What can we learn from the fact that Goldman Sachs earned record profits despite the stagnation in the broader economy?:

The Joy of Sachs, by Paul Krugman, Commentary, NY Times: The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits — and it’s preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?

First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America.

Second, it shows that Wall Street’s bad habits — above all, the system of compensation that helped cause the financial crisis — have not gone away.

Third, it shows that by rescuing the financial system without reforming it, Washington has ... made another crisis more likely.

Let’s start by talking about how Goldman makes money.

Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared...

Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? ...

Goldman’s role in the financialization of America was similar to that of other players, except for one thing: Goldman didn’t believe its own hype. ... Goldman, famously, made a lot of money selling securities backed by subprime mortgages — then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.

And Wall Streeters have every incentive to keep playing that kind of game.

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. ... You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong. ... Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.

You can argue that such rescues are necessary if we’re to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system’s liabilities are now backed by an implicit government guarantee.

Now, the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didn’t abuse their privileges. This time, new regulations are still in the drawing-board stage — and the finance lobby is already fighting against even the most basic protections for consumers.

If these lobbying efforts succeed, we’ll have set the stage for an even bigger financial disaster a few years down the road. The next crisis could look something like the savings-and-loan mess of the 1980s, in which deregulated banks gambled with, or in some cases stole, taxpayers’ money — except that it would involve the financial industry as a whole.

The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.

The other reason we are more vulnerable is, as this story points out, is that "two giants" are emerging from the financial crisis, and they are "starting to tower over the handful of financial titans that used to dominate the industry." Thus, if other competitors cannot recover similarly, and if the government does not use regulation and other means to level the playing field, the banking industry could end up even more concentrated and vulnerable than it was before (a point I wish I'd made here).

Tim Duy analyzes the economic projections in the minutes from the June FOMC meeting:

FOMC Forecasts - Reality or Fantasy?, by Tim Duy: It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.

The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":

In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.

Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.

Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then accelerate further in subsequent years. Is such optimism justified? Yes and no.

I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle. Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007. Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:

See also consumption data:

Not to mention to mention the initial claims data (see CR and his caveats). To be sure, one could worry that industrial production continues to fall, but note the rate of decline is slowing and capacity utilization looks to be stabilizing. Moreover, the recent stability in auto sales will lend support for manufacturing in the months ahead:

Notice that the vehicle sales increased 1.3% during the quarter, pointing to a gain in this component of GDP. As always, do not underestimate the data impact of moving from significant declines to just flattening out. With such clear evidence of bottoming out emerging, not only does the near term data get a boost, but downside risks fall - and both point to upward revisions of near term forecasts.

The more interesting parts of the staff's forecast are in the 2010 and beyond range. The fact that they suggest immaculate recovery, I suspect, is largely a model driven outcome. Econometric models tend to force forecasts back to trend, and, in this case, are likely fighting with a large gap between actual and potential GDP. The only way to close that gap is through rapid growth which would in turn lead to "significant" declines in the unemployment rate.

How should we handicap this optimistic forecast? First off, I would remind readers that the bar has been lowered. The long run growth forecast from the FOMC participants are in the 2.5-2.7% range. While this is not a revision, I think commentators tend to forget how much the bar has been lowered since the late 1990s, when some foresaw potential growth as 4% or higher. Likewise, I believe evidence was building prior to the recession that the corresponding job growth rate is around 100k a month. In other words, 100k holds the unemployment rate roughly steady, rather than the 150k that is commonly suggested. In short, diminished expectations likely help the forecast clear the hurdle of reducing the unemployment rate in 2011 and beyond.

Moving toward the diminished expectation for potential output, I suspect, will not be terribly hard to accomplish. Stabilizing consumer spending itself will go a long way toward keeping GDP growth in positive territory as will just a lessening of the inventory drag. Moreover, fiscal stimulus will add positively over the next year, as will the external sector, especially if China can maintain its current dynamic and a weakened US consumer continues to weigh on import growth. And if consumer and export spending hold together, then investment spending will also cease to be a drag.

That said, positive territory for growth could easily be consistent with an economy limping along above recession but insufficient for any significant job growth, a scenario that remains my favorite. Given that 70% of the economy is driven by consumer spending, I find it hard to believe that you can supercharge growth well above potential without the active participation of households. We know, however, that households continue to struggle under heavy debt burdens which, combined with the now tighter underwriting conditions that are likely to be more permanent than temporary, suggest that spending growth is likely to be constrained sufficiently to prevent supercharged growth. I would imagine that to propel consumption growth to rates consistent with the staff's forecast, the staff must be anticipating significant real wealth gains sufficient to drive savings rates back to zero. That, I believe implies a housing rebound…which I can't see unless conditions revert back to the "let's give everyone one with a pulse a loan" era.

Could the Fed staff really believe that the stage is set for such a rebound? More importantly, could FOMC members? Perhaps some do, at least that is the impression from the growth projections:

The range of growth expectations is quite wide, as noted in this Bloomberg article. Some policymakers are expecting a solid V shaped recovery evolving in 2010, while the other side of the spectrum is looking for a more gradual acceleration to potential growth (the scenario I tend toward). The latter scenario suggests a jobless recovery, with growth insufficient to make much of a dent in unemployment. From a policy perspective, such a scenario points to additional pressure to ease further, complicated by the unknown impact of general balance sheet expansion. It certainly does not point to any rush to unwind the liquidity/credit support programs. The optimistic view implies the opposite, a concern that programs need to be unwound quickly, with a rapid move to normalize interest rates. Until the 2011 forecast comes more fully into view, sometime around the second quarter of 2010, policy will remain in a holding pattern. But note that the wide range of forecasts implies a wide range of Fedspeak, which will lend an irritating feature to the discourse: Seemingly opposite opinions nearly side by side in the press.

A final point: The range of forecasts, both high and low, can be used to argue against another stimulus package as the direction of growth is headed in the right direction. This is especially the case if unemployment stabilizes, even if at a relatively high level. Moreover, note that US Treasury Secretary Timothy Geithner is on something of a world tour, first China, now the Middle East, promising US fiscal restraint:

"Policies of the United States are designed to lay the conditions for a strong dollar," Mr. Geithner said on Tuesday, adding: "We are very committed ... to making sure that as we get through the crisis, we bring down fiscal deficits and we reverse these extraordinary interventions we've taken."

I suspect conditions would need to deteriorate markedly in order to force the Administration to push a fresh round of stimulus. That is not the Fed's projection.

Bottom Line: Clear signs of a bottom are an obvious reason to stabilize and boost near term forecasts. Still, the Fed staff's projections appear overly optimistic, seeming to imply that future dynamics will be very similar to the past. I am skeptical. Remember to interpret forecasts of potential GDP in the context of diminished expectations. The wide range of projections speaks to an interesting spectrum of Fedspeak in upcoming months. The game will be to track the data, being wary not to read to much into a short-lived bounce off the bottom. I side with the low end of the FOMC forecasts; call me a pessimist. Place your own bets, being prepared to adjust with the data.

This is a summary of the "causes and nature" of the financial crisis. I've added a few comments along the way:

Lessons for the future: Ideas and rules for the world in the aftermath of the storm, Part I, by Guido Tabellini, Vox EU: Almost two years after the beginning of the financial crisis that has overwhelmed the world economy, it may be time to draw some conclusions and outline the main lessons for the future. Is it really a turning point for market economies, a systemic crisis that will radically change the division of tasks between state and market? Or will everything be back to normal once a number of important technical problems concerning financial regulation are solved?

Market failure

Let us start with the market failure. There is no doubt that the crisis has revealed a serious failure in one of the most sophisticated markets in the world – modern finance. One of the crucial tasks of financial markets is allocating risk. They have failed stunningly. Risk has been underestimated, and many intermediaries took excessive risks. The reasons for this failure and the implications for economic policy, however, are less clear.

One possible explanation is that it was just due to poor judgement. Financial innovation has been so fast that even sophisticated operators were not always able to fully understand the degree of risk of the financial instruments that were constructed. The systemic implications of those instruments were even less clear. As a consequence, many investors overestimated global financial markets’ capacities, overlooking the systemic risk and the illiquidity risk that proved crucial in this crisis. This mistake can partly be explained by the difficulty of correctly evaluating the probability of rare or infrequent events. If this were all, there would be no need to worry. This crisis will not be forgotten, and it will certainly leave a mark on risk management practices and organisation models of financial intermediaries.

There is also a less benevolent explanation for the failure of financial markets, however, that highlights a systematic distortion of individual incentives rather than a mistake. First of all, the “originate and distribute” model, which separates the concession of the loan from the financial investment decision, entails obvious moral hazard problems. Secondly, rating agencies, paid by those issuing the very assets being rated, experience an obvious conflict of interest. Third, managers’ remuneration schemes encourage myopic behaviour and excessive risk taking – if the bonus depends on short-term performance indicators, each individual manager is induced to take risks that are large but rare. If this is true, it means that we cannot trust the ability of markets to learn. Distorted incentives must also be redressed, through new, stricter regulation, even at the cost of significantly slowing down financial innovation or giving up some of its beneficial effects.

It's worth pointing out that there are distinct market failures here because the best policy to overcome the market failure depends upon the type of market failure it addresses. I would have also highlighted the asymmetric information problem in these markets since the desire for reliable information on risks is what drives the need for the ratings agencies, and I would have also noted that the mal incentives extended beyond just the "originate and distribute" model, homeowners (with no recourse loans), real estate agents (who want to sell as many houses as they can for as much as they can to increase commissions), appraisers (who share some of the conflicts that ratings agencies have and also exist to solve an information problem), and so on. So it wasn't just banks and brokers responding to the bad incentives of the originate and distribute model, just about every link in the chain had bad incentives that distorted outcomes in ways that encouraged the build up of excessive risk.

Also, these two explanations are not mutually exclusive. The market failures can lead to excessive risk accumulation, and the extent of this risk could be misperceived. I think it was the interaction of the market failures and the misperception, not predominantly one or the other. If the market failures do not allow dangerous risk levels to accumulate, misperceiving it is not nearly so dangerous.

Regulatory failure

Mistakes in risk management cannot be only attributed to private operators. Supervisors have made major mistakes as well, allowing banks to accumulate off-balance-sheet liabilities and tolerating an excessive growth of leverage (i.e. the ratio of total assets to shareholders' equity) and indebtedness. This could be due to capture of supervisors by banks, arbitrage and international competition among supervising agencies, or implementation deficiencies. But more importantly, there has been a fundamental conceptual mistake –monitoring each financial institution solely on an individual basis, considering as the value at risk of the individual intermediary without taking systemic risk into any consideration. This is the same mistake that the individual intermediaries made.

I agree with the conceptual mistake noted here, but there was another one too. Everyone thought it was a good idea to get risk off of the traditional banking systems balance sheet. Somehow the notion was present that this would - through worldwide distribution of risks - reduce the chances of a meltdown to nearly zero, i.e. to reduce systemic risk. This, of course, turned out to be wrong since risk did, in fact, get concentrated in dangerous ways.

A crisis of these proportions cannot have stemmed exclusively from mistakes in risk management. The reason is that high-risk investments were relatively small compared to the overall dimension of global financial markets (Calomiris 2007). Many observers expected that the American real estate bubble would burst. But few imagined that that would overwhelm financial markets all over the world. If this has happened, it must be that the shocks hit important amplifying mechanisms. This amplification can largely be attributed to financial regulation. In other words, even more than a market failure, the crisis was triggered by a failure of regulation (see the eleventh ICMB-Geneva Report, summarised by Wyplosz 2009).

Not so much that regulation was too lenient, or that deregulation had gone too far – rather, the very founding principles of regulation have amplified the effects of a shock that in reality was not that large. Subprime mortgages, the financial products whose insolvency has originated the current crisis, amount to about one trillion dollars. It is a large number in absolute terms, but small with respect to the total of about 80 trillion dollars of financial assets of the world banking system. As a comparison, consider that the losses originally estimated in 1990 during the savings and loans crisis were about 600-800 millions of dollars, less than the total of subprime mortgages, but the total amount of financial assets was much smaller then. Yet, that crisis was quickly overcome without major upheavals. Why has it been so different this time?

There are two aspects of regulation that have amplified the effects of the initial shock: (i) the procyclicality of leverage, induced by constraints on banks’ equity, and (ii) accounting principles that require assets to be evaluated according to their market value. In case of a loss on investments, which erodes the capital of financial intermediaries, capital adequacy constraints under the Basel accord require reduced leverage and thus force banks to sell assets to obtain liquidity. The problem is thus exacerbated: forced sales reduce the market price of assets, worsening the balance sheets of other investors and inducing further forced sales of assets, in a vicious circle. Exactly the opposite happens during a boom: capital gains on portfolio assets allow intermediaries to expand leverage, which means taking on more debt in order to acquire new assets, in such a way that the price of assets is pushed up and other intermediaries become indebted chasing increasingly high prices. In sum, banking regulation has created a mechanism that amplifies the effects of shocks and accentuates cyclic fluctuations in the indebtedness of financial intermediaries.

I am coming around on the need to regulate leverage, and it does appear to have important cyclical variations. As to the mark to model versus mark to market debate, I still don't like the bad incentives and the possibility for error that exists with the mark to model framework. But the general question of how to best value the assets on a balance sheet during a time like this is an area where I still have some uncertainty.

One of the main lessons to be drawn from this crisis is that we need to deeply reconsider financial regulation and ask ourselves what its ultimate objective is – correcting distorted incentives of agents, creating buffers that reduce procyclicality of leverage, or reducing risks, and, if so, which risks? A sound regulatory system should address two concerns:

1. Correct distorted incentives of individual intermediaries or financial operators;
2. Reduce negative externalities and systemic risk, bearing in mind that evaluating risk management practices within individual intermediaries is not sufficient.

Finally, inevitably, this will have to translate into rules that reduce the size of leverage in absolute terms and its procyclicality.

And just to amplify a point from above, since a variety of problems caused the crisis, no single solution can fix them all. It will take a variety of fixes to shore up the system going forward.

Mistakes in managing the crisis

It is widely held that the current situation is mostly the result of economic policy mistakes (in regulation, in supervision and, according to some, monetary policy) made before the outbreak of the crisis. The corollary of this thesis is that it is sufficient to correct these mistakes in order to avoid the next crisis. But the truth is that many serious mistakes have been made during the management of the crisis and have significantly contributed to worsening the situation.

The unclear causes of the crisis have resulted in its management being improvised from step one without a clear path in mind. Bear Stearns was saved, Lehman Brothers failed, AIG was saved. Each decision was improvised, guided by neither pre-established criteria nor a sound and consistent strategy. The result is that, rather than boosting confidence, economic policy interventions have contributed to increasing confusion, panic, and fear.

I have made this point many times as well, and believe it created a lot of additional uncertainty. The handling of Lehman was a costly misstep.

Loss of confidence is always at the heart of any financial crisis. Expectations concerning the behaviour of authorities and other operators play a fundamental role in determining whether there will be contagion or whether the shock will be absorbed. But in order to influence expectations and restore confidence, policymakers must act according to procedures and criteria that are agreed upon and well understood, identifying the ultimate objectives and the policy tools to reach them. There has never been such clarity in this crisis, and that is an important lesson. To avoid repeating similar mistakes, it will be necessary to elaborate new and detailed procedures for managing complex phenomena such as the bankruptcy of large banks and more general policies aimed at preventing the worsening of systemic crises.

I agree, but how do we make these plans credible? We cannot bind future policymakers - they can do as they please - so how do credibly commit to these plans? When the next crisis hits and we have bankruptcy plans for a too big to fail institution, will we actually carry through or will we worry that it might not work out so well after all and step in as we did this time? Still, I think it's important that we try, and if the plans are good ones, we at least have a chance.

Given that large banks with systemic implications are typically multinational, these procedures will need to be coordinated at the international level. This is not easy, since, after all, only the state, and hence taxpayers, can cover systemic risk. Taxpayers must take on the burden of failing institutions’ debts, at least temporarily. But which state, which taxpayers, when the institution is a large multinational bank?

Although difficult, this problem is not new. Financial crises in developing countries, which occurred almost yearly in the 1990s, have now become less frequent and less devastating thanks to the procedures of crisis management elaborated within the International Monetary Fund. It is now time to learn from those experiences, adapting them to the specific problems of large multinational banks.

Yes, we need an institution that can serve as a global and modern version of a lender of last resort.

In my next column, I will outline where we might go from here.

One final comment. I think there are dangers when political power becomes concentrated in too interconnected to fail financial institutions, and this potential contributor to the crisis deserves more emphasis.

References

Brunnermeier, Markus K, Andrew Crockett, Charles A Goodhart, Avinash Persaud, and Hyun Song Shin (2009). The Fundamental Principles of Financial Regulation. Centre for Economic Policy Research and International Center for Monetary and Banking Studies.
Calomiris, Charles (2007). “Not (Yet) a ‘Minsky Moment’” VoxEU.org, 23 November.
Wyplosz, Charles (2009). “The ICMB-CEPR Geneva Report: ‘The Future of Financial Regulation’” VoxEU.org, 27 January.

This article may be reproduced with appropriate attribution.

Robin-Hood Reich is happy:

The House: Tax the Wealthy to Keep Everyone Healthy, by Robert Reich: It's the most blatant form of Robin-Hood economics ever proposed. The universal health care bill reported by the House yesterday pays for the health insurance of the 20 percent of Americans who need help affording it with a surtax on the richest 1 percent.

I don't recall the last time Congress came up with such a direct redistribution. Occasionally Congress closes a few tax loopholes at the top and offers a refundable tax credit to workers at the bottom, or it creates a poor people's program like Medicaid, paid for out of general revenues from a progressive income tax. But to say out loud, as the House has just done, that those in our society who can most readily afford it should pay for the health insurance of those who cannot is, well, audacious.

There's another word for it: fair. According to the most recent data (for 2007), the best-off 1 percent of American households take home about 20 percent of total income -- the highest percentage since 1928. Yes, I know: Critics will charge that these are the very people who invest, innovate, and hire, and thereby keep the economy going. So raising their taxes will burden the economy and thereby hurt everyone, including those who are supposed to be helped.

But there's no reason to suppose that taking a tiny sliver of the incomes of the top 1 percent will reduce all that much of their ardor to invest, innovate, and hire in the future. Yet if this tiny sliver means affordable health care for a far larger number of Americans, who will be able to get regular checkups and thereby stay healthy and productive, the positive effect on the American economy is likely to be far greater.

Don't believe critics who say the surtax will harm small business. According to the Center for Tax Justice, it would hit only five percent of small business owners... Besides, only the profits of a small business would be taxed. ... So, for example, a couple whose income comes entirely from a small business would have to earn more than $350,000 in business profits -- after paying all their expenses, including salaries -- before the surcharge would affect them... And if they earned more, the surcharge wouldn't reduce their incentive to hire more employees because they pay employees with pre-tax income. And not even purchases of equipment ... would be affected because most small business owners can write off up to $250,000 of the costs of such equipment immediately.

A surtax is easy to administer. And the whole idea is easy to understand. Tax the wealthy to keep everyone healthy. Not even a bad bumper sticker.

I'll be very surprised if the Senate goes along with this.

Nick Rowe use California's IOUs and Canadian Tire money to illustrate possible outcomes when two currencies circulate side by side:

The State(s) Theory of Money: California and Canadian Tire, by Nick Rowe: I learn via [this] that there is a distinct chance that California will allow taxes to be paid in the new scrip it issued when it ran out of funds. I have no idea whether this will happen, or whether the Federal government will stop it. Let me just assume that it does happen, and that the Federal government does not stop it. I'm (almost) hoping that it does happen, and that the Fed doesn't stop it, because it would be such a fascinating experiment in monetary theory.

Assuming this experiment does go ahead, what are the chances that California scrip will circulate as a medium of exchange, and be generally acceptable, not just at banks, but in exchange for all or most goods and services?

Another way to ask this question: what's the difference between California and Canadian Tire?

For non-Canadian readers let me explain that Canadian Tire corporation is a large chain of stores selling a wide range of automotive supplies, hardware, sports and camping equipment, gasoline, etc., that has many outlets across Canada. And it issues Canadian Tire "Money". CT money consists of small paper notes, about the same size as US dollar bills, in denominations ranging from a few cents up to a couple of dollars. When you buy something at Canadian Tire, you get CT money with a face value of a couple of percent of the purchase price. Canadian Tire money is redeemable for merchandise, at par with Canadian dollars, at all Canadian Tire stores.

That last sentence is crucial. If the State of California accepts California scrip for payment of taxes, at par with US dollars, it is just like Canadian Tire. Sure, you have to pay taxes, and you don't have to shop at Canadian Tire, but most Canadians do shop at Canadian Tire, and do so more times a year than most Californians pay taxes (if we are talking about annual income taxes, at least). So the frequency with which Canadian Tire money can be redeemed at its issuer will exceed that of California scrip.

But Canadian Tire "Money" does not normally circulate as a generally accepted medium of exchange. In special circumstances, someone (other than Canadian Tire) might accept Canadian Tire money in payment for goods, but only as a favour if you have run out of "real" money, or at a discount. It is not generally used outside of Canadian Tire stores. People generally redeem it as soon as they next visit a Canadian Tire store (or just leave it stashed away until they remember to do so).

And we can understand why Canadian Tire money does not circulate as a medium of exchange. This is a case where, contrary to Gresham's Law, good money drives out bad. (Gresham's Law does not apply because there is no legal tender law saying that merchants have to accept Canadian Tire money at par, and only Canadian Tire does so).

We have known since Carl Menger that money, like language, has network effects. If the people with whom you interact are already speaking a particular language, or using a particular medium of exchange, that increases your incentive to adopt that same language or medium of exchange. Conventions can arise spontaneously, and have the force of custom. Canadian Tire money would have to be, not just as good as, but significantly better than the Loonie, in order to compete with the Loonie as a medium of exchange. It isn't. You can redeem Canadian Tire money at par in Canadian Tire stores, and below par elsewhere, so everybody just redeems it at Canadian Tire stores. It doesn't circulate.

So California scrip would end up like Canadian Tire money - being kept in the glove box until your next visit to the issuing store - except for one thing: California scrip pays 3.5% interest; Canadian Tire money pays none. In that one respect at least, California scrip is better than US dollars.

Suppose California scrip does end up circulating as a medium of exchange, being generally acceptable at par to US dollars. Is that possible? I don't think it is, because then Gresham's Law would kick in. If I hold both in my pocket, and merchants will accept both, at par, I would pay with US dollars, and hoard the California scrip, to collect the interest.

It's hard to model a stable equilibrium in which two different monies could circulate side-by-side. If one money gains any slight advantage over the other, and becomes more widely accepted, that makes people even more willing to use it, and less willing to use the other, until one money dominates. And that's what we normally see, except in "bilingual" border zones.

And I just find it hard to imagine that California scrip could ever displace the US dollar as the preferred medium of exchange, even in California. The 3.5% interest might offset any risk of default or depreciation, but the sheer force of custom should outweigh both.

The NY Times Room for Debate is discussing how we should interpret Goldman Sach's compensation pool, which will be an $11.36 billion set aside for the first half of 2009. Here's the unedited version of my entry (you may like the shorter, edited version better):  

Returning to High-Risk Strategies, Room for Debate, NY Times, by Mark Thoma: What does the size of Goldman's compensation pool tell us? It signals several things. First, it gives some indication that the financial sector is improving, and that is good news. There's no guarantee, however, that the overall economy will follow anytime soon. Even with improvements in the financial sector, the recovery of the broader economy is likely to be a slow process.

One of the reasons I expect the recovery to be slow despite improvements in the financial sector is that the economy cannot go back to where it was before the crisis hit. The financial and housing sectors need to shrink, too many economic resources were used unproductively in support of these activities, and the automobile sector is also in transition.

And it's not just that the financial sector needs to get smaller so that resources can be used productively elsewhere, the financial sector also needs to change its ways so that risk accumulations do not threaten the financial system and the broader economy. As Robert Reich notes today, Goldman's chief financial officer tells Bloomberg News that "Our model really never changed, we’ve said very consistently that our business model remained the same." Thus, a second signal from Goldman's unexpectedly large earnings is that firms such as Goldman Sachs are returning to the same high-risk strategies backed by too big to fail government guarantees that got us into trouble in the first place, and that aspect of Goldman's success is worrisome. It's a signal that the excesses that led to the high incomes of financial executives have not ended.

Why aren't the profits and the bonuses paid to executives justifiable? Don't they signal the superior talents of Goldman employees, and don't those talents deserve to be rewarded by the marketplace? I think we can legitimately question whether this is a reward for superior talent. Goldman was helped by bailout funds -- there's some debate about whether it actually needed a direct infusion of funds -- but it's certainly true that Goldman benefitted when its counterparties such as AIG were bailed out. Goldman is also benefitting from its early escape from government constraints that still inhibit the ability of other firms to compete on equal - though perhaps overly slippery and risky - footing.

 So Goldman's earnings are not simply the product of the superior talent of Goldman's executives, there is more to the story. In addition, the bad incentives that executive compensation structures provide was one of the factors that caused the crisis, and the size of the compensation pool tells us there is work yet to be done to fix this problem.

Other entries from William K. Black, Yves Smith, Charles Geisst, David Merkel, and Jeffrey Miron.

Richard Green takes on Peter Wallison's arguments against establishing a Financial Product Safety Commission:

Peter Wallison calls Consumer Protection Elitist: He writes:

Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure all consumers -- of whatever level of sophistication -- could make rational decisions about the products and services they are offered. No more. If the administration's plan is adopted, many consumers will be told that they cannot have particular products or services because they are not sophisticated, educated or perhaps intelligent enough to understand what they have been offered.

Conservatives have always argued that liberals are elitists who do not respect ordinary Americans; this legislation seems to prove it. For example, the administration's plan would allow the educated and sophisticated elites to have access to whatever financial services they want but limit the range of products available to ordinary Americans.

This unprecedented result comes about because, under the proposed legislation, every provider of a financial service (a term that includes organizations as varied as banks, check-cashing services, leasing companies and payment services) is required to offer a "standard" product or service -- to be defined and approved by the proposed agency -- that will be simple and entail "lower risks" for consumers. These standard products are called "plain vanilla" in the white paper that the administration circulated in advance of the legislation.

Such protection is actually not unprecedented. For example, people must be deemed to be "accredited investors" or (for more complicated products) "qualified purchasers" in order to invest in certain types of hedge funds. And stock brokers have an obligation to make sure their clients' investments are "suitable."

But beyond the issue of precedence, there is a broader issue of safety. We reasonably forbid or require a variety of actions in the interest of safety. We require people to wear seatbelts. Be don't allow people to buy certain type of narcotics over the counter. Perhaps Mr. Wallison thinks such protections are a bad idea too, in which case he is consistent, if not also ridiculous. Mortgages can be dangerous products. Let's turn it over to Richard Thaler:

Fast forward to 2008, and the world of mortgage shopping had become a much more complicated place. Borrowers were quoted low initial “teaser” rates that would jump later to some higher level, depending on market interest rates at the time, and there were prepayment penalties for paying off the loans early. For such mortgages, an A.P.R. was no longer an adequate measure of the loan’s cost.

How can we help people make sense of all this?

One extreme approach would be to ban complex mortgages entirely: we could just go back to the world of uniform fixed-rate mortgages. But the cost of simplicity is an end to innovation. ...

A better approach is to strive for maintaining diverse options but helping consumers make smart choices and avoid the most common pitfalls. ... As the administration plan describes it, lenders could be required to offer some mortgages they call “plain vanilla,” with uniform terms. There might be one vanilla 30-year, fixed-rate mortgage and one five-year, adjustable-rate mortgage. The features of these plain mortgages would be uniform, much as in a standard lease used in most rental agreements.

Lenders would also be free to offer other exotic mortgages — perhaps called “rocky road” mortgages? — along with the vanilla variety, but these offerings would receive more intense scrutiny from regulators.

I am not sure what is so elitist about this, other than the fact that those who are hostile to regulations tend to like to use elitist as an epithet for their opponents. So I guess I have two questions for Mr. Wallison:

(1) If I gave him an HP12C calculator, assumptions about an interest rate path, and the terms of an option-ARM mortgage, would he be able to tell me the payment on that mortgage in, say, month 62? Perhaps he could, but I don't know too many lawyers (and he is a lawyer) who could do that calculation. ... The point is ... to emphasize a fact--most of us do not have the equipment to make informed judgments about complex financial products.

(2) I am curious how often Mr. Wallison hangs out with those who are not elite. Does he socialize with, say, median income people? ... Perhaps he does, in which case he is entitled to refer to "the elite" as an other. But I have my doubts.

I would be hesitant to endorse this banks weren't "free to offer other exotic mortgages," but that's not a problem.

Why make these products identical, i.e. why have a plain vanilla option? Have you ever tried to compare the price of mattresses at different stores? It's almost impossible - intentionally - to find matching model numbers and exactly identical products, so you are never quite sure which is the better deal. That uncertainty gives the stores pricing power. If stores were required to offer two or three identical mattresses, such comparison shopping would no longer be a problem and you'd expect competition to drive the price down its minimum level. There would still be exotic mattresses at each store, nobody would make you purchase the standard option, you would still have choices. But even if you aren't a mattress expert and hence have little idea if the exotic mattresses are worth the price, at least there would be two or three choices where you could be sure that the mattresses were priced fairly and that they adhered to particular quality and safety standards.

Of course, since such a proposal would take away pricing power of firms selling mattresses, and they would be opposed to such a requirement. It's no different for financial firms, and Simon Johnson doesn't think the administration is being aggressive enough in countering efforts to undermine and weaken the proposed consumer protection legislation:

Waiting For The Big Push: Selling The Consumer Protection Agency For Financial Products. by Simon Johnson: ...[T]he administration’s major remaining initiative is its version of a Financial Product Safety Commission - something that would be clearly beneficial for the public.  And the skepticism – and outright opposition – comes from the banking sector. ...

As far as I can see, [the administration is] not pushing this new consumer protection/safety agency hard enough. Some sources claim that Secretary Geithner is fully on board with the Agency...  But there is no sign of the frenzied effort that accompanied efforts to launch the PPIP – when, for example, almost every economist in the administration seemed pressed into service to call potential critics and ask them to “give it a chance.”

One symptom of this “effort gap” is that counter-arguments and disinformation about the proposed agency begin to gain the upper hand.  One senior executive recently told me that this agency would have unprecedented powers to determine the design of individual products – “something not even the FDA can do.”

Of course, this is nonsense.  The new agency would be powerful – and thus it is feared by the industry – and presumably it would be able to prevent sufficiently toxic products from being sold.  Hopefully, it will also be able to require that all financial institutions also offer some vanilla products, to make consumers’ choices easier.  But the idea that an agency would design the details of all products for any sector is both implausible and a malicious rumor being spread by opponents (actually, it reminds me of the pushback from meatpackers, and others, early in the 20th century). 

If Treasury is so supportive of this new Agency, now is the time to launch public, high profile, and clever counterattacks.  By the time the legislation is being voted on, it will be too late.

And in this context, the administration should push hard on one of the great ironies here.  Financial sector executives like to stress the importance of “consumer confidence,” and they urge the government to take steps to restore this confidence...

But the same people completely reject the idea that consumers will feel more confident about financial products if there is finally some serious consumer protection around those products.  Whenever people learn – or just fear – that a particular food product is unsafe, they stop buying it.  When the stock market ripped people off in the late 1920s, it took legislation with real teeth to rebuild investor confidence – take a look at, for example, the Securities Exchange Act of 1934. ...

If Treasury and the administration really wants a Consumer Protection/Safety Agency for finance, they need to kick their support campaign into much higher gear immediately.

Consumers have a big information disadvantage when it comes to mortgages and understanding which product fits their needs without exposing them to unnecessary risk, and in some cases they may not even be presented with the full spectrum of mortgage products that are available when they apply for a loan. And though it's better than it used to be, it's also difficult to shop around due to the transactions costs involved. The information problem combined with the difficulty in comparison shopping give brokers the opportunity to steer people toward products that are more profitable, but not as good a fit for the borrower. Having a few common options that are available across brokers makes comparison shopping easier and helps to overcome the information problem.

Update: More at Rortybomb.

Update: Tim Fernholz disagrees with Simon Johnson:

Simon Johnson writes that the administration isn't supporting the proposed Consumer Financial Products Agency enough. Since I wrote a piece arguing the exact opposite last week, I thought I'd respond, though I do agree with Simon in so far as he administration could never do too much to support the creation of the agency.

Dani Rodrik says "mercantilism deserves a rethink":

Mercantilism Reconsidered, by Dani Rodrik, Commentary, Project Syndicate: A businessman walks into a government minister's office and says he needs help. What should the minister do? Invite him in for a cup of coffee and ask how the government can be of help? Or throw him out, on the principle that government should not be handing out favors to business?

This question constitutes a Rorschach test for policymakers and economists. On one side are free-market enthusiasts and neo-classical economists, who believe in a stark separation between state and business. In their view, the government's role is to establish clear rules and regulations and then let businesses sink or swim on their own. ... This view reflects a venerable tradition that goes back to Adam Smith...

On the other side are what we may call corporatists or neo-mercantilists, who view an alliance between government and business as critical to good economic performance and social harmony. In this model, the economy needs a state that eagerly lends an ear to business, and, when necessary, greases the wheels of commerce by providing incentives, subsidies, and other discretionary benefits. Because investment and job creation ensure economic prosperity, the objective of government policy should be to make producers happy. ... This view reflects an even older tradition that goes back to the mercantilist practices of the seventeenth century. ...

Adam Smith and his followers decisively won the intellectual battle between these two models of capitalism. But the facts on the ground tell a more ambiguous story.

The growth champions of the past few decades - Japan..., South Korea..., and China... - have all had activist governments collaborating closely with large business. ... China's pursuit of a high-saving, large-trade-surplus economy in recent years embodies mercantilist teachings.

Early mercantilism deserves a rethink too. It is doubtful that the great expansion of intercontinental trade in the sixteenth and seventeenth centuries would have been possible without the incentives that states provided, such as monopoly charters. As many economic historians argue, the trade networks and profits that mercantilism provided for Britain may have been critical in launching the country's industrial revolution...

None of this is to idealize mercantilist practices... Governments can too easily end up in the pockets of business, resulting in cronyism and rent-seeking instead of economic growth. ... The pursuit of trade surpluses inevitably triggers conflicts with trade partners...

Nonetheless, the mercantilist mindset provides policymakers with some important advantages: better feedback about the constraints and opportunities that private economic activity faces, and the ability to create a sense of national purpose around economic goals. There is much that liberals can learn from it.

Indeed, the inability to see the advantages of close state-business relations is the blind spot of modern economic liberalism. ...Just look at how the search for the causes of the financial crisis has played out in the US. Current conventional wisdom places the blame squarely on the close ties that developed between policymakers and the financial industry in recent decades. For textbook liberals, the state should have kept its distance...

But the problem is not that government listened too much to Wall Street; rather, the problem is that it didn't listen enough to Main Street, where the real producers and innovators were. That is how untested economic theories about efficient markets and self-regulation could substitute for common sense, enabling financial interests to gain hegemony, while leaving everyone else, including governments, to pick up the pieces.

If policymakers had listened just as much as before to Wall Street, somehow listening to Main Street would have saved the day and we would have avoided the financial crisis? I'd like to hear a bit more about how that would have happened since exactly how listening to Main Street would have prevented the crisis is left unexplained, and it's not at all clear to me how that would have avoided the problems in the financial sector. (And aren't there examples of countries that followed these types of polices, but still had some sort of financial meltdown?)

Awhile back there was some controversy over the role of the shadow banking system in the financial crisis. Resetting the stage:

Much Ado About the Shadow Banking System, The Hearing: Occasionally, a blog post will flower into a wide-ranging debate in what is usually called the "economics blogosphere." Last Friday's guest post on regulation by Mark Thoma triggered just such a debate. I'll quote the controversial passage at some length:

Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.

The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.

We need to bring the shadow banking system – essentially any institution that takes deposits and makes loans either directly or indirectly – under the same regulatory umbrella as the traditional banking system.

Dr. Manhattan, an anonymous blogger at The Atlantic, focused on that middle paragraph in a post called "Sentences That Don't Compute," arguing that the crisis was due to problems at regulated financial institutions, such as AIG, not the shadow banking system.

Brad DeLong defended Thoma, drawing the line between commercial deposit-taking banks (heavily regulated) and other institutions (lightly regulated).

Thoma also responded on his own blog, pointing to the fact that AIG's problems, for example, were caused by the unregulated part if its business - the Financial Products derivatives-trading business.

Arnold Kling (who usually blogs here) responded to DeLong at The Atlantic, saying that failures of regulation of commercial banks were also a problem.

Finally, Rortybomb has a careful review of the issues, showing how different people mean different things by "shadow banking system." Ultimately he sides with Thoma on this point: money shifted into a sector of the financial system where there was no backstop against a liquidity crisis - unlike the regulated operations of the commercial banks, where deposit insurance plays that role. This is a problem that needs to be fixed.

Mike Rorty follows up today in The Atlantic's business blog with an interview with Perry Mehrling on shadow banking and its role in the crisis. Mehrling's bottom line for regulators is a "new Bagehot Rule" for modern markets: Insure freely but at a high premium.

Here's part of the interview:

Shadow Banking: What It Is, How it Broke, and How to Fix It, by Mike Rorty: We hear a lot of chatter about the shadow banking system and its crucial role in the financial crisis. But rarely do we find time to step back and ask the basic questions: What is shadow banking, where did it come from, how did it operate, what role did it play in this crisis and how do we deal with it going forward? I hope this Q&A with a very smart professor and economist at Barnard College Professor Perry Mehrling provides answers to each of those questions.

...[Mike Rorty:] So let's talk about shadow banks. What are they, where did they come from, and how did they operate?

We have to appreciate that we are writing history as it is being made so these are provisional theories. ... The shadow banking system was built up alongside the traditional banking system, using some of these tools of modern finance we were just talking about like interest rate swaps and credit default swaps. The idea was to make credit cheaper for the ultimate borrower and more available, but also to separate the credit system from the payment system. A lot of the regulation we have on the traditional banking system is there to protect the payment system, to make sure that when you write a check on your deposit account, that money actually gets transferred.

The idea of the shadow banking system was in some way, not only tolerated by regulators, but encouraged by regulators. They thought, "Let's get some of these risks off the balance sheet of the traditional banking system. Let's get interest rate risk off the balance sheet of the traditional banking system. Let's get credit risk off the balance sheet of the traditional banking system." They thought that would be a good thing. The traditional banks became an originator of loans which they packaged, securitized, and then sold to the shadow banking system, which then raised funds in the money market from mutual funds and asset-backed commercial paper that they issued to whomever. It was avoiding the traditional banking system entirely in this regard, and also avoiding all the regulation of the traditional banking system as well as all the regulatory support of the traditional banking system.

But of course it had the same risks. You aren't actually getting rid of liquidity risk or getting rid of solvency risk; you are just moving them into a different place. ...

So that explains how the shadow banks evolved. Now where did the weaknesses start to show up?

There's some controversy about this. It is certainly true that problems in subprime started to create some anxiety as to whether or not these assets were really AAA or not. But I don't think that this can be sustained, the notion that this was just a housing bubble that collapsed. Because if it was, we'd be done already. As many people said at the beginning of the crash, "oh [the problem is] just subprime, there's only, say, $400 billion of that stuff out there, it is not big enough to undermine the entire financial system." The fact that crisis continues shows that it isn't just a crisis of subprime, but a crisis of the whole securitization structure, that everything came into question.

The way this played out is the following. Once there is any concern about the value of the collateral you are putting up in an overnight borrowing situation, the first thing the lender does is to alter the deal, to say "Ok, we'll continue to lend. But just to be on the safe side, instead of giving you 99 cents on the dollar we'll give you 95 cents on the dollar." That immediately creates a problem for the shadow bank that is borrowing. Where are they going to get that other 4%? The way that plays out is that ... collateral value was marked down. You couldn't borrow as much as you used to in order to carry the underlying security. This became a self-fulfilling prophesy on the way down, something I refer to as a "liquidity-solvency downward spiral."

I've told my students for a decade that this new system would inevitably get tested by a crisis. And when it got tested it was inevitable that it was going to break. We didn't know where it was going to break, and the important thing now is to identify where it broke and to fix it so it doesn't break there again. ...

So what can the Federal Reserve do going forward to try and regulate this shadow banking system?

I use the term "Credit Insurer of Last Resort." And here's the idea: The Bagehot Rule - lend freely, at a high rate, in a crisis - dates from 1873. That was a good enough rule for the 19th century British economy, an economy that ran on short term commercial bills of exchange, 90-day paper. You can see for the new capital markets banking system we have a problem. We have 30-year mortgages that are the underlying asset that are being turned into 90-day paper through asset-backed commercial paper, or a repurchasing agreement, or repo, but the underlying asset is still a 30-year mortgage. That is where the system broke, because those mortgages serve as collateral for the short term borrowing.

Floating the system with money market liquidity, which is what the Fed did, didn't solve the problem, because it wasn't getting to the capital markets. That's why we need a credit insurer of last resort, to put a floor on the value of the best collateral in the system. I say the new Bagehot Rule should be: Insure freely but at a high premium.

Why a high premium? If you insure an earthquake, you are not making earthquakes more likely. The insurance contract is a purely derivative contract, it isn't influencing earthquakes. That is not true of insurance of financial risk. When AIG is selling you systemic risk insurance for 15 basis points, that price is too low. People said: "If I can get rid of the whole tail risk that cheaply, I should load up. I should take more systemic risk." So the prices were wrong. So the important thing for government intervention here is to get that price closer to a reasonable rate to prevent people from creating earthquakes.

Mike also notes:

Mehrling has a fantastic paper, The Global Credit Crisis, and Policy Response, about the shadow banks and their role in the current crisis. It’s very accessible to a general reader with an interest in the subject matter and just a bit of background knowledge and by far the best explanation of this part of the crisis; I highly encourage you to read it before or after tackling the interview. He also has a video of him presenting the paper, as well as a webpage full of relevant papers and editorials. Check it out.

Update: Arnold Kling disagrees based upon the idea that the market will always be one step ahead:

Merhling's solution is for the government to be a risk insurer of last resort. That sounds to me like Freddie Mac and Fannie Mae, which did not work well at all. But Merhling says,

With all due respect to Professor Mehrling, I think that this is unworkable. The market will figure out a way to make the insurer of last resort take much more risk than it thinks it is taking. That is what the market did to AIG, as Merhling points out. I see no reason to expect that the government insurer will always be able to outsmart the market.

Whether that's true or not, to me it says nothing about whether we should add regulation to close the holes we already know exist - we should - though I suppose one could counter with an unintended consequences argument. And we should also close any holes we are able to anticipate. We won't always stay one step ahead, that's true, but at least we won't fall further behind.

Update: James Kwak adds:

Merhling’s takeaway point is that there needs to be a “credit insurer of last resort,” who will insure any asset against a fall in value – for a sufficiently high premium. This would make it possible for financial institutions to unload the risk of their asset portfolios in a crisis, if they are willing to pay enough to do so. The only institution that would have the credibility to play this role in a real crisis would be the federal government; as we saw, AIG – the world’s largest insurance company, remember – was not up to the task. Still, though, I’m not sure this would do the trick. If I’m a large bank with a balance sheet full of toxic assets, and I don’t want to pay the premium that the insurer of last resort is charging, then I go to the government, say the price is too high, and ask for a bailout. The credit insurer of last resort would need to be coupled with a commitment not to provide an alternative form of government support, or we would end up where we are today.

Update: More from Mike Rorty, Ezra Klein, and Free Exchange.

Marshall Auerback says California is challenging the federal monopoly on money creation:

Schwarznegger to Obama: Watch and Learn, by Marshall Auerback: According to the San Diego Union-Tribune, Republicans and Democrats alike embraced legislation last Friday that would make California IOUs legal tender for all taxes, fees and other payments owed to the state.

Effectively, California is using its IOUs to create a currency. If this bill passes it would allow California to deficit spend just like the Federal Government and with the IOU's acceptable as payment of state taxes, it instantly imparts value to them. In effect, what you have is a state of the union creating a sovereign currency right under the noses of Treasury, Fed. They are stumbling their way into it... It will be viewed as a stop gap measure at first, and then could very well become entrenched as states realize they have a way to escape balanced budget requirements. ...

The ... Federal government retains this monopoly under our existing monetary arrangements. If California is successful here in allowing its IOUs to pay tax, it has profound constitutional ramifications. ...

It will be interesting to see what the exchange rate is between California IOU and US currency - the IOUs do offer a yield, so should be less than par by design. I wonder if NY is next.

This is like some sort of return to the 13 colonies with all kinds of ersatz currency floating about. It's hard to believe the Rubinite wing of the Democrats will just let it be, given the threat it represents to Wall Street's prevailing economic interests, but it is an understandable response...

There are political benefits for Obama...: If the Federal government allows this proposal of the state of California to go unchallenged, it would relieve the President of a major political quandary, which is, does he help California and then open himself to aid requests from other states?..., or, does he let California go and lose 56 electoral votes in the next election?

By allowing them to "solve" their own problem in the manner proposed by the legislation he avoids the quandary. And ... they just might let them do it until the import is fully understood.

It is true that this legislation represents a profound break from all federal laws. It is almost bound to incur some sort of constitutional challenge, representing as it does, a profound threat to the Federal government's currency monopoly powers. But this is another instance where Obama's inattentiveness to the ramifications of the states' respective fiscal crises has come back to haunt him. This situation would not have arisen had Obama embraced a simple revenue sharing plan with the states (so that the states' respective fiscal policies would be working in harmony with his proposals, rather than mitigating the impact of the Federal fiscal stimulus), as recommended by any number of prominent economists...

It will be interesting to see how this plays out. As California goes, will the nation follow? ...

Setting aside the particulars of the California case and whether or not the IOUs are actually functioning as money - that's debatable - very, very generally, the federal government has a budget constraint just like everyone else, well sort of like everyone else anyway -- most of us can't levy taxes or print money. Federal government finances must satisfy

G - T = ΔM + ΔB,

where Δ means "change in," G is government spending, T is taxes, M is the money supply, and B is bonds. The left-hand side is the deficit, and the right-hand is how it is financed. Thus, when G is greater than T so that there is a deficit in a given budget period, it must be financed by printing new money (ΔM) or issuing new bonds (ΔB). (If it helps, think of G as being 100 and T being 70 so that the deficit is 30. The deficit can be financed by printing 30 new dollars, by borrowing 30 dollars from the public, or some combination of the two)

Now, for states, ΔM is zero since that would be money creation, and they are not allowed to do that. Thus, a state's budget constraint is:

G - T = ΔB

This must be satisfied each budget period. Because this constraint must hold each budget period, notice what happens if there is a legal or political debt limit -- in some states it is effectively B=0 -- and B is already at the limit (which means ΔB cannot be positive since that would add to the debt). If the state's budget deficit rises in a recession due to decreased tax revenue and increased spending on social services, then G must fall to eliminate the deficit, or new taxes must be levied, and the cutback in spending and/or increase in taxes makes the recession worse.

But what if a state was suddenly granted the power to print money? Then it could pay for that year's deficit without increasing bonds (i.e. debt) any further, i.e. G - T could be financed solely by ΔM if it so chooses. That is, the state now has the constraint

G - T = ΔM + ΔB

If B is maxed out politically or legally so that ΔB must equal zero (or be negative), then a deficit, G - T, could still be financed with ΔM.

Having fifty different currencies isn't necessarily bad, there are pros and cons to having a single currency across all fifty states, i.e. to forming currency union. With a currency union, individual members lose the ability to conduct independent monetary policy - there is one money and one policy so everyone in the group gets the same treatment - but that is less costly when the the economic differences among the members of the union is small and the same policy is generally applicable. There are many advantages to having a single currency (no exchange rate uncertainty and lower transactions costs to name just two), and for countries considering forming a currency union, there is a list of factors that are cited as working for or against unification. Many of these factors involve social, political, economic, and geographic factors, and generally, though not always, the more similar the countries are, the more likely it is that a currency union will be beneficial (e.g. similar levels of development, a similar mix of products, similar legal institutions, same language). In the case of the fifty states within the U.S., I believe the advantages of a single currency far outweigh the disadvantages, and states should not be allowed to create their own currencies.

Robert Frank returns to the point he made in Alpha Markets, i.e. that Charles Darwin provides the "true intellectual foundation" for economics. Though the example this time is male elk rather than bull elephant seals, the central point - and it's one worth giving more thought to - is that "Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance." In these situations, which occur frequently in economic and social relationships, the assumption in neoclassical economic models that the maximization of self-interest is consistent with the maximization of social interest does not hold, and failure to recognize this has " undermined regulatory efforts ... causing considerable harm to us all":

The Invisible Hand, Trumped by Darwin?, by Robert Frank, Commentary, NY Times: If asked to identify the intellectual founder of their discipline, most economists today would probably cite Adam Smith. But that will change. ... Charles Darwin ... tracks economic reality much more closely. ...

Smith’s basic idea was that business owners ... have powerful incentives to introduce improved product designs and cost-saving innovations. These moves bolster innovators’ profits in the short term. But rivals respond by adopting the same innovations, and the resulting competition gradually drives down prices and profits. In the end, Smith argued, consumers reap all the gains.

The central theme of Darwin’s narrative was that competition favors traits and behavior according to how they affect the success of individuals, not species or other groups. As in Smith’s account, traits that enhance individual fitness sometimes promote group interests. For example, a mutation for keener eyesight in hawks benefits not only any individual hawk that bears it, but also makes hawks more likely to prosper as a species.

In other cases, however, traits that help individuals are harmful to larger groups. For instance, a mutation for larger antlers served the reproductive interests of an individual male elk, because it helped him prevail in battles ... for access to mates. But as this mutation spread, it started an arms race that made life more hazardous for male elk over all. The antlers of male elk can now span five feet or more. And despite their utility in battle, they often become a fatal handicap when predators pursue males into dense woods.

In Darwin’s framework, then,... [c]ompetition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always.

Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance, as in the antlers arms race. In the marketplace, such reward structures are the rule, not the exception. The income of investment managers, for example, depends mainly on the amount of money they manage, which in turn depends largely on their funds’ relative performance. Relative performance affects many other rewards in contemporary life. ...

In cases like these, relative incentive structures undermine the invisible hand. To make their funds more attractive to investors, money managers create complex securities that impose serious, if often well-camouflaged, risks on society. But when all managers take such steps, they are mutually offsetting. No one benefits, yet the risk of financial crises rises sharply. ...

It’s the same with athletes who take anabolic steroids. ...

If male elk could vote to scale back their antlers by half, they would have compelling reasons for doing so, because only relative antler size matters. Of course, they have no means to enact such regulations.

But humans can and do. ... Darwin has identified the rationale for much of the regulation we observe in modern societies — including steroid bans in sports, safety and hours regulation in the workplace, product safety standards and the myriad restrictions typically imposed on the financial sector.

Ideas have consequences. The uncritical celebration of the invisible hand by Smith’s disciples has undermined regulatory efforts to reconcile conflicts between individual and collective interests in recent decades, causing considerable harm to us all. ...

[And, again, for those who might be interested, see also Paul Krugman's: What Economists Can Learn from Evolutionary Theorists Synopsis.]