Friday, April 30, 2010
Kenneth Rogoff on the IMF's proposal for a tax that increases with the size of financial institutions:
All for One Tax and One Tax for All?, by Kenneth Rogoff, Commentary, Project Syndicate: ...Recently, the IMF proposed a new global tax on financial institutions loosely in proportion to their size...The Fund’s proposal has been greeted with predictable disdain and derision by the financial industry. More interesting and significant are the mixed reviews from G-20 presidents and finance ministers. Governments at the epicenter of the recent financial crisis, especially the United States and the United Kingdom, are downright enthusiastic... Countries that did not experience recent bank meltdowns, such as Canada, Australia, China, Brazil, and India, are unenthusiastic. Why should they change systems that proved so resilient?
It is all too easy to criticize the specifics of the IMF plan. ... But, while regulation must address the oversized bank balance sheets that were at the root of the crisis, the IMF is right not to focus excessively on fixing the “too big to fail” problem. A surprising number of pundits seem to think that if one could only break up the big banks, governments would be far more resilient to bailouts, and the whole “moral hazard” problem would be muted.
That logic is dubious... A systemic crisis that simultaneously hits a large number of medium-sized banks would put just as much pressure on governments to bail out the system as would a crisis that hits a couple of large banks. ...
Any robust solution must be reasonably simple to understand and implement. The IMF proposal seems to pass these tests. ... The IMF is on much weaker ground, however, in thinking that its one-size-fits-all global tax system will somehow level the playing field internationally. It won’t. Countries that now have solid financial regulatory systems in place are already effectively “taxing” their financial firms more than, say, the US and the UK, where financial regulation is more minimal. The US and the UK don’t want to weaken their competitive advantage by taxing banks while some other countries do not. But it is their systems that are in the greatest and most urgent need of stronger checks and balances.
Let’s not go too far in defending the “holdout” countries that are resisting the IMF proposal. These countries need to recognize that if the US and the UK do implement even modest reforms, a lot of capital will flow elsewhere, potentially overwhelming regulatory systems that seemed to work well until now. ...
The IMF’s first effort at prescribing a cure may be flawed, but its diagnosis of a financial sector bloated by moral hazard is manifestly correct. Let’s hope that when the G-20 leaders meet later this year, they decide to take the problem seriously...
At CBS MoneyWatch, a reaction to today's release of the advance estimate of 3.2% GDP growth for the first quarter of this year, and to yesterday's news that the four week average for initial claims for unemployment insurance increased slightly:
I explain why I am not as excited by the 3.2 percent growth figure as others seem to be.
Deficit hawks are trying to use the "euro-mess" to support their case for austerity. But that's not the real lesson of the European crisis:
The Euro Trap, by Paul Krugman, Commentary, NY Times: Not that long ago, European economists used to mock their American counterparts for having questioned the wisdom of Europe’s march to monetary union. ... Oops..., right now it does seem to have been a bad idea for exactly the reasons the skeptics cited. And as for whether it will last — suddenly, that’s looking like an open question.
To understand the euro-mess — and its lessons for the rest of us — you need to see past the headlines. Right now everyone is focused on public debt, which can make it seem as if this is a simple story of governments that couldn’t control their spending. But that’s only part of the story for Greece, much less for Portugal, and not at all the story for Spain.
The fact is that three years ago none of the countries now in or near crisis seemed to be in deep fiscal trouble. ... And all of the countries were attracting large inflows of foreign capital, largely because markets believed that membership in the euro zone made Greek, Portuguese and Spanish bonds safe investments.
Then came the global financial crisis. Those inflows of capital dried up; revenues plunged and deficits soared; and membership in the euro ... turned into a trap.
What’s the nature of the trap? During the years of easy money, wages and prices in the crisis countries rose much faster than in the rest of Europe. Now that the money is no longer rolling in, those countries need to get costs back in line.
But that’s a much harder thing to do now than it was when each European nation had its own currency. Back then, costs could be brought in line by adjusting exchange rates... Now..., however, the only way to reduce Greek relative costs is through ... deflation. ...
The problem is that deflation — falling wages and prices — is always and everywhere a deeply painful process. It invariably involves a prolonged slump with high unemployment. And it also aggravates debt problems, both public and private, because incomes fall while the debt burden doesn’t.
Hence the crisis. ... All this is exactly what the euro-skeptics feared. Giving up the ability to adjust exchange rates, they warned, would invite future crises. And it has.
So what will happen to the euro? Until recently, most analysts, myself included, considered a euro breakup basically impossible, since any government that even hinted that it was considering leaving the euro would be inviting a catastrophic run on its banks. But if the crisis countries are forced into default, they’ll probably face severe bank runs anyway... This would open the door to euro exit.
So is the euro itself in danger? In a word, yes. If European leaders don’t start acting much more forcefully, providing Greece with enough help to avoid the worst, a chain reaction that starts with a Greek default and ends up wreaking much wider havoc looks all too possible.
Meanwhile, what are the lessons for the rest of us?
The deficit hawks are already trying to appropriate the European crisis, presenting it as an object lesson in the evils of government red ink. What the crisis really demonstrates, however, is the dangers of putting yourself in a policy straitjacket. When they joined the euro,... governments ... denied themselves the ability to do some bad things, like printing too much money; but they also denied themselves the ability to respond flexibly to events.
And when crisis strikes, governments need to be able to act. That’s what the architects of the euro forgot — and the rest of us need to remember.
Thursday, April 29, 2010
We Can't All Be (Net) Exporters, by Tim Duy: The Greek crisis, which helped further extend the Dollar's uptrend in place since the beginning of the year, is a reminder that global imbalances are still with us - and, if not corrected, will eventually threaten the sustainability of the global recovery. Indeed, how sustainable can any recovery be if the vast majority of nations are pursuing an export oriented growth strategy? After all, clearly that is not a game all can play - there needs to be a net importer to offset the net exports. Who wants to fill that role? If the US is pushed into filling that role, we have simply come full circle over the past three years.
The Administration is clearly aware of this challenge, but concerns are growing that any action will fall short of what is necessary to bring about real change. From Sudeep Reddy at the Wall Street Journal:
President Barack Obama's goal of doubling U.S. exports over the next five years will be difficult to meet, business leaders and economists say, because of the lack of momentum on demolishing trade barriers and the shift by more American companies toward producing overseas.
U.S. exporters want Washington to put more pressure on trading partners to eliminate tariffs, crack down on intellectual-property violations and take a harder line on trading partners' currency policies. American firms say stronger action by the federal government could substantially boost prospects for U.S. exports.
Policymakers argue that it is far too early to admit defeat:
Christina Romer, chair of the White House Council of Economic Advisers, calls the administration's export target "an ambitious but reasonable goal."
"Going up 100% over a five-year period is not such a radical idea when you think about historical experience," she said, noting that exports increased more than 75% between 2003 and 2008. "It is going to be a gradual process. We are just starting the concrete steps in terms of what we can do to lower the fixed costs associated with exporting through trade promotion and commercial diplomacy."
Am I the only one that finds the Administration's focus on doubling exports somewhat disingenuous? Economic growth depends on net exports - doubling exports is a fine goal, as long as import growth is contained, such that the net effect is positive. But with the economy bouncing back, will import growth remain contained? Recent signs are not supportive - the recovery so far has ended the improvement in the real trade gap:
Moreover, Romer claims the process will be "gradual." Will it be so gradual that US firms will resume expansion of overseas capacity at the expense of domestic production? Back to the Wall Street Journal:
But the shift by more U.S. companies toward producing goods overseas is one of the factors that makes doubling exports tougher. These firms have built more factories in fast-growing foreign countries to serve emerging markets, so they often supply the goods and services from an overseas arm—not by loading shipping containers in the U.S.
American businesses say they must contend with a long list of disadvantages, from higher tax rates than in many countries to rising costs for benefits such as health care. U.S. producers also say an artificially low Chinese currency makes Chinese goods especially cheap in foreign markets and therefore tougher competitors for American goods.
Once that production leaves, I suspect it is largely gone for good, barring a very large, sustained, and broad-based shift in the value of the Dollar. To be sure, the Administration is pressing China to revalue the renminbi, but the pace of any appreciation is likely to disappoint. Moreover, the uptrend in the Dollar raises a new concern. From Yves Smith:
A further source of trouble is political. If the euro continues on its expected slide and the pound is devalued, the dollar’s strength will put a major dent in the US ambitions to increase exports. Moreover, the rise in the greenback relative to other currencies will no doubt make China much more reluctant to revalue the renminbi against the dollar
Also, further pressure on the Euro is likely necessary to compensate for the fiscal drag of deficit containment in the PIIGS. Note too that recent events are driving capital to the US, holding down interest rates. From the Wall Street Journal:
Mortgage rates stayed flat last week, rising just slightly to 5.08% from 5.04% one week earlier, according to the Mortgage Bankers Association. So far, the big rise in rates that some had expected when the Federal Reserve ended its mortgage-backed securities purchase program last month hasn’t materialized.
In fact, the instability in Europe amid looming debt woes for Greece and Portugal on Tuesday sent investors looking for safer assets such as the 10-year Treasury, to which fixed-rate mortgages are closely tied. That has helped to keep rates down.
Sustained low rates will help keep US demand from waning, so much the better for to fuel the flow of imports necessary to meet the needs and wants of US consumers (it is not coincidence that the trade deficit began improving when the faltering housing market took the steam off consumer spending). And, intriguingly, Japan looks ready to resume the export push. Also from the Wall Street Journal:
As many Japanese enjoy their annual "Golden Week" holidays starting Thursday, some of Japan's economic ministers will be traveling to the U.S. and Asia to pitch what they hope will become a new driver of the nation's growth: infrastructure exports.
Transport Minister Seiji Maehara will spend Thursday and Friday in Washington to promote Japan's superfast bullet-train system as it chases part of President Barack Obama's high-speed railway project, which has an initial $8 billion price tag. Central Japan Railway Co. is among the hopefuls on some projects.
Meanwhile, Economic Strategy Minister Yoshito Sengoku will be wooing officials in Vietnam to choose a consortium of Japanese nuclear-power companies over French and South Korean rivals. Vietnam last year approved a resolution to build its first two nuclear-power plants, estimated to cost about $10.5 billion at current rates.
"In the past, Japanese ministers were too proud to go out there and cheer for our companies as they worried about failing to deliver successful results," Mr. Maehara said. "I intend to play the role of the top salesman for Japanese companies as their success equals the nation's economic growth."
Tokyo has begun a push to help Japanese companies win multibillion-dollar infrastructure projects abroad as its domestic economy continues to slump and a population decline threatens to sink demand further.
At the same time, rising environmental concerns in developed nations and rapid expansion of emerging economies are resulting in bumper crops of projects in areas like railways, nuclear power and clean energy.
"There is no growth for Japan unless we enhance exports," says Hiroki Mitsumata, director of nuclear-energy policy at the Ministry of Economy, Trade and Industry. "No matter how superior our technology is, if it's confined within Japan, it will become obsolete like the species in the Galapagos."
Given the consistent global policy theme of "more exports," at least one US firm recognizes the potential for disappointment with the Administration's goal:
Todd Teske, chief executive of Briggs & Stratton Corp., a Wauwatosa, Wis.-based small-engine maker, says he is partly counting on more exports to rebuild his sales after the recent downturn. Briggs & Stratton already receives about a fifth of its $2 billion in revenue from sales abroad, particularly in Europe. Mr. Teske calls the U.S. goal of doubling exports a "lofty goal" and one worth pursuing. But he's realistic. "It seems like every country or region wants to fuel their recovery plan with exports," he said.
Bottom Line: My gut tells me that in any battle for export oriented growth, the US will come up the loser. When push comes to shove, the US will do nothing in response to the accumulation of dollar assets abroad. Ultimately, nations need to do more to support domestic demand to drive economic growth. But the risk is that as the broad global financial crisis continues to fade, nations will increasingly attempt to withdraw fiscal support for their economies - even more so with the Greece example now so vivid - and attempt to rely on external growth to compensate. It is not a game everyone can win. But if it deteriorates into competitive devaluations, it is a game everyone can lose.
- Consumer credit: More than meets the eye - macroblog
- Big business pleads for loopholes in financial regulation - Steven Pearlstein
- Comment on “Will Chinese revaluation create American jobs?” - voxeu
- All for One Tax and One Tax for All? - Ken Rogoff
- Democrats Tweak Financial Bill to Preclude Bailouts - NYTimes.com
- Diamond nominated for Federal Reserve post - MIT News
- Why Environmentalists Don’t Trust Economists - Open Economics
- Amartya Sen’s Redundancy and Priority Claims - Crooked Timber
- Calorie posting at chain restaurants - Greed, Green and Grains
- When We Will Get a VAT - Capital Gains and Games
- Financial News Express - links
- Marginal Revolution - links
- Abnormal Returns - links
- Credit Writedowns - links
- Felix Salmon - links
- Market Talk - links
- Free Exchange - links
- Brad DeLong - links
As I travel, here's an automatic post of video from two of the lunchtime sessions at the Milken Global Conference. First, the panel on "Geopolitics, Global Demand and the Quest for Energy Security":
Panel: Geopolitics, Global Demand and the Quest for Energy Security
- Aris Candris, President and CEO, Westinghouse Electric Company
- Wesley Clark, Army General (ret.) and former Supreme Allied Commander, NATO; Chairman, Rodman & Renshaw
- Anne Korin, Co-Director, Institute for the Analysis of Global Security; Chair, Set America Free Coalition
- Jay Pryor, Vice President, Corporate Business Development, Chevron
- R. James Woolsey, Venture Partner, VantagePoint Venture Partners; Of Counsel, Goodwin Procter LLP; former Director, Central Intelligence Agency
Moderator: Brian Sullivan, Anchor, Fox Business Network
Second, here is video showing a debate between Michael Milken and Nouriel Roubini. I think Paul Kedrosky sums it up well:
There was some good stuff in the lunch discussion between Nouriel Roubini and Mike Milken at the Milken conference today. Note: It's long, and some segments are less interesting than others. Then again, there is the bit where Mike suggests the solution to the U.S's deficits & entitlements problem is in obesity -- the biological kind.
Here's the video from the session "Nouriel Roubini and Mike Milken Debate Where We've Been – Where We're Going":
Panel: Nouriel Roubini and Mike Milken Debate Where We've Been – Where We're Going
- Michael Milken, Chairman, Milken Institute
- Nouriel Roubini, Professor of Economics and International Business, Stern School of Business, New York University
Moderator: Matthew Winkler, Editor-in-Chief, Bloomberg News
Obama the Centrist, by J. Bradford DeLong, Commentary, Project Syndicate: Despite the frequent cries of ... Republicans that Barack Obama is trying to bring European-style socialism to the United States, it is now very clear that the US president wishes to govern from one place and one place only: the center. ...On all of these policies – anti-recession, banking, fiscal, environmental, anti-discrimination, rule of law, healthcare – you could close your eyes and convince yourself that, at least as far as the substance is concerned, Obama is in fact a moderate Republican named George H.W. Bush, Mitt Romney, John McCain, or Colin Powell. ... [...more...]
Nick Krafft argues that heterodox economists are right about the need to get rid of the assumption that individuals are rational utility maximizers:
In which I “attack old-fashioned economics,” i.e. utility maximization, by Nick Krafft: At an off-campus discussion toward the end of my senior year of college, the topic of behavioral economics came up. Leading the discussion was a professor of mine, David Ruccio- whose blog I link to regularly- who argued that to really move forward with these iconoclast ideas, we still have to get rid of the max u thing- it’s holding everything back. I didn’t really agree with him at the time, or I just didn’t know, but a recent panel I attended helped clarify why Ruccio, and other heterodox economists before him, are right, even if the panelists themselves don’t want to see it it or admit.
The topic of the panel, hosted by the Brookings Institution, was “Happiness in a Time of Uncertainty.” The panel was striking in it’s premise- 4 mainstream economists discussing the topic of subjective well-being. A number of interesting points were raised. For instance, it was pointed out that people seem to be very adaptive with regards to happiness, such that they can settle into what one might consider a “bad” equilibrium but regain subjective happiness, and thus show little incentive to leave.
CAROL GRAHAM: But there is one major complication or a fly in the ointment so to speak, and that’s adaptation. People seem to be able to adapt to high levels of adversity, poor health and all kinds of things and retain their natural cheerfulness or their natural happiness…People really can adapt to adversity. They also adapt to prosperity. As I thought about this around the world and how it aggregated up across societies I thought it’s probably really good from an individual psychological perspective that people are able to adapt to adversity and maintain their natural cheerfulness, but it may also result in collective tolerance for bad equilibrium.
The comments from panelists also touched on what behavioural economics has been saying for a while- people do a lot of things that don’t seem to be maximizing anything; there are myriad inconsistencies across time and across situations.
During Q&A, I raised the issue that these points seem to undermine the whole utility maximization assumption, and that we may need to completely overhaul the so-called microfoundations of neoclassical models (EJ Dionne, the moderator, called it an “attack on old-fashioned economics). Here’s the exchange, copied from the event transcript (pdf):
Jon Faust responds to Goldman Sachs caveat emptor defense:
Caveat Emptor Is Not a Business Plan, by Jon Faust: The Securities and Exchange Commission case against Goldman Sachs raises the cherished American principle of caveat emptor — let the buyer beware. The charming story of how this principle came to prominence in American law is remarkably enlightening about recent events.
During the War of 1812, the British blockaded American trade, depressing the price of tobacco stuck inside the United States. On Christmas Eve 1814, the Treaty of Ghent ended the war. Ships bearing the news were dispatched, arriving in New Orleans on Feb. 15.
That night, news leaked ashore to a tobacco buyer named Organ who dashed to Laidlaw & Company at sunup the next morning hoping to seal a previously discussed deal to buy 111 hogsheads of tobacco. Presumably surprised by Organ’s eagerness, Laidlaw’s representative asked if there was any reason for the rush.
Organ apparently dissembled and the deal was done. Almost immediately thereafter, the price of tobacco jumped 30 to 50 percent, and the ensuing lawsuit went to the Supreme Court. (This account is taken from the Supreme Court documents, 15 U.S. 178.)
Writing for the majority, Chief Justice John Marshall ruled that Organ had no obligation to share his information: “The Court is of opinion that he was not bound to communicate it. It would be difficult to circumscribe the contrary doctrine within proper limits…”
What is striking is that caveat emptor arises as a legal principle mainly because of the tangle the courts would get into if they tried to enforce a more ambitious standard of right and wrong.
Chief Justice Marshall’s logic surely applies with even greater force to modern deals between investment banks and sophisticated qualified investors, both of which will be simultaneously working on many deals, each involving sensitive proprietary information.
Caveat emptor makes good sense as a practical limitation on what courts might reasonably be expected to sort out. So should shareholders of Goldman Sachs be concerned? About the suit, I don’t know. More generally, perhaps so.
As I reminded my undergraduates the other day, caveat emptor is a legal principle, not a business plan.
Wednesday, April 28, 2010
Since, at the moment, I'm listening to Vincent Reinhart talk about when the Fed will tighten in a session entitled The Fed at a Crossroads -- he says rates will stay low for an "extended period" -- I should note that the FOMC announced today that rates will stay low for, again, an extended period. (Reinhart was more specific and said he thinks rates will start to increase late this year or, more likely, early in 2011 -- Update: at the end of the session, he gave May 2011 as the most likely date.)
One side note: Jon Hilsenrath of the WSJ noted that the phrase "extended period" was coined by Reinhart when he was the Director of the Division of Monetary Affairs at the Federal Reserve Board.
[I'll post the video from this session later. Update: Posted here.]
At CBS MoneyWatch:
A Loss of Faith in Government, by Mark Thoma: I'm at the Milken Global Conference, my third, and I've been trying to detect changes in the attitude of participants, changes in the program, etc. relative to the past two years now that we've moved from recession to what appears to be the beginning of a recovery.
One of the biggest changes I've noticed, and this goes beyond the conference, is the attitude toward government. Republicans have always targeted government as inefficient, bloated, a threat to liberty, and so on, but this is different. The criticism and contempt for government is more widespread, and it's gone beyond a party slogan. Even with many accomplishments under its belt, e.g. health care legislation, and even with the perception of moving forward on immigration, financial reform, and climate change legislation, government is still viewed as ineffective, irresponsible, and unresponsive to people's needs. ... [...continue...]...
The administration supports legislation that grants paid sick leave to "some of nation's lowest-paid employees":
Paid sick leave pushed for low-income workers, by Tony Pugh, McClatchy Newspapers: Fresh off passage of a sweeping health care overhaul, the Obama administration is supporting legislation to provide mandatory paid sick leave for more than 30 million additional workers who are some of nation's lowest-paid employees.
The Healthy Families Act, sponsored by Sen. Christopher Dodd, and Rep. Rosa DeLauro, both Democrats from Connecticut, would require companies that have 15 or more employees to provide one hour of paid sick leave for every 30 hours worked or up to seven sick days a year for a full-time worker.
Both bills — HR 2460/S1152 — are stuck in committee... Top Obama administration officials voiced their support for the federal proposal this week... Groups such as the Institute for Women's Policy Research and the National Partnership for Women and Families say the proposal would provide an overdue measure of economic and workplace justice.
Only 25 percent of low-wage workers have paid sick leave, which makes it a financial hardship for them to get sick and miss work. Those who do stay home to heal or to tend to a family member's illness fear that they could lose their jobs if they miss too many days.
At a briefing Tuesday morning, Terrell McSweeny, domestic policy adviser to Vice President Joe Biden, called the proposal "an issue of middle-class economic security" for struggling families.
Business groups such as the National Federation of Independent Business and the Employment Policies Institute oppose the measure. They say a government mandate on sick leave ... would hurt the very people it's intended to help because employers would offset the cost of the benefit by cutting positions and workers' hours. ...
More than 50 million American workers — nearly 40 percent of the private labor force — don't get paid if they miss work because of illness.
The problem is most pronounced in lower-paying industries such as food service and child care, in which only 27 percent of workers get paid sick leave. A recent report by the Institute for Women's Policy Research estimates that people who came to work while they were sick with the H1N1 virus may have infected 7 million people at the height of the outbreak last year.
After trying to call in sick with the flu several years ago, 23-year-old Megan Sacks of Tacoma, Wash., was told she would have to be "on her deathbed" in order to miss her lunchtime shift as a waitress. After she showed up visibly ill, however, a customer contacted the health department to complain. Sacks ... was ... later fired because her boss thought that she'd called the health officials. "I was really hurt ... because I thought I was a valued employee," she said. "And to this day I still don't know who called the health department. If I knew, I would have asked them not to, because I lost my job over this." ...
One thing that came up in the session The 21st-Century Workplace: Time to Talk About What Works and What Doesn't is that even when workers have the legal right to a benefit like sick leave, very often they are still afraid to use it. Workers won't be able to take full advantage of these types of benefits if the culture within the workplace doesn't change along with the change in the law. Leadership from the administration and others can help to change the workplace culture, and changing the law will help in any case -- see this chart -- but changes to workplace culture won't happen overnight. Employers benefit from the current arrangement and they will resist changes to workplace norms no matter what the law says, and no matter how strongly they are lectured about their moral obligation to their workers.
I'll focus on things related to economics -- there's more in the original:
Solving the Social Sciences' Hard Problems, Harvard Magazine: Across all the disciplines of the social sciences—economics, history, anthropology, political science, sociology, and more—what are the hardest problems that need solving, and which are most worthy of time spent working on a solution?
Scholars from a range of disciplines presented their answers to this question in an April 10 symposium at Harvard. The discussion continues online...
Nicholas Christakis, professor of medical sociology and of medicine at Harvard Medical School and professor of sociology in FAS, argued for further exploration of how the social becomes biological. ...: why, for example, does emotional contagion exist? Why would it provide a selective advantage if, when you meet someone in a foul mood, it poisons your own mood, too? And how can biology account for behavior—which is not genetically determined, although genes may contribute—with findings such as abusive behavior being transmitted through subsequent generations of rats?
Noting that he and collaborators recently published a study showing that altruism spreads through social networks, Christakis said he believes this line of inquiry will also shed light on the origins of goodness. ...
University of California, Berkeley sociology professor Ann Swidler ’66 highlighted the question of how societies create institutions, and how they restore missing or damaged ones. The American military’s experiences in Iraq and Afghanistan indicate just how little is known about this, she said. Swidler cautioned that any solutions would be tremendously complicated...
Nassim Taleb ... spoke of “the problem of small probability.” Taleb ... noted that science—whether lab science or social science—cannot account for extremely rare events such as financial meltdowns. ... “Not only can we not predict rare events,” he said, “but we cannot even figure out what role they play in the data.” That is because “you don’t measure risk like you measure a table,” he said: risk cannot be quantified in a precise way. This problem may not be solvable, Taleb acknowledged; the most to hope for, he said, may be to define its boundaries. ...
Oxford University philosopher Nick Bostrom challenged the academic community to identify the biggest fallacies that are accepted as common knowledge today, and highlighted past misconceptions that were once universally believed... “Not all progress consists of going forward,” said Bostrom. “Sometimes if we’ve taken a wrong turn, what we need to do is turn back.”
Weatherhead University Professor Gary King, who directs Harvard’s Institute for Quantitative Social Science, posed a methodological problem: “post-treatment bias in big social-science questions.” Post-treatment bias happens when researchers, in attempting to control for variables that may skew the results of a study, inadvertently control for a variable that is directly related to the outcome they wish to measure, yielding erroneous results.
King gave the example of a company accused of paying black employees less than white employees. When studying whether the accusation is true, a researcher’s natural instinct would be to control for position within the firm, so that the question being asked is whether employees are getting equal pay for equal work. But if 99 percent of employees in the mailroom are black, and 99 percent of employees in upper management are white, it might not matter that all the mailroom employees are paid at the same rate ... and all the high-level managers are paid at the same rate.... “If you control for position in the firm,” said King, then you’ll find that race has “no effect on salary—and then this racist firm gets to say, ‘Hey, no problem!’ ” King highlighted ... pressing real-world questions for which post-treatment bias stands in the way of finding answers...
Emily Oster ’02, Ph.D. ’06, focused on behavior change in health. Massive increases in life expectancy during the twentieth century resulted from advances in sanitation, technology, and medicine; in the twenty-first century, she said, they will depend on getting people to change their behavior—an infinitely trickier task.
Oster ... noted that newly diagnosed diabetics who are very obese gain more weight, in the year following their diagnosis, than similarly sized people who are not diabetic—contrary to what one might expect... In addition, she noted, only 60 percent of diabetics who are prescribed medication take it as directed.
Over and over, when economics and public-health researchers ask, “Do people do good things for their health if they’re very easy?” the answer turns out to be no...
Lee professor of economics Claudia Goldin called for further research on the persistent problem of why women are paid less than men are, and how to level the playing field. Her own research has shown that most or all of this bias is unintentional: women self-select into fields that pay less. ...
Beren professor of economics Roland Fryer drew attention to another persistent problem in American society: the racial achievement gap in education. This gap, he said, underlies numerous other social problems: racial differences in the incarceration rate, employment, wages, and health. ...
Although each presenter supposedly outlined what he or she saw as the most pressing problems in the social sciences today, an audience inquiry about what other questions the panel would have raised, having heard each other’s contributions, prompted the formation of a whole new list.
“I’m glad that we were given this opportunity,” Goldin responded, “because when we were asked to come up with a hard problem in the social sciences, I think all of us thought very hard about it, and we came up with a bunch of hard problems. But when we had to create something for the audience, we realized that we had to come up with something that we actually knew something about, so then we threw away that hard problem and we took our research.”
She added that the problem she really wanted to talk about was how and why social norms change. Other presenters added these problems to the mix:
- the problem of emergence: “How do you get the mind out of a bunch of neurons? How do you get a political system or an economic system out of a bunch of individual people?” (Kosslyn)
- the role for genetics in thinking about social-science problems (Oster)
- how, in general, to jump from breakthroughs on small problems to progress on big problems: “We’re better at biology than behavior.” Obesity, from a biologist’s point of view, is “totally solved,” said King—people just need to exercise more and eat less. But as Oster noted, getting people to do these things is easier said than done, and so from the point of view of economics and psychology, the problem is “not solved at all.”
- how to square the realization that people don’t always behave rationally with the need to avoid paternalism and let people make their own decisions even when they choose an outcome that isn’t good for them (Zeckhauser)
- trying to understand ideologies—“the beliefs we have that we’re willing to die for” (Carey)
- the “translational gap”—the gap between advances in knowledge and their implementation. “You go to business school and take a class in finance, and they teach you theory that we know doesn’t work, that we have known doesn’t work now for 25 years,” said Taleb. But “people still teach it today.”
- how to explain “small outbursts of creativity and achievement”: such Renaissance Florence, the Scottish Enlightenment, Silicon Valley. “What enabled small populations to achieve disproportionately for a period of time?” Bostrom asked. “Is that something we could learn to recreate deliberately?”
- the evolutionary origin of overconfidence. Citing a study that showed that 94 percent of academics think their work was above average, Fowler said, “We have this ‘Lake Wobegon effect’ that really interests me.”
- developing better models of what culture is and how it works. “It’s really important to remember,” said Swidler, “that you cannot derive the properties of a complex arrangement from the properties of the individual pieces.”
- the question of where tastes come from. “If your tastes come from the people around you,” asked Christakis, “where do their tastes come from? Maybe all of a sudden one person wants something for a chance reason, and it just ripples through the network.”
Tuesday, April 27, 2010
- Aaron Brown, Risk Manager, AQR Capital Management; Author, The Poker Face of Wall Street and A World of Chance
- Colin Camerer, Robert Kirby Professor of Behavioral Finance and Economics, California Institute of Technology
- Stacy-Marie Ishmael, Reporter, Financial Times
- Myron Scholes, Nobel Laureate, 1997; Chairman, Platinum Grove Asset Management
- Bruce Tuckman, Director of Financial Markets Research, Center for Financial Stability
Moderator: Glenn Yago, Executive Director, Financial Research, Milken Institute
Update: See also:
What's Wrong with Risk Models, by John Cassidy: First up, sincere apologies to the organizers and attendees of the Milken Global Forum, in Los Angeles, where I was due to appear this afternoon at a session about economic models of risk. I was looking forward to engaging the other panelists, who included Nobel laureate Myron Scholes, of “Black Scholes” fame; Colin Camerer, a Cal-Tech behavioral economist I’ve written about in the past; and Aaron Brown, a former Wall Street risk modeler. Unfortunately, my early morning flight from Ottawa, Canada, where I had another speaking engagement last night, was canceled...
Anyway, here is roughly what I would have said ...
Since I'm at a conference, I haven't been able to pay as much attention as I'd like to the Goldman subcommittee hearings being held today in the Senate. Here are a couple of reports:
Goldman Sachs on trial, by Andrew Leonard: Fans and detractors of Goldman Sachs agree on at least one point: The investment bank employs the smartest traders on Wall Street. The best risk managers, the most deadly sharks, the crème de la crème. But at the start of a full day of congressional hearings featuring Goldman Sachs executives, past and present, Sen. Carl Levin, chairman of the Senate's Permanent Subcommittee on Investigations, made Daniel Sparks, Goldman's former head of mortgage trading, look pretty dumb.
The first panel featured four Goldman executives at the heart of Goldman's structured finance division, including Fabrice Tourre, the trader who is the focus of the SEC's allegations of securities fraud against the investment bank. It would not be an exaggeration to describe these four men as the belly of the structured finance beast...
Levin's first question, directed at Sparks, concerned Goldman's efforts to sell to clients a security that referenced mortgage loans originated by New Century Finance -- one of the most notoriously reckless subprime lenders. The loans were terrible, and Goldman knew that they were terrible -- Goldman was hedging its own risk by betting that the security would decline in value.
One of Goldman's clients asked via e-mail, "How do you get comfortable with the collateral behind those securities?" Meaning, basically: Those loans are crap, how in the world can you possibly be comfortable pushing this deal?
Levin wanted to know whether Sparks thought Goldman had a responsibility to tell its client that it was "getting comfortable" by selling the security short, by betting against it. In other words, did Goldman have a responsibility to tell its client that Goldman's own opinion was that the security was likely a bad investment?
And Daniel Sparks simply would not answer the question. ... But a relentless Levin kept pressing the point, which boiled down to something very simple: Did Goldman have a responsibility to its client to indicate its own evaluation of the securities it was pushing?
Susan Collins, the ranking Republican present on the committee, followed up with an even more direct question: "Do you have a responsibility to act in the best interest of your client?" Seems like a simple enough question, but Sparks could not answer it either, saying only, after much pressure: "I believe we have a duty to serve our clients."
Right then and there, Goldman Sachs lost any chance it had of making a positive case to the American public. Right then and there, Goldman Sachs declared to all who were watching that its vaunted dedication to the interests of its clients was just so much hot air.
Goldman's defenders, if you can find them, will say that Goldman's responsibility was just to broker deals, to be a "market maker." If a sophisticated investor wanted to get on the side of a deal that Goldman was betting against, that's OK. ...
That may well be a legally defensible position. But the reality is that most Americans do not understand the definition of "serving your client" to include "pushing your client to invest in a 'shitty deal'" (as one Goldman exec characterized a deal zeroed in on by Levin) on their clients. And that's what Goldman was doing.
Wall Street was, in fact, a factory for turning shitty deals into profit. Goldman was the best in the business, but it was a very, very bad business.
And, one more:
Goldman Sachs execs still don't get it, by Barbara Kiviat: Today's Goldman Sachs hearing in the Senate is fantastic theater. The kind of theater that makes you want to run to the restroom to vomit.
I've been watching the hearing on TV, and I am nauseated to report that they still don't get it. The world came to the brink of financial ruin, and the people driving the mortgage securities death-machine still can only look back and say that at the time it all made sense. To say that the Goldman Sachs executives testifying lack introspection is like saying that the Black Death was a minor health scare.
Consider the following exchange between Senator Ted Kaufman and Daniel Sparks, who ran Goldman's mortgage division from late 2006 until mid-2008. Kaufman wanted to know about stated-income loans—mortgages in which borrowers don't have to prove they make the amount of money they claim to. These loans, which may make sense for rich people with variable income (an entrepreneur, say), came to be sold to all stripes of borrower, including many with subprime credit. Kaufman remarked on one securitization in which 90% of the loans were stated-income. ...
Kaufman went on to detail how Goldman didn't just securitize some stated-income loans, but a lot of them. ... Kaufman then launched into a tirade about how, if the witnesses in front of him were to be believed, the United States had suffered some great natural disaster—an event that had been in no way been man's doing. It was if the financial crisis was something that just kind of happened to us.
I am equally as appalled. ...
Time and again at today's hearing, Goldman executives refused to admit, even in retrospect, that they had crossed a line. Time and again at today's hearing, they defended their actions by saying that they were rightly responding to market demand—as if responding to market demand somehow absolves one of the responsibility to use human judgment. ...
[T]he people who work at Goldman Sachs are terribly smart, and it would be helpful to have them seriously thinking about what went wrong and how we might better manage the financial ecosystem in order to avoid meltdowns in the future. Instead, they seem to be using all their energy to circle the wagons. Senator Kaufman's question about stated-income loans was open-ended and non-confrontational. What might that exchange have looked like if Sparks had started with, "You know, stated-income loans are great for some people, but not for others. In the bubble, they went to the wrong people. It's a good question—how do you design products so that they're not misused?"
What really frightens me in all of this is that it didn't seem like a legal or PR strategy. It seemed like these Goldman executives genuinely had no ability to take a step back and make observations about the system in which they operate. It seemed like they had been so thoroughly inculcated in the culture of high finance that it was literally impossible for them to do the thing intelligent people are supposed to be able to do in the wake of a systemic breakdown—re-evaluate the assumptions that went into building that system.
Perhaps I was expecting too much out of my fellow human beings. ... I just thought—especially after hearing that the Goldman executives agreed to testify without being subpoenaed—that we might learn something useful in these hearings. That we might actually gain some insight instead of just another reason to want to bring these people down a peg.
I was wrong.
Any other reactions???
After the failed attempt to begin debate on financial reform -- the Democrats couldn't get the 60 votes they need -- Harry Reid is going to try again later today. The result is not likely to be any different, the game here is to generate negative headlines for the GOP and, hopefully, get them to back down on their opposition. If today's vote fails, another vote is being set up for Wednesday.
I'm not sure who will win this battle, or that it will do much to rein in the financial industry if reform does pass in its current form, but it's hard to imagine the Republicans looking good on this one.
I don't agree with every word of this argument by Dean Baker, particularly some of the parts about the bias in the CPI, but I do agree with the main thrust:
Deficit reduction: argument by authority, by Dean Baker, CIF: The deficit hawks are going into high gear with their drive to cut social security and Medicare. President Obama's deficit commission is having a big public event on Tuesday in which many of the country's most prominent deficit hawks will tout the need to reduce the budget deficit. The next day, Wall Street investment banker Peter Peterson will be hosting a "summit on fiscal responsibility", which will feature more luminaries touting the need to get deficits under control.
What will be missing from both of these events is any serious debate on the extent of the deficit problem and its causes. These affairs are not about promoting a real exchange of views on issues like the future of social security, Medicare, and public support for education, research and infrastructure, the purpose of these events is to tell the public that everyone agrees, we have to cut the deficit. And, this means cutting social security and Medicare. This is argument by authority.
Many public debates in the United States take this form. The issue is not what is said, but rather who says it. A few years ago all the authorities said that there was no housing bubble. The large body of evidence showing that house prices had hugely diverged from the fundamentals did not matter...
Going further back to the mid-90s, many of this same group of deficit hawk luminaries tried to use argument by authority to cut social security. They came up with the story that the consumer price index (CPI) overstated the true rate of inflation. ... This crew (which included then Senator Alan Simpson, a co-chair of President Obama's commission, and Peter Peterson) argued that social security benefits should lag the CPI by one percentage point a year. In other words, if the CPI shows 3% inflation, then social security benefits will only rise by 2%.
That may seem a small cut, but it adds up over time. A worker retired for 10 years would have their benefits reduced by approximately 10%. A worker retired for 20 years would have their benefits cut by almost 20%.
To push this agenda, they put together a panel of the country's most prominent economists, all of whom blessed the claim that the CPI overstated the true rate of inflation... In addition to this panel, the social security cutters also pulled in other prominent economists, including Martin Feldstein...
The social security cutters were so successful in rounding up the big names that virtually no economists were prepared to publicly stand up and question their claims about the CPI. They had near free rein, running around the country with the "all the experts agree" line.
As events unfolded they were not able to get their cut in social security benefits. (Ted Kennedy and Dick Gephardt deserve big credit on this.) But what is really interesting for the current debate is what happened to the experts' claim on the CPI. There were some changes made to the CPI, but in the view of the expert panel, the major causes of the biases in the CPI were not fixed. They concluded that even after the changes the CPI still overstated the true rate of inflation by 0.8 percentage points annually.
If this claim is really true then it has enormous ramifications for our assessment of the economy. It means, for example, that incomes and wages are rising far more rapidly than the official data show. It means that people in the recent past were far poorer than is indicated by official statistics. If the claim about the CPI being overstated is true, then we would have to re-examine a vast amount of economic research that starts from the premise that the CPI is an accurate measure of inflation.
However, almost no economists have adjusted their research for a CPI's overstatement of inflation. In fact, even the members of the expert panel don't generally use a measure of inflation that adjusts for the alleged bias in the CPI. In other words, when they are not pushing cuts to social security, these economists act as though the CPI is an accurate measure of the rate of inflation. This could lead one to question these experts' integrity.
This history should give the public serious grounds for being suspicious about the latest efforts to cut social security and Medicare. A serious discussion of the deficit will show that in the short-term the deficit is not a problem and that the longer-term deficit problem is really a problem of a broken US healthcare system. The public should not allow the deficit hawks to derail a more serious discussion with their argument by authority.
I suppose I should explain what it is I disagree with. First, the second to last paragraph doesn't make the case Dean Baker claims it makes. If the bias in the CPI is a constant .8 percent, then regressions involving this variable will still have unbiased slope coefficients -- the bias will be picked up by the constant term. (That is, suppose that a thermometer is off by four degrees. It will still tell you how many degrees the temperature has changed, e.g. that the temperature went up by ten degrees, and it will do so accurately, but it won't get the actual temperature right. Since the change in temperature determines the slope coefficient in a regression, and the change in temperature is correct, the slope coefficient will be measured accurately.) Since we are almost always interested in the slope term which is unbiased, and only rarely care about the estimates of the constant, the bias in the slope coefficient is is not generally a problem. The main point is that the use of a biased inflation measure in empirical work does not necessarily lead to questions about the integrity of the researchers. (If the bias varies with the "temperature", then the slope coefficient will also be biased, but the claim is a constant bias of .8%).
Second, on the more general question of whether a bias exists at all, I'll refer you to this post by Brad DeLong, "The Meaning of CPI Bias."
Finally, I am not taking issue with the basic claim that the deficit hawks are trying to take control of the debate and push it in a particular direction, a direction that has social programs in its sights. So let me repeat that "A serious discussion of the deficit will show that in the short-term the deficit is not a problem and that the longer-term deficit problem is really a problem of a broken US healthcare system. The public should not allow the deficit hawks to derail a more serious discussion..."
At this session yesterday, Michael Gough (on behalf of Adobe) and Hal Varian (on behalf of Google) identified similar strategies that the two companies have adopted to try to maintain the hunger that drives innovation. The problem is the complacency that sets in after a company has grown and attained some success. Both said that they try to set up smaller units external to the company to compete with "the mothership". Apparently, the smaller units -- often in other countries -- are very anxious to show up the hotshots at the main company and will work very, very hard to show that they can do it better. And they often do.
Nothing earth shattering, I just found it interesting.
Here's the video (the above is just a small part of the session):
Chris Blattman argues that we can't expect too much from countries in need of aid:
Donors’ three mistakes in fragile states, by Chris Blattman: You’re the Finance Minister in a country just coming out of conflict. Or maybe you’re disaster-struck like Haiti. Donors line up and make big pledges. UN agencies arrive and occupy whole blocks of office buildings. Each come in with a template. It looks reasonable. It’s certainly well-intentioned.
None of you know it yet, but you’re setting yourself up to fail ... with three mistakes donors will probably make.
1. Let’s set high standards for governing and disbursing public money. Bad idea. Bureaucracies need procedures, norms and experienced personnel. If a Mozambique or Liberia improves its bureaucracy at the fastest rate in human history, it will have the sophistication of an India or Pakistan in 20 years.
2. Invest quickly in education, health and infrastructure. Actually, these aren’t the country’s first priority. Law, order and security come first. Unfortunately, freedom from violence, or access to justice, are not MDGs [Millennium Development Goals]. Your donors are focused (and evaluated) on human development and poverty alleviation. That’s also what they know how to do best. Security sector reform and justice? Less so.
3. Get NGOs to deliver aid directly. Since the state bureaucracy can’t meet high standards, you can forget direct budget support. But how to build schools and clinics and roads? Enter the NGOs and contractors. Unfortunately, this direct delivery is not going to help you build bureaucratic capability. It might even undermine it.
So what’s the solution?
Set goals for the rate of bureaucratic improvement, not the level of standards. In the meantime, this or that Deputy Minister is going to need to send pork to his constituents. And money is going to get mismanaged or diverted.
Keep education and poverty on the table, but make certain that law and order are first not fourth on the agenda. ...
Finally, in place of direct aid, there’s a nice new trick: community-driven development. Rich countries give the state a big pot of money, then the state defines simple local procedures for disbursement. The donors love it: it sounds all participatory and pro-poor (and often it is). But most of all, it lets a weak state actually disburse cash without a ridiculous amount of accounting, with lots of room for pork and (diminishing over time) diversion of funds to ruling party coffers.
The short story: shoot for the possible, not the impossible.
Monday, April 26, 2010
This is probably a "grass is greener on the other side" argument, but when I listen to market fundamentalists argue for their side, as many have so far today in the sessions I've attended at the Milken Global Conference, I get envious. It's such an easy argument to make. No matter what the problem, the solution -- though stated in many, many creative ways -- is always the same. Get government out of the way and let markets do their magic. A tax cut, a reduction in government spending, or easing of regulation will always make things better, not worse. And if there are problems in markets, they can always be blamed on government. Even when fundamentalists admit there is a market failure because it cannot be denied, they can (and do) argue that the government will still make things worse if it intervenes. Thus, no matter the problem, there is always a simple explanation and a simple solution. When you argue for government intervention, the job is much harder. You have to identify the specific market failure, argue that it's significant enough to justify government intervention, come up with a policy that will address the particular failure without making other things worse, and then argue that the political process won't mangle the policy so badly as to make it worthless or counterproductive.
I don't have a problem with the baseline assumption being that we should leave markets alone unless it can be demonstrated that significant problems exist, and that there's a chance of making things better, but the deck does seem to be stacked against the interventionist position.
I'm at the Jobs, Jobs, Jobs session at the Milken Global Conference. As much as I'd like to comment, my daughter is the Press Secretary for one of the participants -- Carly Fiorina, Republican candidate for Senate in California -- so I am going to skip commenting on this one (she was not responsible for the sheep video, or the Passover email).
Interesting. The opening session at the Milken Global Conference -- Q&A from the moderator -- turned almost immediately to whining about government regulation and how it will go overboard and kill the economy (Steve Forbes and Ken Griffen in particular, Mohamed El-Erian is being a bit more reasonable). They are complaining about both financial regulation and coming climate change regulation, and how it's all part of the administration's agenda to increase the size and scope of government.
It's pretty clear that the first order of business is to block as much regulation as possible, and then, if it happens anyway, to do everything possible to overturn any new regulatory initiatives. It also seems pretty clear that ths group still has a relatively high opinion of the importance of financial innovation as a key source of economic growth, and seem to have forgotten all about the risks such innovation poses for the economy.
So my first impression of the conference is that unlike last year when many (though not all) financial leaders seemed to have their tails between their legs and in retreat, the attitude seems to be we're back! and the first order of business is to prevent government from getting in the way. Thus, while there's quite a bit of sentiment presently to impose more regulation on banks, it's not clear that once all is said and done the new regulation will go anywhere near as far as needed. It's also not clear that any new regulation that is put into place will survive the movement to overturn it that will surely come in the next few years. But perhaps being here with people mostly from the financial industry gives me a biased and pessimistic outlook on the future of regulation. I sure hope so.
Berating the Raters, by Paul Krugman, Commentary, NY Times: Let’s hear it for the Senate’s Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.
That’s the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.
No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.
What those e-mails reveal is a deeply corrupt system ... that financial reform, as currently proposed, wouldn’t fix.
The rating agencies ... play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.
It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of ... securities ... could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It’s all too obvious, in retrospect, how this could have corrupted the process.
And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” Clearly, the rating agencies skewed their assessments to please their clients.
These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. ...
So what can be done to keep it from happening again?
The bill now before the Senate tries to do something..., but all in all it’s pretty weak... The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in “knowing or reckless failure” to do the right thing. But that surely isn’t enough...
What we really need is a fundamental change in the raters’ incentives..., something ... to end the fundamentally corrupt nature of the the issuer-pays system.
An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University ... in which firms issuing bonds continue paying rating agencies to assess those bonds — but ... the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.
I’m not wedded to that particular proposal. But doing nothing isn’t an option. It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.
Carlo Cottarelli, Director of the IMF’s Fiscal Affairs Department, explains the thinking behind the IMF's call for taxes on the financial sector (detailed in a leaked report):
Fair and Substantial—Taxing the Financial Sector, by Carlo Cottarelli: We knew we were in for a tough time when the ... Group of Twenty (G-20) asked the IMF to give them our views, at their summit coming up in June 2010, on “… the ... options countries have ... as to how the financial sector could make a fair and substantial contribution toward paying for ... government interventions to repair the banking system.” ...
Last week the IMF gave an interim report to the G-20 finance ministers... That report is confidential, but—you may have noticed—has still managed to attract a lot of attention. So let me set out how our thinking on this stands. ...
What is to be done?
The challenge is to ensure that financial institutions bear the direct fiscal costs that any future failures or crises will impose—and maybe somewhat more, given all the other costs that bank failure can impose on the economy. We also need to make these events both less likely to happen and less costly when they do. We think two types of tax can play a role.
A ‘Financial Stability Contribution’—I come to bury Caesar, not to bail him out
One reason the crisis was such a painful mess was that many governments did not have the tools to wind down failing institutions in a quick and orderly manner. ... Governments lacked a way to ‘resolve’ ... large failing institutions.
Resolution means equity holders would be wiped out, management replaced, and unsecured creditors take a loss—a ‘haircut’—on their claims. All this should be nasty enough for owners and managers to reduce any problems of ‘moral hazard’... But most countries still don’t have such a mechanism. Financial stability requires creating them.
So where does the idea of a contribution come in? Resolution requires upfront cash, to reduce uncertainty for creditors (and the creditors’ creditors…) by quickly giving some value to their claims. And the industry should pay for this... This is what we call a Financial Stability Contribution (FSC).
It would ensure that the industry does indeed pay a reasonable chunk of these resolution costs before a crisis occurs, with this amount topped up, if needed, by ‘ex post’ charges after disaster strikes (much as the Financial Crisis Responsibility fee proposed in the United States aims to recoup some of the costs of public support). ...
A ‘Financial Activities Tax’
A FAT is just a tax on the sum of the profits and remuneration paid by financial institutions. That sounds simple, and, in essence, it is. But why an extra tax on financial institutions? Here, I’m afraid, things get a bit nerdy. So brace up for what is coming.
Profits plus all remuneration is value added. So a tax of this kind would be a kind of Value-Added Tax or VAT. ... This means that a FAT of this kind could ... help offset a tendency for the financial sector, purely for tax reasons, to be too large—or too fat.
Now suppose that the base included only remuneration above some high level, and only profits above a ‘normal’ rate of return. Then the base of the FAT may not be a bad proxy for taxes on ‘rents’—return in excess of competitive levels—earned in the sector. Some might find taxing that excess fair. ... Taxing away some of these high returns in good times may help correct for any tendency to excessive risk-taking implied by financial institutions not attaching enough weight to outcomes in bad times...
What about a financial transactions tax?
We also looked at the idea of a general financial transactions tax (FTT)—the last few months have left us in no doubt as to the seriousness of the public support this enjoys. This would be a tax paid every time a share, bond, or other financial instrument is bought or sold, and/or whenever foreign currency is bought or sold.
Our work is not yet complete—this is an interim report, remember—but, while some forms of FTT may be feasible (indeed most G-20 countries already tax some financial transactions),... the ... FTT is not focused on reducing systemic risk and it isn’t effective at taxing rents in the financial sector—much of the burden may well fall on ordinary consumers.
Moreover, the financial services industry is very good at devising schemes to get around such a tax and (this is also true, to be fair, of the FSC and FAT, but we suspect to a lesser extent). One way to think about the comparison is that just as a FAT is like a VAT, an FTT is like a turnover tax—and most countries have long found that the VAT is better at raising revenue: in the jargon, more efficient. ...
What we gave to G-20 ministers was an interim report, and we will be working more on this... We ... hope to contribute to the debate on what really matters in all this: how to reduce the risk, and costliness, of future financial failures.
Some form of a Financial Stability Contribution might make it through Congress, though Republicans are using misrepresentation and other means to try to prevent the extension of resolution authority to the shadow banking system (that might make sense politically, though that's not clear, but it makes no sense at all from an economic standpoint). As for a FAT tax (or a FTT), it's a good idea that has little if any chance of getting through a Congress whose reelection chances depend upon donations from the financial industry.
Sunday, April 25, 2010
Traveling here today. Comments are open...
This story about banks "offering high-cost loans to many black borrowers during the subprime lending boom, even though many of the applicants could have qualified for lower interest rates and closing costs" hasn't received enough attention. I won't speculate as to why this story has been so widely ignored, but it's not hard to come up with reasons that echo the racial-discrimination discussed below:
Bias Accord as Harbinger, by Bob Tedeschi, NY Times: A decision this month by the National Association for the Advancement of Colored People to drop its racial-discrimination lawsuit against Wells Fargo in exchange for a say in reviewing its lending practices could set the stage for similar agreements with other big mortgage lenders...
From 2007 to 2009, the N.A.A.C.P. filed suit against 15 lenders, accusing them of offering high-cost loans to many black borrowers during the subprime lending boom, even though many of the applicants could have qualified for lower interest rates and closing costs.
Wells Fargo, the first of the lenders to end the litigation, agreed to allow the N.A.A.C.P. to review its lending practices and recommend ways to “improve credit availability to African American and diverse businesses and consumers”...
Kenneth D. Wade, the chief executive of NeighborWorks America, a nonprofit group that assists homeowners, said he supported the N.A.A.C.P.’s contention that many minority borrowers had faced racial discrimination when they applied for loans during the mortgage bubble.
“People of color were disproportionately impacted by the subprime debacle,” he said. “And it’s likely going to result in the largest loss of wealth for African-Americans and Latinos in the country’s history.” ...
Mr. Jealous[, N.A.A.C.P. president,] said he was optimistic that the N.A.A.C.P. would reach similar agreements with Citibank and JPMorgan Chase, which the N.A.A.C.P. is also suing. He added that he also hoped to negotiate such an agreement with Bank of America, which is not part of the lawsuit. “Bankers were using affinity-based marketing — for instance, going into churches and other networks and aggressively marketing,” Mr. Jealous said, and as a result, the borrowers often believed that the lenders’ offers were trustworthy. ...
Brian Kabateck, a lawyer representing the N.A.A.C.P. in its remaining lawsuits,... said he was ... tracking loan modifications. “Blacks are having a harder time keeping their homes,” he said, “and it’s not just related to their ability to pay or not pay.” ...
Robert Frank defends progressive taxes as compensation for the implicit "the costs and benefits of different rungs on the social ladder":
The Tax That Hides in Your Paycheck, by Robert H. Frank. Commentary, NY Times: Every year at tax time, libertarians indignantly denounce government income transfers from rich to poor. Society’s income distribution, they argue, should reflect as closely as possible what people would earn in unregulated private markets. ... As closer scrutiny of that premise will make clear, the libertarian denunciation of income transfers fails on its own terms. ...
Economic theory holds that in competitive labor markets, workers are paid the market value of what they produce. In actual markets, pay does rise with productivity, but not by much. ...
To see the pattern..., consider groups of co-workers who perform similar tasks in your own company. In one case, suppose that your two most productive co-workers leave the job; in the other, suppose that the three least productive leave. Which group’s departure causes a greater loss of value? Most people would answer that losing the top two hurts more.
If so, economic theory holds that their combined salaries should be higher than the combined salaries of the bottom three. Yet the typical pattern is the reverse: any three workers ... earn substantially more than any other two.
In short, the startling fact is that private businesses typically transfer large amounts of income from the most productive to the least productive workers. Because labor contracts are voluntary..., it would be bizarre to object that these transfers violate anyone’s rights.
But...: If the most productive workers in a group are paid less than t he value of what they produce, why don’t rival employers just lure them all away? One answer is that these employees may care about ... their status... The high ranking they enjoy is more than enough to offset their sacrifice in pay. Similarly, their less productive co-workers may find it onerous to be at the bottom of the ladder, but they are compensated for that fact by their premium wages.
So, in effect, private markets are already applying an implicit progressive tax in the way they pay workers. And, in the process, they serve the interests of everyone in the hierarchy. The alternative would be costly social fragmentation.
Can anyone doubt that high rank has value, not just among groups of co-workers but also in society? ... [H]igh-ranking positions in the real world ... are possible only when others bear the costs associated with a low social ranking.
Tax systems that transfer income from rich to poor, thus ... reflect the costs and benefits of different rungs on the social ladder. They help make stable, diverse societies possible.
Enlightened libertarians believe that the best social institutions mimic the agreements people would have negotiated among themselves, if free exchange had been practical. Private pay patterns suggest that our current tax code meets that test.
Update: Kevin Grier emails a response.
Saturday, April 24, 2010
Citizens' assemblies, by Daniel Little: There is quite a bit of interest today in exploring better mechanisms for implementing the goals of democracy in more effective and broadly legitimate ways than most electoral democracies have succeeded in doing to date. A core democratic goal is to create deliberation and decision mechanisms that permit citizens to become sufficiently educated about the issues that confront the polity that they can meaningfully deliberate about them, and to find decision-making processes that fairly and neutrally permit each citizen to contribute equally to the final outcome.
The deficiencies of current democratic processes are fairly visible around the television dial, the Internet, and the town-hall meeting and state house: demagogic leaders who deliberately whip up the most negative emotions in their followers, citizens who take almost no effort to learn the details of the issues, strident and verbally violent attacks against one's political adversaries, the excessive power possessed by economic interests to prevail through influence on agencies and legislators, and an overall lack of civility and trust within the polity. (Many of these deficiencies are highlighted in an earlier post.) It is hard to see that the public's considered interests are the ultimate guide to our democratic actions. Some people are now referring to these flaws as the "democratic deficit" -- a set of structural flaws in existing democratic institutions that lead to disappointing results.
So how can we do better?
This is by Amartya Sen (several additional ideas are developed in the full essay, e.g. Smith's belief "that there are good ethical and practical grounds for encouraging motives other than self-interest"):
The economist manifesto, by Amartya Sen, Commentary, New Statesman: The 18th-century philosopher Adam Smith wasn’t the free-market fundamentalist he is thought to have been. It’s time we realized the relevance of his ideas to today’s financial crisis.
The Theory of Moral Sentiments, Adam Smith's first book, was published in early 1759. Smith, then a young professor at the University of Glasgow, had some understandable anxiety about the public reception of the book, which was based on his quite progressive lectures. On 12 April, Smith heard from his friend David Hume in London about how the book was doing. If Smith was, Hume told him, prepared for "the worst", then he must now be given "the melancholy news" that unfortunately "the public seem disposed to applaud [your book] extremely". ... After its immediate success, Moral Sentiments went into something of an eclipse from the beginning of the 19th century... The neglect of Moral Sentiments, which lasted through the 19th and 20th centuries, has had ... rather unfortunate effects. ...... The nature of the present economic crisis illustrates very clearly the need for departures from unmitigated and unrestrained self-seeking in order to have a decent society. Even John McCain ... complained constantly in his campaign speeches of "the greed of Wall Street". Smith had a diagnosis for this: he called such promoters of excessive risk in search of profits "prodigals and projectors" - which, by the way, is quite a good description of many of the entrepreneurs of credit swap insurances and sub-prime mortgages in the recent past.
The term "projector" is used by Smith not in the neutral sense of "one who forms a project", but in the pejorative sense, apparently common from 1616..., meaning, among other things, "a promoter of bubble companies; a speculator; a cheat". Indeed, Jonathan Swift's unflattering portrait of "projectors" in Gulliver's Travels, published in 1726 (50 years before The Wealth of Nations), corresponds closely to what Smith seems to have had in mind. Relying entirely on an unregulated market economy can result in a dire predicament in which, as Smith writes, "a great part of the capital of the country" is "kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it".
The spirited attempt to see Smith as an advocate of pure capitalism, with complete reliance on the market mechanism guided by pure profit motive, is altogether misconceived. ...
... One of the striking features of Smith's personality is his inclination to be as inclusive as possible, not only locally but also globally. He does acknowledge that we may have special obligations to our neighbors, but the reach of our concern must ultimately transcend that confinement. ... There is something quite remarkable in the ease with which Smith rides over barriers of class, gender, race and nationality to see human beings with a presumed equality of potential, and without any innate difference in talents and abilities.
He emphasized the class-related neglect of human talents through the lack of education and the unimaginative nature of the work that many members of the working classes are forced to do by economic circumstances. Class divisions, Smith argued, reflect this inequality of opportunity, rather than indicating differences of inborn talents and abilities. ...
The global reach of Smith's moral and political reasoning is quite a distinctive feature of his thought, but it is strongly supplemented by his belief that all human beings are born with similar potential and, most importantly for policymaking, that the inequalities in the world reflect socially generated, rather than natural, disparities.
There is a vision here that has a remarkably current ring. The continuing global relevance of Smith's ideas is quite astonishing, and it is a tribute to the power of his mind that this global vision is so forcefully presented by someone who, a quarter of a millennium ago, lived most of his life in considerable seclusion in a tiny coastal Scottish town. Smith's analyses and explorations are of critical importance for any society in the world in which issues of morals, politics and economics receive attention. The Theory of Moral Sentiments is a global manifesto of profound significance to the interdependent world in which we live.
It looks like it wasn't too hard to game the formula the ratings agencies used to evaluate bonds:
Rating Agency Data Aided Wall Street in Mortgage Deals, by Gretchen Morgenson and Louise Story, NY Times: One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good.
One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them.
In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested...
The rating agencies made public computer models that were used to devise ratings to make the process less secretive. That way, banks and others issuing bonds — companies and states, for instance — wouldn’t be surprised by a weak rating that could make it harder to sell the bonds or that would require them to offer a higher interest rate.
But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings.
“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.” ...
But for Goldman and other banks, a road map to the right ratings wasn’t enough. Analysts from the agencies were hired to help construct the deals. ... For example, a top concern of investors was that mortgage deals be underpinned by a variety of loans. Few wanted investments backed by loans from only one part of the country or handled by one mortgage servicer.
But some bankers would simply list a different servicer, even though the bonds were serviced by the same institution, and thus produce a better rating... Others relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same...
Banks were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer.
Sometimes agency employees caught and corrected such entries. Checking them all was difficult, however. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive... “If they had the time, they would fix it, but we were so overwhelmed.”
There are two problems that need to be fixed. The first is the incentive that ratings agencies have to give high ratings, and the second is the gaming of the ratings formula described above
The first problem, the incentive to provide high ratings, arises because the firm paying to have the financial asset evaluated also picks the ratings agency. A reputation as a tough rater is not good for future business, so there is an incentive for the agency to provide the rating the company is looking for. There are a variety of ways to fix this, e.g. a third party selects the particular agency that will do the rating (so that low rating does not affect the probability of being selected in the future), but so far Congress has not proposed the needed reform.
The second problem, the gaming of the ratings formula, is also helped by having a third party select the ratings agency. When the company gets to select the ratings agency itself, it can craft a strategy to precisely take advantage of the formula used by that agency. But if each company has different strengths and weaknesses, and any company could be selected by the third party, it won't be as easy to know which particular game to play. If the wrong agency is chosen, the result could be a lower than expected rating. This doesn't stop all potential gaming, for example a common flaw across all ratings agencies can still be exploited, but it does make it generally harder to game the system.
I don't think ratings agencies were the root cause of the financial crisis, but they did make it much, much worse by allowing so many highly rated but actually toxic assets onto the balance sheets of financial institutions. There is a need to fix the ratings agency problem, but as noted above there has been no action from Congress on this issue. Perhaps the recent attention to the role the ratings agencies played in the crisis will change that, but I'm certainly not counting on it.
Friday, April 23, 2010
An argument that revaluation of the renminbi/renembi won't have much effect on jobs in the US:
Will Chinese revaluation create American jobs?, by Simon J Evenett and Joseph Francois, Vox EU: Many in the US are pushing China to revalue the renminbi. Will that create US jobs? Traditional Keynesian analysis associates higher exports and lower imports with more jobs, but today’s world is more complex. Chinese parts and components feed into US firms’ global competitiveness. This column says a dearer renembi would boost the competitiveness of US exports to China but reduce US competitiveness everywhere else. A revaluation may be the right policy for other reasons, but its impact on US jobs is far from clear.
Undervaluation of China’s exchange rate is central to the debate on the right global policy mix in the aftermath of the economic crisis. Estimates of the undervaluation vary (from zero to 40%, Cheung, Chinn, and Fuji 2010) along with the reasons for focusing on the renembi:
- The IMF expresses concern about persistent capital account imbalances and asymmetries between surplus and deficit countries, with concern that imbalances contributed to past global financial instability and could so in future. The IMF also calls an exchange rate appreciation “essential” for China’s domestic macroeconomic situation (IMF 2010).
- Senior Brazilian and Indian officials call upon their Chinese counterparts to revalue the renminbi to mitigate competitiveness concerns.
- In the US, some call for revaluation as a means of redressing the bilateral imbalance with China and quickly creating US jobs.
In this column, we focus on the last issue; that is, whether it is realistic to expect a US jobs bonus to follow a Chinese revaluation. ...
With extensive global supply chains and outsourcing, a modest Chinese revaluation will ... raise costs for US firms and thus harm US competitiveness everywhere except in the Chinese market. This cost-raising effect mutes the current account improvement and, by our estimates, may result in 424,000 jobs losses in the US.
Findings such as these call for a rethink of aggressive foreign trade policy towards China, not just by the US but all those nations that supply and source parts and components to and from China as part of global supply chains.
Estimating the effect of renminbi appreciation on US jobs: A comment on Francois' China result, by William R. Cline, Vox EU: Would appreciation of the renminbi actually destroy US jobs? This column discusses recent estimates that find that making intermediate inputs from China more expensive would hurt US global competitiveness. It argues that the direct effect of an improvement in the US trade balance would create far more jobs than might be lost to more expensive intermediate inputs.
In a recent study, Francois (2010) estimates that if China appreciated the renminbi by 10%, the US trade balance would rise by $100 billion but the number of US jobs would decline by 430,000. He uses a computable general equilibrium (CGE) model to make this calculation. He allows for below-full capacity and sticky wages so that it is possible for a change in the external balance to affect the level of employment. The paradoxical negative sign on employment as a consequence of the currency correction stems from the model specification that emphasizes induced losses of jobs throughout the economy that result as a consequence of the increase in costs of intermediate inputs imported from China and used in the US economy. Francois argues that the gain of employment in exports and import substitutes would be too small to offset the loss of jobs in the general economy; hence the net loss of 430,000 jobs. This column examines whether these results make sense. ...
This exercise suggests that something appears to have gone wrong in the Francois calculations. A reasonable approximation of his two opposing effects suggests that the 10% RMB appreciation would create 320,000 jobs from the US trade balance improvement and eliminate only 32,000 jobs from the induced effect of higher intermediate input costs to US manufacturing. ...
Even if the effect on US jobs is small, we should still care about the effect of China's currency policy on other developing countries. That's where China's currency policy is likely have the greatest effect in terms of shifting the location of manufacturing employment.
The effect of the policy on global imbalances and the potential impact on financial stability is also of concern. However, given the IMF's behavior toward countries that needed help in the past, it's hard to be critical of the desire to establish a reserve fund as insurance against having to turn to the IMF for help. That's why giving countries such as China a larger role in determining IMF policies could help with currency alignment problems. With a credible change in IMF policy, countries could get the help they need when troubles arise at a smaller cost than it takes to build up large reserve balances.
As usual, Barry Ritholtz is anything but wishy-washy:
10 Things You Don’t Know (or were misinformed) About the GS Case, by Barry Ritholtz: I have been watching with a mixture of awe and dismay some of the really bad analysis, sloppy reporting, and just unsupported commentary about the GS case.
I put together this list based on what I know as a lawyer, a market observer, a quant and someone with contacts within the SEC. (Note: This represents my opinions, and no one else's).
Ten Things You Don’t Know (or were misinformed by the Media) About the GS Case
1. This is a Weak Case: Actually, no — its a very strong case. Based upon what is in the SEC complaint, parts of the case are a slam dunk. The claim Paulson & Co. were long $200 million dollars when they were actually short is a material misrepresentation — that’s Rule 10b-5, and its a no brainer. The rest is gravy.
2. Robert Khuzami is a bad ass, no-nonsense, thorough, award winning Prosecutor: This guy is the real deal — he busted terrorist rings, broke up the mob, took down security frauds. He is now the director of SEC enforcement. He is fearless, and was awarded the Attorney General’s Exceptional Service Award (1996), for “extraordinary courage and voluntary risk of life in performing an act resulting in direct benefits to the Department of Justice or the nation.”
When you prosecute mass murderers who use guns and bombs and threaten your life, and you kick their asses anyway, you ain’t afraid of a group of billionaire bankers and their spreadsheets. ... My advice to anyone on Wall Street in his crosshairs: If you are indicted in a case by Khuzami, do yourself a big favor: Settle.
3. Goldman lost $90 million dollars, hence, they are innocent: This is a civil, not a criminal case. Hence, any mens rea — guilty mind — does not matter. Did they or did they not violate the letter of the law? That is all that matters, regardless of what they were thinking — or their P&L.
4. ACA is a victim in this case: Not exactly, they were an active participant in ratings gaming. Look at the back and forth between Paulson’s selection and ACAs management. 55 items in the synthetic CDO were added and removed. Why?
What ACA was doing was gaming the ratings agencies for their investment grade, Triple AAA ratings approval. Their expertise (if you can call it that) was knowing exactly how much junk they could include in the CDO to raise yield, yet still get investment grade from Moody’s or S&P. They are hardly an innocent party in this.
5. This was only one incident: The Market sure as hell doesn’t think so — it whacked 15% off of Goldman’s Market cap. The aggressive SEC posture, the huge reaction from Goldie, and the short term market verdict all suggest there is more coming.
If it were only this one case, and there was nothing else worrisome behind it, GS would have written a check and quietly settled this. Their reaction (some say over-reaction) belies that theory. I suspect this is a tip of the iceberg, with lots more problematic synthetics behind it.
And not just at GS. I suspect the kids over at Deutsche bank, Merrill and Morgan are working furiously to review their various CDOs deals.
6. The Timing of this case is suspect. More coincidental, really. The Wells notice (notification from the SEC they intend to recommend enforcement) was over 8 months ago. The White House is not involved in the timing of the suit itself, it is a lower level staff decision.
7. This is a Complex Case: Again, no. Parts of it are a little more sophisticated than others, but this is a simple case of fraud/misrepresentation. The most difficult part of this case is likely to turn on what is a “material omission.” Paulson’s role in selecting mortgages may or may not be material — that is an issue of fact for a jury to determine. But complex? Not even close.
8. The case looks thin: What we see in the complaint is the bare minimum the prosecutor has to reveal to make their case. What you don’t see are all the emails, depositions, interrogations, phone taps, etc. that the prosecutors know about and GS does not. During the litigation discovery process, this material slowly gets turned over (some is held back if there are other pending investigations into GS).
Going back to who the prosecutor in this case is: His legal reputation is he is very thorough, very precise, meticulous litigator. If he decided to recommend bringing a case against the biggest baddest investment house on Wall Street bank, I assure you he has a major arsenal of additional evidence you don’t know about. Yet.
Typically, at a certain point the lawyers will tell their client that the evidence is overwhelming and advise settling. That is around 6-12 months after the suit has begun.
9. This case is Political: I keep hearing that phrase, due to the SEC party vote. It is incorrect. What that means is the case is not political, it means it has been politicized as a defense tactic. There is a huge difference between the two.
10. I’m not a lawyer, but . . . Then you should not be ignorantly commenting on securities litigation. Why don’t you pour yourself a tall glass of STF up and go sit quietly in the corner.
I have $1,000 against any and all comers that GS does not win — they settle or lose in court. Any takers? My money is already in escrow — waiting for yours to join it. Winnings go to the charity of the winners choice.
The administration's proposal for financial reform doesn't do enough to cut the financial sector down to size:
Don’t Cry for Wall Street, by Paul Krugman, Commentary, NY Times: On Thursday, President Obama went to Manhattan, where he urged an audience drawn largely from Wall Street to back financial reform. “I believe,” he declared, “that these reforms are, in the end, not only in the best interest of our country, but in the best interest of the financial sector.”
Well, I wish he hadn’t said that... Mr. Obama should be trying to do what’s right for the country — full stop. If doing so hurts the bankers, that’s O.K.
More than that, reform actually should hurt the bankers. A growing body of analysis suggests that an oversized financial industry is hurting the broader economy. Shrinking that oversized industry won’t make Wall Street happy, but what’s bad for Wall Street would be good for America.
Now, the reforms currently on the table — which I support — ... only deal with part of the problem: they would make finance safer, but they might not make it smaller. ...
In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.
These profits were justified, we were told, because the industry was ... channeling capital to productive uses; it was spreading risk; it was enhancing financial stability. None of those were true. Capital was channeled not to job-creating innovators, but into an unsustainable housing bubble; risk was concentrated, not spread; and when the housing bubble burst, the supposedly stable financial system imploded...
So why were bankers raking it in? My take ... is that it was mainly about gambling with other people’s money. The financial industry took big, risky bets with borrowed funds — bets that paid high returns until they went bad — but was able to borrow cheaply because investors didn’t understand how fragile the industry was.
And what about the much-touted benefits of financial innovation? I’m with ... Andrei Shleifer and Robert Vishny, who argue ... a lot of that innovation was about creating the illusion of safety, providing investors with “false substitutes” for old-fashioned assets like bank deposits. Eventually the illusion failed — and the result was a disastrous financial crisis.
In his Thursday speech, by the way, Mr. Obama insisted — twice — that financial reform won’t stifle innovation. Too bad.
And here’s the thing..., financial-industry profits are soaring again. It seems all too likely that the industry will soon go back to playing the same games that got us into this mess in the first place.
So what should be done? As I said, I support the reform proposals of the Obama administration... Among other things, it would be a shame to see the antireform campaign by Republican leaders — a campaign marked by breathtaking dishonesty and hypocrisy — succeed.
But... We also need to cut finance down to size. ... An intriguing proposal is about to be unveiled from, of all places, the International Monetary Fund. In a leaked paper..., the fund calls for a Financial Activity Tax — yes, FAT — levied on financial-industry profits and remuneration.
Such a tax, the fund argues, could “mitigate excessive risk-taking.” It could also “tend to reduce the size of the financial sector,” which the fund presents as a good thing.
Now, the I.M.F. proposal is actually quite mild. Nonetheless, if it moves toward reality, Wall Street will howl.
But the fact is that we’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?
James Grant wants an extreme version of capital requirements:
The best financial reform? Let the bankers fail, by James Grant, Commentary, Washington Post: The trouble with Wall Street isn't that too many bankers get rich in the booms. The trouble, rather, is that too few get poor -- really, suitably poor -- in the busts. To the titans of finance go the upside. To we, the people, nowadays, goes the downside. How much better it would be if the bankers took the losses just as they do the profits.
Happily, there's a ready-made and time-tested solution. Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. ... The plausible threat of personal bankruptcy would suffice to focus the minds of American financiers on safety and soundness...
Here are a few passages from a much longer article by Robin Wells and Paul Krugman in the New York Review of Books:
Our Giant Banking Crisis - What to Expect, by Robin Wells and Paul Krugman, NYRB:This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff
World Economic Outlook, April 2009: Crisis and Recovery by the International Monetary Fund (available at imf.org)
World Economic Outlook, October 2009: Sustaining the Recovery by the International Monetary Fund (available at imf.org)
...From an economist’s point of view, there are two striking aspects of This Time Is Different. The first is the sheer range of evidence brought to bear. ... The second ... is the absence of fancy theorizing. ... This Time Is Different takes a Sergeant Friday, just-the-facts-ma’am approach: before we start theorizing, let’s take a hard look at what history tells us. ...
So what is the message of This Time Is Different? In a nutshell, it is that too much debt is always dangerous. It’s dangerous when a government borrows heavily from foreigners—but it’s equally dangerous when a government borrows heavily from its own citizens. It’s dangerous, too, when the private sector borrows heavily...
Yet people—both investors and policymakers—tend to rationalize away these dangers. After any prolonged period of financial calm, they either forget history or invent reasons to believe that historical experience is irrelevant. Encouraged by these rationalizations, people run up ever more debt—and in so doing set the stage for eventual crisis. ...
So now we’ve experienced a severe financial crisis, fundamentally similar to those of the past. What does history tell us to expect next? That’s the subject of Reinhart and Rogoff’s Chapter 14... This chapter can usefully be read in tandem with two studies by the International Monetary Fund... All three studies offer a grim prognosis: the aftermath of financial crises tends to be nasty, brutish, and long. That is, financial crises are typically followed by deep recessions, and these recessions are followed by slow, disappointing recoveries. ...
History says that the next few years will be difficult. But can anything be done to improve the situation? Unfortunately, This Time Is Different says little on this score. ... That said, history can offer some evidence on the extent to which Keynesian policies work as advertised. ... Thus the IMF, squinting hard at a relatively limited run of experience..., finds evidence that boosting government spending in the face of a financial crisis shortens the slump that follows—but also finds (weak) evidence that such policies might backfire when governments already have a high level of debt... Interestingly, the IMF also finds that monetary policies, usually the recession-fighting tool of choice, don’t appear effective in the wake of financial crises...
Much of This Time Is Different is devoted to sovereign debt crises.... Implicitly,... the book warns against taking it for granted that nations can get away with deficit spending. On the other hand, advanced nations have historically been able to go remarkably deeply into debt without creating a crisis. ...
So should we be comforted or worried by the historical record? ... The truth is that the historical record on the consequences of government debt is ... ambiguous... We read the evidence as supporting a policy of stimulate now, pay later: spend strongly to promote employment in the crisis, but take measures to curb spending and raise revenue once the crisis has passed. Others will see it differently. The main thing to notice, perhaps, is that there is no safe path: debt has long-term risks, but so does failing to engineer a solid recovery. ...
Clearly, the best way to deal with debt crises is not to have them. Is there anything in the historical record indicating how we can do that? Reinhart and Rogoff don’t address this question directly, but Chapter 16... is suggestive. What the data show is a dramatic drop in the frequency of crises of all kinds after World War II, then an irregularly rising trend after about 1980... What changed after World War II, and what changed it back? The obvious answer is regulation. ...
Why didn’t more people see this coming? One answer, of course, lies in Reinhart and Rogoff’s title. There were superficial differences between debt now and debt three generations ago: more elaborate financial instruments, seemingly more sophisticated techniques of assessment, an apparent wider spreading of risks (which turned out to have been an illusion). So financial executives, policymakers, and many economists convinced themselves that the old rules didn’t apply.
We should not forget, too, that some people were making a lot of money from the explosive growth both of debt and of the financial industry, and money talks. The world’s two great financial centers, in New York and London, wielded vast influence over their respective governments, regardless of party. The Clinton administration in the US and the Labour government in Britain succumbed alike to the siren song of financial innovation—... politicians were all too easily convinced that having a large financial industry was a wonderful thing. Only when the crisis struck did it become clear that the growth of Wall Street and the City actually exposed their home nations to special risks...
Now that the multiple bubbles have burst, there’s obviously a strong case for a return to much stricter regulation. It’s by no means clear, however, whether this will actually happen. For one thing, the ideology used to justify the dismantling of regulation has proved remarkably resilient. ...
Equally important, the financial industry’s political power has not gone away. ... Despite the steady drumbeat of scandalous revelations ... top financial executives continue to have ready access to the corridors of power. And as many have noted, President Obama’s chief economic and financial officials are men closely associated with Clinton-era deregulation and financial triumphalism; they may have revised their views but the continuity remains striking.
In that sense, this time really is different: while the first great global financial crisis was followed by major reforms, it’s not clear that anything comparable will happen after the second. And history tells us what will happen if those reforms don’t take place. There will be a resurgence of financial folly, which always flourishes given a chance. And the consequence of that folly will be more and quite possibly worse crises in the years to come.
Thursday, April 22, 2010
Barry Eichengreen says that China's exchange rate policy is "exactly right":
Why China is Right on the Renminbi, by Barry Eichengreen, Commentary, Project Syndicate: After a period of high tension between the United States and China, culminating earlier this month in rumblings of an all-out trade war, it is now evident that ... China is finally prepared to let the renminbi resume its slow but steady upward march. ...
Some observers, including those most fearful of a trade war, will be relieved. Others, who see a substantially undervalued renminbi as a significant factor in US unemployment, will be disappointed by gradual adjustment. They would have preferred a sharp revaluation of perhaps 20%...
Still others dismiss the change in Chinese exchange-rate policy as beside the point. For them, the Chinese current-account surplus and its mirror image, the US current-account deficit, are the central problem. ... The US is running external deficits because of a national savings shortfall, which once reflected spendthrift households but now is the fault of a feckless government.
There is no reason, they conclude, why a change in the renminbi-dollar exchange rate should have a first-order impact on savings or investment in China, much less in the US. There is no reason, therefore, why it should have a first-order impact on the bilateral current-account balance, or, for that matter, on unemployment, which depends on the same saving and investment behavior.
In fact, both sets of critics have it wrong. China was right to wait in adjusting its exchange rate, and it is now right to move gradually rather than discontinuously. ...
China successfully navigated the crisis, avoiding a significant slowdown, by ramping up public spending. But, as a result, it now has no further scope for increasing public consumption or investment.
To be sure, building a social safety net, developing financial markets, and strengthening corporate governance to encourage state enterprises to pay out more of what they earn would encourage Chinese households to consume. But such reforms take years to complete. In the meantime, the rate of spending growth in China will not change dramatically.
As a result, Chinese policymakers have been waiting to see whether the recovery in the US is real. If it is, China’s exports will grow more rapidly. And if its exports grow more rapidly, they can allow the renminbi to rise. ...
Evidence that the US recovery will be sustained is mounting. As always, there is no guarantee. ... Because the increase in US spending on Chinese exports will be gradual, it also is appropriate for the adjustment in the renminbi-dollar exchange rate to be gradual. ...
Chinese officials have been on the receiving end of a lot of gratuitous advice. They have been wise to disregard it. In managing their exchange rate, they have gotten it exactly right.
At MoneyWatch, why the 6 percent headline inflation number for producer prices announced this morning does not signal that inflation is imminent, and why core inflation rate of .9 percent is a better measure to look at:
Is the Six Percent Rise in Producer Prices a Signal that Inflation is Coming?, by Mark Thoma: Many news reports are noting the six percent increase in the producer price index on a year over year basis and wondering if it signals that inflation is back. However, this report should not be read as a warning that inflation is just around the corner.
Why? The pass through from producer prices to consumer prices is less than 100 percent in any case, and in some cases it is close to zero. Pass through to consumer prices is smaller when the change in producer prices is temporary, and core inflation measures indicate that most of the rise in producer prices was due to a rise in food and energy prices. Once the temporary changes in food and energy prices are stripped out, the core inflation rate only increased .9 percent over the previous year, and that isn't much different from previous measures.But which measure of inflation should we pay attention to if we want to predict future inflation? Why do we use core inflation instead of "headline" inflation for this purpose?...[...continue reading...]...
As financial reform progresses through the legislative process, how can you tell if it is being watered down by "lobbyists and their politician allies"?:
The Two Issues to Watch on Financial Reform, by Alan Blinder, Commentary, WSJ: We may now be approaching the final act of the lengthy legislative drama of financial regulatory reform. ...
That said, it is way too early to declare victory. Armies of lobbyists and their politician allies are still fighting to weaken the bill in a variety of ways. ... So here are two bellwether issues to watch.
The first is the fate of the proposed Consumer Financial Protection Agency (CFPA). ... On the consumer protection front, there are the three key things to watch:
First, how much independence will the new agency have, especially for writing and enforcing rules? ... People who come to bury the CFPA, not to praise it, want to subordinate it to some more powerful agency.
Second, and related, to what extent does the legislation create an agency focused on a single mission: protecting consumers? Opponents of the CFPA concept would rather hand the responsibilities over to, say, the Fed, where consumer protection would be its fourth most important priority—after monetary policy, financial stability, and safety-and-soundness regulation.
Last, but certainly not least, watch how many institutions and financial products get exempted from consumer protection regulations. The more, the merrier for the industry—but not for the public.
The second bellwether issue is the regulation of derivatives. ... Creative derivatives such as the notorious CDOs ... and CDSs ... made it too easy for financial gamblers to synthesize dangerous amounts of leverage. One way or another, regulators must restrain the wild-and-wooly derivative markets.
Alas, there is no perfect way. But my favorite approach has long been to push derivative trading onto organized exchanges... But before derivative contracts can be traded on exchanges, they must be standardized—which is now the exception, not the rule.
Both the House and Senate bills embody this idea—except for the exceptions. ... As the debate progresses, watch those exceptions like a hawk. How many derivatives will be allowed to remain customized...? ...
Yes, there are unusual cases in which customization is important. But let's not deceive ourselves: The primary beneficiaries of customization are the ... five big Wall Street firms... If they can stave off standardization and exchange trading, comparison shopping will remain very difficult and profit margins will remain sky high. But if reform makes standardized, exchange-traded products dominant, competition will squeeze profit margins to the bone. ...
Under heavy pressure, the House bill allowed too many exceptions. But the bill passed yesterday ... suggests the Senate may take a much tougher stand. Let's hope so. ...
While much else will be going on, watch the exceptions for derivatives and the strength of consumer protections. And keep your fingers crossed. This just might work
There seems to be a lot of optimism building over financial reform, but in key areas such as limiting leverage, bank size, the CFPA, and derivatives, the reforms do not go far enough. The worst outcome of all is a bill that makes people believe they system is safer when in fact the risks are still present.
We will be safe so long as the present crisis is fresh in our minds and caution is the order of the day in the financial marketplace, but it won't be too long until we forget and that's when the danger begins. Once the appetite for risk returns, if the financial system -- including regulatory oversight -- operates under the false presumption that the system has adequate protection built into it, another meltdown is all too possible.
Wednesday, April 21, 2010
Interesting development on China's currency policy:
Brazil and India add to China pressure, by Geoff Dyer, Financial Times: China is facing growing pressure from other developing countries to begin appreciating its currency, providing unexpected allies for the US in the diplomatic tussle over Beijing’s exchange rate policy. ...
Indian and Brazilian central bank presidents have made the most forceful statements yet by their countries about the case for a stronger Chinese currency.
While most of the public pressure on China has come from the US, the comments underline that a number of developing economies feel that China’s dollar peg has imposed costs on their economies. ...
Lee Hsien Loong, prime minister of Singapore, added his country’s voice to the debate last week, saying it was “in China’s own interests” with the financial crisis over to have a more flexible exchange rate.
Some in China have fended off US pressure for a stronger currency, describing it as a distraction from the real causes of the financial crisis. However, criticism from developing countries is not so easy to bat away. ...
The increase in criticism of China comes at a time of relative calm between Beijing and Washington over the issue, with many US officials and analysts assuming China has already decided to abandon its peg with the dollar over coming months. ...
I've been interested in how the crisis would affect the strategy of developing economies, in particular if we would see an increase in the number of countries abandoning Western-style development strategies that are, at their heart, market-based in favor of more centrally directed development such as in China.
However, part of China's development strategy includes its currency policy, and if both developed and developing countries begin to view these policies as coming at the expense of other nations, at the expense of developing nations in particular, there may be less willingness to pursue similar strategies (e.g. due to fear of retaliation in the form of trade restrictions imposed by nations that believe they are being harmed by the policy).
Dan Froomkin vs. Bob Rubin, by Brad DeLong: I call this one for Rubin on points, narrowly. Dan Froomkin reports:
Rubin: I Actually Supported Regulating Derivatives: Clinton-era Treasury Secretary Robert Rubin, who will go down in history as one of the men who killed derivatives regulation, insisted today that he has long thought that derivatives should, in fact, be regulated. "I thought we should regulate derivatives; I thought so when I was at Goldman Sachs and I thought so afterwards," he told HuffPost during a break at an event for the Hamilton Project, a think tank he founded to support Wall-Street-friendly Democrats. Rubin was chairman at Goldman Sachs before joining the Clinton administration in 1993; after he left, he went on to head Citigroup, which he nearly bankrupted with his excessive risk-taking.
The financial instruments known as derivatives have become a hot-button issue due to their central role in the financial crisis. Derivatives allow investors to make wild, nontransparent bets without any capital requirements. Combine them with the popping of the housing bubble and you've got a financial meltdown of massive proportions. Democrats are trying to make most derivative contracts transparent and public, and President Obama has said he'll veto any financial reform bill that doesn't do so.
Rubin can in fact point to a long paper trail suggesting that he supported regulating derivatives -- at least in theory.
But in practice, in 1998, Rubin was one of several top Clinton administration officials who quashed an attempt by Brooksley Born, then head of the Commodity Futures Trading Commission, to regulate them...
As I understand things, Rubin's position on derivatives regulation in the late 1990s had five parts:
- Derivatives should be regulated, with proper disclosure and capital adequacy and information requirements, especially to protect unsophisticated investors.
- Phil Gramm is Chairman of the Senate Banking Committee, and would always rather regulate less rather than more--and the House side is even more so.
- Brooksley Born and her organization are the wrong people to regulate derivatives.
- Derivatives should be regulated with a light hand, because they are a small and specialized corner of financial markets and are simply not large enough to pose any systemic threat.
- The Federal Reserve has adequate powers to stem financial crisis and keep it from becoming a threat to the economy, and is also not worried about derivatives.
As I see it, Rubin was correct on (1), (2), and (3). He was correct on (4) when he was in office--when derivatives were too small to pose any systemic threat to financial stability. But that changed in the 2000s. And Rubin was completely, utterly, and totally wrong about (5) (as was I).
One other place where Rubin was wrong in the late 1990s (and where I was right), was that he was not worried about the opacity of derivatives. He was confident that senior managers at large Wall Street firms could maintain control over their derivatives books, and understand what risks their firms were facing, and what risks their underlings were exposing their firms to.
There he was wrong.
Rubin helped to foster the myth that financial innovation was always and everywhere a good thing, and that anything standing in the way of it, e.g. misguided regulation, would be harmful to economic growth. He was part of a march of former Wall Street types into government where they had the power to sell this idea more broadly. And they did. For that reason, I don't think a list like the one above absolves him and others from responsibility for creating the conditions that led to the crisis. When derivatives were no longer "too small to pose any systemic threat to financial stability," that attitude prevailed -- an attitude Rubin and others helped to create -- and the ideological capture of regulators it brought about prevented the type of intervention that was needed in the derivatives market.
Update: See also "What Did Robert Rubin Think About Derivatives?," by James Kwak.