis occur, they can act quickly. There are risks, of course, to concentrating power so narrowly, but in the aftermath of the Depression we were quite willing to take that risk if it helped to avoid another catastrophic outcome (as it may well have done).

                                                                                                Thus, after the Great Depression power was concentrated. For example, banks no longer control the discount rate in their districts. They can propose a change in the discount rate at an FOMC meeting, but the Board of Governors must approve the rate and they will only approve one rate, the rate they decide. So while the rates are still formally set in the districts, they are essentially set by the Board of Governors. When all such changes in the concentration of power over time from the districts to the Central Bank in Washington D.C. are considered, it becomes very clear that the Fed has evolved from a very democratic, shared power arrangement at its inception to one where it functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.

                                                                                                *****

                                                                                                I am not at all in favor of lessening the degree of independence that the Fed currently has, but I do think we need to make changes in the way the President and Boards of the district banks are chosen. As it stands, the Board of Governors in Washington has considerable influence over who is appointed to key positions such as the President of the district banks, and those Presidents represent five of the twelve votes at the meetings where monetary policy is set. More independence of the district bank Presidents and other district bank personnel from the Board of Governors would be a healthy change (there is also a question of whether geographic representation through district banks is the best way to capture the public interest, but I'll leave that aside for now).

                                                                                                  Posted by on Wednesday, July 22, 2009 at 12:33 AM in Economics, Monetary Policy, Politics | Permalink  Comments (63)


                                                                                                  "Two Ideas for Appraisal Reform"

                                                                                                  These seem like reasonable ideas to me:

                                                                                                  Two ideas for appraisal reform, by Richard Green: Lawrence Yun of NAR is complaining that appraisals are preventing legitimate real estate transactions from occurring. Because of the way appraisers sometimes choose comparables, I have some sympathy for this view. And as I noted in an earlier post, Rhonda Porter says the Home Value Code of Conduct is nothing more than a way to line the pockets of Appraisal Management Companies. I have some sympathy for this view as well.

                                                                                                  But we should not go back to the days when appraisers were basically paid to stay out of the way of the consummation of a deal. So let me suggest two proposals:

                                                                                                  (1) Appraisers should not be allowed to see the offer price of a house. This is the only way their valuation will be truly independent.

                                                                                                  (2) Appraisers should use valuation techniques that allow them to report a standard deviation of their estimate. Subdivision tract houses will have small standard deviations; architect designed villas will have large standard deviations.

                                                                                                  We could then move to a pricing rule where Mortgage Insurance will be required if (1) the LTV based on appraised value is greater than 80 percent or (2) there is a greater than five percent chance that the true value of the house implies an LTV of 95 percent.

                                                                                                  Step (1) would be easy to implement, and I think would help a lot. Step (2) will require lots of training (and perhaps different parameters from those that I am suggesting).

                                                                                                  We need to stop kidding ourselves that we can measure house prices precisely. We need to start measuring the level of imprecision.

                                                                                                    Posted by on Wednesday, July 22, 2009 at 12:17 AM in Economics, Housing, Regulation | Permalink  Comments (13)


                                                                                                    links for 2009-07-22

                                                                                                      Posted by on Wednesday, July 22, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (6)