Economist's View

"Let The Good Times Roll Again?"

The question of how to interpret Goldman Sachs' unexpectedly large earnings has been addressed here and here (with an addendum at the bottom of the second post). One lesson appears to be that the bad incentives underlying executive compensation are still be present. However, exactly why that is the case - other than the sheer size of the profits - has not been fully addressed. This argument from Lucian Bebchuk takes a step in that direction by noting that the Goldman Sachs' bonuses are a reward for short-term gains, when we ought to be tying compensation to long-run performance. Thus, the problematic incentive to take on large amounts of risk in pursuit of immediate profits is still present. (Though it's not included below, he also argues that compensation should be based upon the long-run value of a broad basket of securities, not just common shares as has been typical in the past, to avoid distorting incentives in a way that gives executives another reason to take on too much risk):

Let the good times roll again?, by Lucian Bebchuk, Commentary, Project Syndicate: Goldman Sachs announced this month plans to provide bonuses at record levels, and there are widespread expectations that bonuses and pay in many other firms will rise substantially this year. Should the good times start rolling again so soon?

Not without reform. Indeed, one key lesson of the financial crisis is that an overhaul of executive compensation must be high on the policy agenda.

Indeed, pay arrangements were a major contributing factor to the excessive risk-taking by financial institutions that helped bring about the financial crisis. By rewarding executives for risky behaviour, and by insulating them from some of the adverse consequences of that behaviour, pay arrangements for financial-sector bosses produced perverse incentives, encouraging them to gamble.

One major factor that induced excessive risk-taking is that firms’ standard pay arrangements reward executives for short-term gains, even when those gains are subsequently reversed. Although the financial sector lost more than half of its stock-market value during the last five years, executives were still able to cash out, prior to the stock market implosion, large amounts of equity compensation and bonus compensation.

Such pay structures gave executives excessive incentives to seek short-term gains ... even when doing so would increase the risks of an implosion later on. ...

Following the crisis, this problem has become widely recognised... But it still needs to be effectively addressed: Goldman’s recent decision to provide record bonuses as a reward for performance in the last two quarters, for example, is a step in the wrong direction.

To avoid rewards for short-term performance and focus on long-term results, pay structures need to be re-designed. As far as equity-based compensation is concerned, executives should not be allowed to cash out options and shares given to them for a period of, say, five years after the time of “vesting”...

Similarly, bonus compensation should be redesigned to reward long-term performance. For starters, the use of bonuses based on one-year results should be discouraged. Furthermore, bonuses should not be paid immediately, but rather placed in a company account for several years and adjusted downward if the company subsequently learns that the reason for awarding a bonus no longer holds up. ...

A thorough overhaul of compensation structures must be an important element of the new financial order.

The latest I'm aware of on this topic is draft legislation Barney Frank circulated today:

All publicly traded U.S. companies, and particularly financial firms, would face new executive-compensation requirements under draft legislation circulated Friday by a top lawmaker in the U.S. House of Representatives.

The measure proposed by Rep. Barney Frank, D-Mass., would give shareholders a greater ability to weigh in on compensation packages, require compensation consultants to satisfy independence criteria established by the government and would ensure that compensation committees are made up of independent directors. ...

Banks, broker-dealers, investment advisers and all other financial firms would be required to disclose any incentive-based compensation structures, while federal regulators would be able to limit "inappropriate or imprudently risky" pay practices.

The panel is expected to take up some form of the legislation next week.

This legislation would give regulators the power to limit executive pay structures that they believe are excessively risky, but exactly what types of compensation structures would be allowed or required under this legislation is a bit vague. It doesn't sound like it will be as restrictive as Lucian Bebchuk would like, but we shall see.

There are two related issues here. First, was the compensation fair in terms of being a reward for productive activities such as directing capital where it was most needed, or distributing and reducing risk? Before the crash, some people tried to make that argument, but for financial executives, it seems clear that the compensation was based upon bubble rather than fundamental values, and that this lead to inflated rewards relative to the value that was actually created. But even for non-financial executives, it's hard to believe that the generous compensation high-level managers and executives received in recent years is due entirely to their superior productivity. The "say on pay" part of the proposed legislation tries to give shareholders a greater voice in setting compensation levels, and is directed at this problem.

The second issue is whether the compensation structures that have been used in the past lead to incentives to accumulate more risk than is optimal. It appears that they did, and the second part of the proposal is an attempt to overcome this problem by giving regulators the ability to limit systemically risky practices.

There are two types of excessive risk to be worried about, but only one is a systemic risk, i.e. a risk to the overall economy. First, a particular executive compensation structure may give an executive the incentive to take on too much risk - more than shareholders desire - but there is no danger to the overall financial system. This type of excessive risk taking needs to be prevented, but it is not a danger to the overall economy, and regulators are generally concerned with microeconomics questions concerning optimal incentive structures. Second, there is excessive risk that endangers the entire financial system and the broader economy. This is systemic risk that is the target of the proposed legislation, the kind of risk regulators such as the Fed are concerned with, and the kind we must do our best to eliminate if we want to avoid a repeat of the present crisis.

To me, both elements of the proposed legislation - the part that gives shareholders the power to limit compensation levels and the part that gives regulators the power to limit risky compensation schemes - seem vague and rather weak. I hope that changes as the legislation develops.

links for 2009-07-18

• More multipliers (double super wonkish) - Paul Krugman
• Why US housing prices will resume growing soon - voxeu.org
• Summers Says Stimulus Plan on Track Despite Job Losses - NYTimes.com
• Behind the Profits Lies Trouble for 2 Bank Giants - NYTimes.com
• Why economics professors seem to have so little time for you - Chris Blattman
• The Colbert Report: Edmund Andrews - ColbertNation.com
• The Middle Class Forum - Think Tank Explosion
• An Interview With Bruce Bartlett - Ezra Klein
• When cycles collide - macroblog
• Employing Krugman’s Cross: Farewell, Mr. Hicks? - Economic Perspectives
• Why is the Federal Reserve so positive? - Free exchange
• What is a farm? - Greed, Green and Grains
• The Stash - links
• Abnormal Returns - links
• naked capitalism - links
• FT Alphaville - links
• Marginal Revolution - links
• New Deal 2.0 - links
• Rortybomb - links
• Econbrowser - links

FRBSF: The Current Economy and the Economic Outlook

Mary Daly of the Federal Reserve Bank of San Francisco gives her views on the current economy and the outlook. There are two issues revealed in the graphs below that I wish I had time to discuss further. First, the graph labeled "Gaps are typical in downturns" shows what happens to state finances in recessions, and how severe the current recession is in that regard. The budget problems of the states in downturns is a key factor working against recovery -- many states have little choice but to reduce spending or increase taxes when the economy goes into recession -- and we need to find a way to fix that problem so that this recovery impeding mechanism doesn't get in the way the next time we face the problem of reviving a stalled economy. Second, the last graph shows the relationship, or rather the lack of a relationship, between budget deficits and inflation. This is a counterpoint to the objection to using fiscal policy based upon the claim that it will have undesirable inflationary consequences. It is also noteworthy, as shown in the second to last graph, that inflationary expectations remain well anchored:

FedViews, by Mary Daly, FRBSF [Charts]: Financial markets are improving, and the crisis mode that has characterized the past year is subsiding. The adverse feedback loop, in which losses by banks and other lenders lead to tighter credit availability, which then leads to lower spending by households and businesses, has begun to slow. As such, investors’ appetite for risk is returning, and some of the barriers to credit that have been constraining businesses and households are diminishing.

Paul Krugman: The Joy of Sachs

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).

Fed Watch: FOMC Forecasts - Reality or Fantasy?

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:

"Congress Must not Touch the Federal Reserve"

Mark Gertler says the Fed's independence should not be compromised:

Congress must not touch the Federal Reserve, by Mark Gertler: The economy was experiencing the worst recession since the war. In Congress, members were beginning to wonder whether the Federal Reserve’s intervention strategy was extracting too great a toll on the economy. Some started to suggest publicly that it may be time to rein in the central bank’s independence.

Sound familiar? Though they bear a strong resemblance to ... today, the events I refer to in fact happened in the early 1980s, in the midst of what was then the most serious economic crisis since the Depression. The head of the institution under threat of losing its independence was none other than Paul Volcker.

Of course, Mr Volcker would go on to be recognised as one of the great central bankers of modern times. He would do so by standing firm against political pressures. By continuing on the course he set out, the economy recovered and a new era of price and output stability began. ... In the Volcker era, the political outcry occurred in the midst of the economic contraction that the Fed had engineered to tame inflation. The costs of the policy were plain to see, but the long-term benefits that would eventually emerge were difficult for many to imagine at the time.

The Fed’s role has been different this time round. Rather than trying to slow the economy, it has been acting to contain the damage brought on by the most complex financial crisis of modern history. By the accounts of many, the Fed has acted masterfully under difficult circumstances. ...

Given that hard times remain, nonetheless, it is natural that Congress is questioning the Fed, just as it did in the early 1980s. ... Unfortunately, the Fed cannot demonstrate what would have happened to the economy if it had not intervened in the way it did. Many observers agree that the situation would be far worse than it is today. Yet discussions of reining in central bank powers proceed as if the financial system would have stabilised itself without any Fed intervention.

The Fed well understands the lesson from the Volcker era that it can be effective only when it resists political attempts to influence its decisions. One can only hope that sober voices in Congress who appreciate the importance of central bank independence will help keep Capitol Hill from taking any measures that do permanent damage to the Fed.

A more constructive route for Congress would be to proceed with regulatory reform that would prevent a repeat of the current situation. At the core of the crisis is an antiquated regulatory system that permitted large financial institutions to take excessive risks. By giving the Fed the ability to monitor risk-taking by these institutions, Congress would diminish greatly the likelihood the central bank would again need to intervene directly in private credit markets.

The Fed may not have been perfect in its response to this or previous crises, but that doesn't mean that a less independent Fed would have done better. Taking away Fed independence - including subjecting the Fed to audits by the GAO - would be a mistake. In addition, if we are going to strengthen regulatory authority so that we can better monitor and reduce systemic risk that threatens the financial system - and we should - that authority needs to be in the hands of an independent entity, and the Fed is the natural place for this. Finally, its role in regulating system-wide risk is complementary to many of its other activities. For example, its role as a systemic risk regulator would involve monitoring risk within large institutions. Should a bank get into trouble, that would be helpful in assessing whether the bank should be granted access to the discount window in its capacity as lender of last resort.

We need to maintain an independent Fed, to give the Fed the powers it needs to monitor and regulate the level of overall risk, and to give the Fed the authority it now lacks to put banks through an orderly bankruptcy process so it can avoid bailing out financial institutions that are in trouble and a threat to overall the financial system.

Update: See Willem Buiter for a longer, more detailed version of many of the same points, e.g.:

Probably the single most damaging  failure of the US Treasury, the US Congress and the US financial regulators was there inability/unwillingness to create a special resolution regime (SRR) with structured early intervention and prompt corrective action for all systemically important financial institutions (those too big, too complex, to interconnected, too international or too politically connected to fail in the ordinary Chapter 11 or Chapter 7 way).  ...

But however weak its past performance and credentials, they are rock-solid compared to those of the other candidate institutions. ...

Only the Fed can fulfill the macro-prudential regulator-supervisor role.  That is because it has the short-term deep pockets.  It is the source of the ultimate, unquestioned liquidity in the economy, through its monopoly of the issuance of base money.  Without the short-term deep pockets, a macro-prudential regulator/supervisor cannot act as lender of last resort, market maker of last resort or provider of enhanced credit support.  It would be ... toothless...

He also makes this point:

The problem with this solution of the macro-prudential regulator/supervisor problem is that it is incompatible with central bank operational independence as interpreted since 1989 or thereabouts. ... When the central bank plays a quasi-fiscal role, as the Fed has been doing on an unprecedented scale in the current crisis, the fullest possible degree of accountability to the Congress, the tax payer and the citizens is essential.  The Fed has no mandate to engage in quasi-fiscal operations, even when it is for a good cause.  ...

If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution.  Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury.

You pick.

Okay. As much as possible, monetary policy should be kept out of the hands of politicians.

Update: Jim Hamilton (I also signed the petition a day or two ago):

I joined many of my colleagues in urging Congress and the President to remember just how valuable an independent central bank is for the ordinary citizens of this country. You may not pay much attention to central bank independence. But you'll miss it when it's gone.

Why is the Recovery of Modern Labor Markets So Slow?

Arnold Kling is puzzled by current macroeconomic developments, particularly that banks are doing better than expected, and labor doing worse. I want focus on the second:

Relative to what a consensus forecast might have predicted last October, it appears that:

Two Puzzles of Current Macroeconomic Condition, Econlog: ...[E]mployment has fallen more than expected. ... Why is the severity of the recession so much greater in the labor market than in the goods market? ...

My answer ... is that we are superimposing a heterogeneous labor force on top of a trend of rapid productivity growth. In some sense, we are seeing an amplified version of what took place from 2001 through 2003. This was dubbed a "jobless recovery," but I called it a "productivity-cushioned recession." That is, growth in trend productivity of 2 to 3 percent per year is maintaining output higher than it would be if the trend were less than 2 percent. (Trend productivity growth is productivity growth measured over periods of five years or more, to iron out short-term fluctuations.)

The heterogeneous labor force means that it is very hard to reallocate labor from sectors that decline. Forty years ago, there were lots of industries that employed men with only a high school education. Today, there are fewer such industries, so that when the construction sector and the automobile sector shrink, the job losers have almost nowhere to go. These guys aren't going to turn into school teachers or nurses next month--or ever. It would be nice if the stimulus were actually creating construction jobs, but the reality is that the net increase in state construction projects is probably infinitesimal, as the states wind up juggling their budgets to keep Medicaid going. ...

There may be another factor as well. I think part of the problem - and the statistics support this interpretation - is that the economy is not creating jobs that pay as well as the jobs people are losing. Being unwilling to take a cut in pay, unemployed workers resist for awhile and keep looking, as long as they can anyway, and it isn't until they begin to exhaust the resources supporting the search and to accept the reality of a new job market that they finally lower their aspirations and take a cut in pay (or exit the labor force altogether). So it's not just that workers can't be retrained fast enough for the new, good jobs that are available, it's also that the availability of the jobs is not sufficient to reemploy workers at their previous rates of compensation.

But there is a factor that works against a long, drawn out search for a job that is a good fit with skills. If unemployment compensation is low, or does not last very long, then a worker may not be able to take the time needed to find a good employment match (though for workers with more personal assets to rely upon, i.e. higher paid workers generally, or another source of income such as an employed spouse that can help to tide them through, searches could still be relatively extended):

US Unemployment Benefits in International Context, by Mathew Yglesias: Gary Burtless has an interesting paper reviewing the social safety net measures in the American Recovery and Reinvestment Act. If you read the paper you’ll see that even though these elements of ARRA have gotten less discussion than the state aid and infrastructure elements, boosts in safety net spending are actually the largest segment of ARRA spending. For blogging purposes, though, I really just wanted to reproduce this chart showing how relatively stingy unemployment benefits are in the United States:

In addition to being relatively stingy, unemployment insurance in many ways fails to protect people from the most salient economic risks. Older workers tend to earn more money than younger workers, in part because over the years they’ve acquired sector- and firm-specific skills that their younger colleagues lack. When they get laid off, however, these skills become devalued and even when recovery comes it’s often difficult to get a new job that’s as remunerative as the old one. This, in turn, encourages the political system to focus a lot of preservation of the status quo which winds up reducing long-run growth potential. Gene Sperling’s idea of comprehensive wage insurance would help solve this issue and do a lot of good.

"Ideas and Rules for the World in the Aftermath of the Storm"

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.

Enough Punishment for One Day

When you are teaching a course, imposing rigorous standards and giving lots of homework can be of great benefit to your students: 

The rigors of the USC Masters in Real Estate Development Program, by Richard Green: A student of ours emails:

I just wanted you to know that this assignment got me out of a traffic ticket this morning.

La Cienega was shutdown to due an accident and I was trapped. So, I made a u-turn which included driving over a curbed median. A motorcycle cop pulled me over and gave me a lecture about how this isn't Texas (I have texas plates) and "cowboy driving" is not acceptable....whatever that means. So I told him that I had to get to campus for the mid- term and I had a limited amount of time to complete the homework assignment. I pulled out assignment #3 to make my story credible and he took it with him when he went back to his motorcycle.

When he came back he told me that it seemed like the assignment was going to be enough punishment and he let me go.

links for 2009-07-16

• Economics Blogs Attract Rabid Followers - WSJ.com
• Some meaty minutes - macroblog
• Development Experiments: Ethical? Feasible? Useful? - William Easterly
• Five reasons it's too soon to declare the recession over - BusinessWeek
• Tax the Wealthy to Keep Everyone Healthy - Robert Reich
• Deficits saved the world - Paul Krugman
• Panel Named to Examine Financial Crisis - NYTimes.com
• Casey Mulligan on the Stimulus: Mismatches and other problems - Menzie Chinn
• Summoning the Ghost of Ferdinand Pecora - New Deal 2.0
• The Daily Grail - links
• Credit Writedowns - links
• Felix Salmon - links
• New Deal 2.0 - links
• The Stash - links
• Ezra Klein - links
• Marginal Revolution - links
• Free Exchange - links
• FT Alphaville - links
• Abnormal Returns - links
• Brad DeLong - links
• Credit Writedowns - links
• Marginal Revolution - links
• The Daily Grail - links
• News N Economics - links
• naked capitalism - links
• Paul Kedrosky - links
• The Big Picture - links

"Tax the Wealthy to Keep US Healthy"

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.

Thomas Schelling on Climate Change

Conor Clarke interviews Thomas Schelling on the implementation of climate change policy (the excerpts run across several questions):

An Interview With Thomas Schelling, Part Two, by Conor Clarke: This is the second part of my interview with Nobel Prize-winning economist Thomas Schelling. Part one is here. In this part we talk very generally about climate change...

...It's not obvious that averting global climate change is in the rational self-interest of anyone ... alive today. The serious consequences probably won't occur until 2080 or 2100 or thereafter..., [and] those consequences are going to be distributed in a radically uneven way. The northwest of the United States might actually benefit. So how does a negotiation process work? How does a generation today negotiate on behalf of future generations? And how do we negotiate when the costs are distributed so unevenly?

Well I do think that one of the difficulties is that most of the beneficiaries aren't yet born. More than that: Most of the beneficiaries will be born in ... the developing world. By 2080 or 2100 five-sixths of the population, at least, will be in places like China, India, Indonesia, Africa and so forth. And what I don't know is whether Americans are really willing to understand that and do anything for the benefit of the unborn Chinese.

It's a tough sell. And probably you have to find ways to exaggerate the threat. And you can in fact find ways to make the threat serious. I think there's a significant likelihood of a kind of a runaway release of carbon and methane ... that will create a huge multiplier effect, and it could become very serious. ...

If I were to come clean to the American public I would say that, except for a very low probability of a very bad result -- which is the disintegration of the West Antarctic ice sheet, which would put Washington DC under water -- we are probably going to outgrow any vulnerability we have to climate change. ... You know, very little of the US economy is susceptible to climate. All of agriculture is less than 3% of our gross product. Forestry may be endangered. Fisheries may be endangered. But recreation might actually benefit!

So if we can double our GDP in the next 70 or 80 years,... -- even if we lose 10% of our GDP from climate change -- we're still ahead so much that the effect of climate change wouldn't be noticed. But it would be pretty disastrous in a lot of the less developed parts of the world. And that's why I think it's crucially important not to demand anything of China, India and so forth that will significantly impede their economic progress. ...

[I]f the developed countries ... are really serious, they'll tell India and China and Brazil, "we're going to provide enormous assistance to help reduce your dependence on fossil fuels. And we don't expect you to pay for it yourselves. We will pay for it because we're rich and you're not." ...

But while people talk about this..., nobody that I know of is thinking about how in the world you organize so that the rich countries can agree what you do with the poor. You need to know who divides the money, and who the monitors is. We're going to need a whole new set of institutions...

It's very hard to get Americans to engage in what they think will be suffering not just for the polar bears but for the poor around the world who will indeed suffer if they can't outgrow their vulnerability to climate change. ...

I think you have to realize that most people have very strong moral feelings. I think in a lot of cases they're misdirected. I wish moral feelings about a two-month old fetus were attached to hungry children in Africa. But I think people have very strong moral feelings. In fact, I'm always amazed by the number of people who at least pretend they're worried about the polar bears.

And one thing that I think ought to help but doesn't is that -- and my impression is that maybe this is slightly changing -- the organized churches in America don't take seriously preserving the heritage that God gave us. ... I get no impression that Protestants and Catholics are sermonizing on the importance of preserving the bounty of the earth, the richness of the species, or preserving the planet as we would like to know it. ... I think the churches don't realize that they could have a potent effect in not letting so much of gods legacy -- in terms of flora and fauna -- be destroyed by climate change.

But I tend to be rather pessimistic. I sometimes wish that we could have, over the next five or ten years, a lot of horrid things happening -- you know, like tornadoes in the Midwest and so forth -- that would get people very concerned about climate change. But I don't think that's going to happen.

Exaggerating the threat won't help. When people find out that you are doing that -- and they will at some point -- you lose credibility and end up further behind than when you started. Also, though this is a bit picky -- this qualification is often omitted to simplify the discussion -- the costs are not fully captured by the loss of GDP. If, for example, some species become extinct due to climate change, that is only included in the costs to the extent that it lowers the output of goods and services. But our concerns are broader than that. Finally, I don't think we should, even just sometimes, wish that horrid things would happen to people no matter how much good might come of it. There are better ways to get there.

Loonie Network Effects

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.

How Should We Interpret Goldman Sach's Unexpectedly Large Earnings?

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.

links for 2009-07-15

• Multiplier muddles (wonkish) - Paul Krugman
• A New Survey of Multipliers (wonkish) - Econbrowser
• Where to start reading about causality (wonkish) - Andrew Gelman
• Shelah does Social Choice (extra wonkish) - Yet another Sheep
• Exclusive Contracts and Investment Incentives - Cheap Talk
• Goldman's Back, and Why We Should Be Worried - Robert Reich
• Sarah Palin’s Supply-side Silliness on Cap & Trade - pgl
• Concerns about the Fed's New Balance Sheet - Econbrowser
• After the storm comes a hard climb - Martin Wolf
• AEI And Consumer Financial Protection - Rortybomb
• Further Thoughts on Shadow Banks - Rortybomb
• Insuring against the apocalypse - Free exchange
• Justice Dept. Investigates Markit Over Derivatives - NYTimes.com
• Conservation programs drive crop production - Greed, Green and Grains
• Coping With Excess - Olivia Judson
• The recession is over! (Technically) - Daniel Gross
• Negative Nominal Interest Rates Miss the Point (II) - Economic Perspectives
• 1. Stimulus 2. Restructuring 3. Growth - Knowing and Making
• Thinking Clearly about Economic Inequality - Will Wilkinson
• Timelines of policy responses to the global financial crisis - voxeu.org
• White Man’s Last Stand - Dowd - NYTimes.com
• Housing and Mobility - Creative Class
• Are Democrats Ready to Fight for Consumer Protection? - Tim Fernholz
• A funny thing happened update - macroblog
• CEA Chair Christina Romer Takes Your Questions - The White House Blog
• Bill Easterly - links
• Ezra Klein - links
• Matthew Yglesias - links
• Felix Salmon - links
• Free Exchange - links
• Marginal Revolution - links
• The Daily Grail - links
• Abnormal Returns - links
• New Deal 2.0 - links
• The Big Picture - links
• naked capitalism - links
• Brad DeLong - links
• FT Alphaville - links

Enough to Help, not Enough to Cure

If the first pill doesn't cure the patient, does that mean the prescription didn't work?

Consumer Protection Elitists? Hardly

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.

links for 2009-07-14

• Time to tackle the real evil: too much debt - Taleb and Spitznagel
• The Case for More Fiscal Stimulus - Freakonomics
• Peter Wallison calls Consumer Protection Elitist - Richard Green
• Selling The Consumer Protection Agency - The Baseline Scenario
• Reality Belies a Health-Care Scare Tactic - washingtonpost.com
• Senate Can Strengthen Climate Legislation - CBPP
• Expanding health care coverage will make it more affordable - TNR
• Changes to Health Insurance and Labor Markets - CBO Director’s Blog
• The Health Care Clock, and Why Obama Has to Act Quickly - Robert Reich
• What Makes a Local Currency Tick? - Economic Perspectives
• White House Gives Upbeat Forecast for Economy - NYTimes.com
• Cracking Chistiano, Eichenbaum, and Rebelo's Big Multipliers - Brad DeLong
• Myth vs the Reality of Adam Smith's Political Economy - Prose
• Sotomayor's Critics Are the Radicals - washingtonpost.com
• Grading Obama's Africa Speech - William Easterly
• Grading Obama's Africa speech - Chris Blattman
• Schama's revolution - Daniel Little
• On penalty cash rates - TVHE
• Trapped in the Bubble - Mother Jones
• The stupidest attempt at criticism I've seen in quite some time
• Chris Martenson - links
• Matthew Yglesias - links
• New Deal 2.0 - links
• Credit Writedowns - links
• Ezra Klein - links
• News N Economics - links
• The Daily Grail - links
• naked capitalism - links
• Marginal Revolution - links
• Abnormal Returns - links
• The Big Picture - links
• Credit Writedowns - links
• FT Alphaville - links
• Brad DeLong - links

Neomercantilism

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 Shadow Knows

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:

Money Monopoly

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.

"Boiling the Frog"

What are we waiting for?:

Boiling the Frog, by Paul Krugman, Commentary, NY Times: Is America on its way to becoming a boiled frog?

I’m referring, of course, to the proverbial frog that, placed in a pot of cold water that is gradually heated, never realizes the danger it’s in and is boiled alive. Real frogs will, in fact, jump out of the pot — but never mind. The hypothetical boiled frog is a useful metaphor for a very real problem: the difficulty of responding to disasters that creep up on you a bit at a time. ...

I started thinking about boiled frogs recently as I watched the depressing state of debate over both economic and environmental policy. These are both areas in which ... it’s very hard to get people to do what it takes to head off a catastrophe foretold. ...

Start with economics: ...Most economic forecasters now expect gross domestic product to start growing soon, if it hasn’t already. But all the signs point to a “jobless recovery”...

Now, it’s bad enough to be jobless for a few weeks; it’s much worse being unemployed for months or years. Yet that’s exactly what will happen to millions of Americans if the average forecast is right — which means that many of the unemployed will lose their savings, their homes and more.

To head off this outcome — and remember, this isn’t what economic Cassandras are saying; it’s the forecasting consensus — we’d need to get another round of fiscal stimulus under way very soon. But neither Congress nor, alas, the Obama administration is showing any inclination to act. Now that the free fall is over, all sense of urgency seems to have vanished.

This will probably change once the reality of the jobless recovery becomes all too apparent. But by then it will be too late to avoid a slow-motion human and social disaster.

Still, the boiled-frog problem on the economy is nothing compared with the problem of ... climate change. ... At this point, the central forecast of leading climate models — not the worst-case scenario but the most likely outcome — is utter catastrophe, a rise in temperatures that will totally disrupt life as we know it... How to head off that catastrophe should be the dominant policy issue of our time.

But it isn’t, because climate change is a creeping threat rather than an attention-grabbing crisis. The full dimensions of the catastrophe won’t be apparent for decades, perhaps generations. ... Unfortunately, if we wait to act until the climate crisis is ... obvious, catastrophe will already have become inevitable.

And while a major environmental bill has passed the House, which was an amazing and inspiring political achievement, the bill fell well short of what the planet really needs — and despite this faces steep odds in the Senate.

What makes the apparent paralysis of policy especially alarming is that so little is happening when the political situation seems, on the surface, to be so favorable...

After all, supply-siders and climate-change-deniers no longer control the White House and key Congressional committees. Democrats have a popular president to lead them, a large majority in the House of Representatives and 60 votes in the Senate. And this isn’t the old Democratic majority, which was an awkward coalition between Northern liberals and Southern conservatives; this is, by historical standards, a relatively solid progressive bloc.

And let’s be clear: both the president and the party’s Congressional leadership understand the economic and environmental issues perfectly well. So if we can’t get action to head off disaster now, what would it take?

I don’t know the answer. And that’s why I keep thinking about boiling frogs.

links for 2009-07-13

• A Homespun Safety Net - NYTimes.com
• Chrome vs. Bing vs. You and Me - NYTimes.com
• Supply, Demand and Speculation - Greed, Green and Grains
• Modern macro even Paul Krugman will love - Greg Mankiw
• Now We May Perhaps to Begin? - Economic Principals
• Securitization and Structured Credit - Interview With Ann Rutledge
• President Obama, please be bolder - Richard Green
• Universal health care could boost economy - Jeff Gelles
• Catholicism as Antidote to Turbo-Capitalism - NYTimes.com
• Opaque Burma - Understanding Society
• Better Lightbulbs And Beyond - Mark Muro
• Brad DeLong - links
• naked capitalism - links
• Econbrowser - links
• Marginal Revolution - links
• Chris Martenson - links
• Abnormal Returns - links

"The Hottest Places in Hell are Reserved for Those Who, in Times of Moral Crisis, Maintain a Neutrality"

Tom Bozzo says to watch this video [parts of transcript below]:

Bill Moyers Journal: BILL MOYERS: Wendell Potter ... worked for CIGNA 15 years and left last year. ... why are you speaking out now?

WENDELL POTTER: I didn't intend to, until it became really clear to me that the industry is resorting to the same tactics they've used over the years, and particularly back in the early '90s, when they were leading the effort to kill the Clinton plan. ...

I was beginning to question what I was doing as the industry shifted from selling primarily managed care plans, to what they refer to as consumer-driven plans. And they're really plans that have very high deductibles, meaning that they're shifting a lot of the cost off health care from employers and insurers, insurance companies, to individuals. And a lot of people can't even afford to make their co-payments when they go get care... But it really took a trip back home to Tennessee for me to see exactly what is happening to so many Americans. I ... went home, to visit relatives. And I picked up the local newspaper and I saw that a health care expedition was being held a few miles up the road, in Wise, Virginia. And I was intrigued.

BILL MOYERS: So you drove there?

WENDELL POTTER: I did. ... It was being held at a Wise County Fairground. ... It was a very cloudy, misty day, it was raining that day, and I walked through the fairground gates. And I didn't know what to expect. I just assumed that it would be, you know, like a health-- booths set up and people just getting their blood pressure checked and things like that.

But what I saw were doctors who were set up to provide care in animal stalls. Or they'd erected tents, to care for people. I mean, there was no privacy. In some cases-- and I've got some pictures of people being treated on gurneys, on rain-soaked pavement.

And I saw people lined up, standing in line or sitting in these long, long lines, waiting to get care. People drove from South Carolina and Georgia and Kentucky, Tennessee-- all over the region, because they knew that this was being done. A lot of them heard about it from word of mouth.

Fiscal Policy: "The Right and the Obvious Thing To Do"

Two things seem relatively clear. First, given the projected baseline for the economy, the previous stimulus package was too small. It was big enough to help, but it won't give anything near the boost the economy needs. Second, the original baseline was far too optimistic.

So I agree:

Fiscal Policy: The Obama Administration Is Not Making Much Sense These Days, by Brad DeLong: ...Last December the Obama administration to be decided on a fiscal stimulus package which they believed would have minor effects on the economy in the first two quarters of 2009 and major effects--would push unemployment down below what it would other wise have been by more than half a percentage point--starting in the third quarter of 2009. They believed that the economy was not that weak, and that with the fiscal stimulus package taking effect unemployment would be peaking now at a rate of 7.9%.

Instead, unemployment is now probably in the 9.5-9.7% range--and without the stimulus package it would right now have turned out to be above 10%:

The financial crisis of last fall hit the economy's levels of production, spending, and employment much harder than people thought at the time. If we had known then what we know now, it would have been prudent then to propose twice as large a fiscal stimulus program as the Obama administration in fact did propose. ...

All in all, it looks like the unemployment rate in 2009 is going to average 1.2 percentage points above where the administration last December thought we would be. ...

It is interesting and important to note that the excess unemployment now forecast over 2009 relative to last December's forecast is of the ... magnitude ... of ... a $170 billion shortfall.

If I were running the government, I would be trying to make up that GDP shortfall right now: I would be rushing a clean $170 billion--$500 per citizen--aid-to-states-that-maintain-effort package through the congress this week. It would seem the right and the obvious thing to do.

At least that much, and the sooner the better.

The Caritas in Veritate: Justice

The only time I ever got an F on an exam, or even close, was in a religious studies course I took to fulfill general education requirements. You know how some of you don't get math? I felt the same way. I somehow managed to pass the course, but I had no foundation whatsoever in the topic going in, and I just didn't get it.

So I am going to let others comment on the Pope's Caritas in Veritate:

Mixing morals and money. by Christopher Caldwell, Commentary, Financial Times: To judge from his encyclical Caritas in Veritate, published this week, Pope Benedict XVI agrees with those who say that something has gone wrong with the way the world does business. ... The encyclical is not anti-global or anti-capitalist. ... Business and finance have not created new excesses. They have opened new routes for an arrogance already present in the hearts of men.

The Pope, in perhaps his most radical passage, laments the “hegemony of the binary model of market-plus-state”. ... Business and government have become specialised fields; each follows a logic that dispenses with the insights of religion. Globalisation can break down cultures, and with them the moral systems in light of which it can be judged. ...

Unfortunately, one of the lost insights concerns justice. The Pope would like us to think about justice as having three aspects. There is commutative justice (the idea of properly judging the prices of things), distributive justice and social justice. National governments, which used to address the second and third, no longer have full power to do so. The global institutions that have replaced them tend to be concerned only with commutative justice – and they do a bad job, the Pope thinks, of judging the value of labour. “If the market is governed solely by the principle of the equivalence in value of exchanged goods, it cannot produce the social cohesion that it requires,” he writes.

links for 2009-07-12

• Ed Lazear on the Stimulus Package - Econbrowser
• Rebuilding Something Better - Barack Obama
• Ben Stein Has Not Heard of Global Warming - Beat the Press
• Forced Sales and House Prices - NBER Digest
• Sled dogs to snowmobiles - Arctic Economics
• Negative Nominal Interest Rates Miss the Point - Economic Perspectives
• Who Said Economists Didn’t See The Crisis Coming? - Edward Hugh
• The Big Picture - links
• Brad DeLong - links
• naked capitalism - links

"Trumped by Darwin?"

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.]

Average Weekly Hours

"Is Benefit-Cost Analysis Helpful for Environmental Regulation?"

 Robert Stavins notes that:

With an exceptionally talented group of thinkers - including scientists, lawyers, and economists - now in key environmental and energy policy positions at the White House, the Environmental Protection Agency, the Department of Energy, and the Department of the Treasury, this question about the usefulness of benefit-cost analysis is of particular importance

Here's his (balanced) discussion. Points four, five, and eight struck me as particularly noteworthy:

Is Benefit-Cost Analysis Helpful for Environmental Regulation?, by Robert Stavins: ...[Does] economic analysis - in particular, the comparison of the benefits and costs of proposed policies - play ... a truly useful role in Washington, or is it little more than a distraction of attention from more important perspectives on public policy, or - worst of all - is it counter-productive, even antithetical, to the development, assessment, and implementation of sound policy in the environmental, resource, and energy realms. ...

For many years, there have been calls from some quarters for greater reliance on the use of economic analysis in the development and evaluation of environmental regulations. As I have noted in previous posts on this blog, most economists would argue that economic efficiency — measured as the difference between benefits and costs — ought to be one of the key criteria for evaluating proposed regulations. ... Because society has limited resources to spend on regulation, such analysis can help illuminate the trade-offs involved in making different kinds of social investments. In this sense, it would seem irresponsible not to conduct such analyses, since they can inform decisions about how scarce resources can be put to the greatest social good.

In principle, benefit-cost analysis can also help answer questions of how much regulation is enough. From an efficiency standpoint, the answer to this question is simple — regulate until the incremental benefits from regulation are just offset by the incremental costs. In practice, however, the problem is much more difficult, in large part because of inherent problems in measuring marginal benefits and costs. In addition, concerns about fairness and process may be very important economic and non-economic factors. Regulatory policies inevitably involve winners and losers, even when aggregate benefits exceed aggregate costs.

Over the years, policy makers have sent mixed signals regarding the use of benefit-cost analysis in policy evaluation. Congress has passed several statutes to protect health, safety, and the environment that effectively preclude the consideration of benefits and costs in the development of certain regulations, even though other statutes actually require the use of benefit-cost analysis. At the same time, Presidents Carter, Reagan, Bush, Clinton, and Bush all put in place formal processes for reviewing economic implications of major environmental, health, and safety regulations. Apparently the Executive Branch, charged with designing and implementing regulations, has seen a greater need than the Congress to develop a yardstick against which regulatory proposals can be assessed. Benefit-cost analysis has been the yardstick of choice.

It was in this context that ten years ago a group of economists from across the political spectrum jointly authored an article in Science magazine, asking whether there is role for benefit-cost analysis in environmental, health, and safety regulation. That diverse group consisted of Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and myself. That article and its findings are particularly timely, with President Obama considering putting in place a new Executive Order on Regulatory Review.

In the article, we suggested that benefit-cost analysis has a potentially important role to play in helping inform regulatory decision making, though it should not be the sole basis for such decision making. We offered eight principles.

First, benefit-cost analysis can be useful for comparing the favorable and unfavorable effects of policies, because it can help decision makers better understand the implications of decisions by identifying and, where appropriate, quantifying the favorable and unfavorable consequences of a proposed policy change. But, in some cases, there is too much uncertainty to use benefit-cost analysis to conclude that the benefits of a decision will exceed or fall short of its costs.

Second, decision makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Removing statutory prohibitions on the balancing of benefits and costs can help promote more efficient and effective regulation.

Third, benefit-cost analysis should be required for all major regulatory decisions. The scale of a benefit-cost analysis should depend on both the stakes involved and the likelihood that the resulting information will affect the ultimate decision.

Fourth, although agencies should be required to conduct benefit-cost analyses for major decisions,... those agencies should not be bound by strict benefit-cost tests. Factors other than aggregate economic benefits and costs may be important.

Fifth, benefits and costs of proposed policies should be quantified wherever possible. But not all impacts can be quantified, let alone monetized. Therefore, care should be taken to assure that quantitative factors do not dominate important qualitative factors in decision making. ...

Sixth, the more external review that regulatory analyses receive, the better...

Seventh, a consistent set of economic assumptions should be used in calculating benefits and costs. Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

Eighth, while benefit-cost analysis focuses primarily on the overall relationship between benefits and costs, a good analysis will also identify important distributional consequences for important subgroups of the population.

From these eight principles, we concluded that benefit-cost analysis can play an important role in legislative and regulatory policy debates on protecting and improving the natural environment, health, and safety. Although formal benefit-cost analysis should not be viewed as either necessary or sufficient for designing sensible public policy, it can provide an exceptionally useful framework for consistently organizing disparate information, and in this way, it can greatly improve the process and hence the outcome of policy analysis.

If properly done, benefit-cost analysis can be of great help...

links for 2009-07-11

• Curbing instability: Policy and regulation - voxeu.org
• Lunch with the FT - Larry Summers
• Correcting Five Myths About the Stimulus Bill - CBPP
• The economy and employment: On the turn? - The Economist
• Are asset allocation models broken? - Abnormal Returns
• Administration Considers Bailout for Small Businesses - washingtonpost.com
• In Defense of the Fed's Independence - The Hearing
• New Deal 2.0 - links
• The Big Picture - links
• Matthew Yglesias - links
• The Stash - links
• Credit Writedowns - links
• Rortybomb - links
• FT Alphaville - links
• naked capitalism - links
• Brad DeLong - links
• Marginal Revolution - links
• Abnormal Returns - links

Haiku Economics

Why the sudden popularity of Haiku Economics??? This is from Steve Ziliak:

Dear Mark:

The economic recession -- something -- is bringing increased attention to "haiku" and "Haiku Economics."

The first fundamental assumption of haiku economics is: Less is more and more is better. The idea seems to be catching on with financial traders as much as with poets and political speechwriters.  The unemployed, it seems, can't resist it, and more than a few economists (heedless of Bentham) have put pens to verse.

"Are Depressions Necessary?"

Chris Hayes takes up a notion I've never been very fond of, that recessions are necessary and healthy since they clear out inefficient firms, and spur the development of new innovation during the recovery phase. (Why do I think this is unnecessary? The entry and exit of firms driven by innovation and the development of new products can be part of a full employment equilibrium, that is, cycles are not needed to clear out old firms and spur innovation. Imagine an economy where a new idea allows a slightly more productive firm to enter a market and displace a less productive firm, and the workers migrate from the old to the new firm over time. If this happens at a constant rate in aggregate over time, there won't be any cycles at all, but we still manage to clear out the inefficient firms and replace them with more innovative rivals. The displaced workers from the the innovation driven structural adjustment are part of the natural rate of unemployment in such an economy):

Are Depressions Necessary?, by Christopher Hayes, The American Prospect: ...Are economic contractions, like the one we're currently experiencing, a good thing? ... It would be career suicide for any elected official to suggest that the widespread stress, misery and heartache being wreaked by ... contraction were are a good thing. But scratch the surface a bit and you'll find a surprisingly vibrant school of thought, one that reaches back all the way back to the Great Depression, that holds precisely this view.

Famed economist Joseph Schumpeter said that "a depression is for capitalism like a good, cold douche," one that rinses off accumulated dysfunction. Robber baron Andrew Mellon (who served as Herbert Hoover's treasury secretary) welcomed the Great Depression with these infamous words: "It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people"

It's not hard to find this same view among bankers, financiers and sundry Wall Streeters today. ...

The stakes for this argument are very high: if steep economic contractions are like forest fires, a necessary part of the system's self-calibration, we should more or less let them burn. If they are more like five-alarms raging through dense city neighborhoods, we should call in the fire department.

Are Small Banks the Answer for Developing Countries?

This week at The Economist:

Justin Lin, the World Bank’s chief economist,... in his guest Economics focus column ... argues that developing countries should base their financial systems on small, local banks:

The size and sophistication of financial institutions and markets in the developed world are not appropriate in low-income markets. Small local banks are the best entities for providing financial services to the enterprises and households that are most important in terms of comparative advantage—be they asparagus farmers in Peru, cut-flower companies in Kenya or garment factories in Bangladesh. The experiences of countries such as Japan, South Korea and China are telling. Those countries managed to avoid financial crises for long stretches of their development as they evolved from low-income to middle- and high-income countries. It helped greatly that they adhered to simple banking systems (rather than rushing to develop their stock markets and integrate into international financial networks) and did not liberalise their capital accounts until they became more advanced.

Mr Lin concludes:

Leave the developed markets to worry about how to reform their highly evolved financial systems. To make sustained progress in lifting the weight of the extreme poverty that will remain after the crisis has subsided, low-income countries need to make their financial institutions small and simple.

Over the course of the next week, we will devote this blog to a discussion of Mr Lin’s column, posting responses from our correspondents, invited experts from the academic and policy worlds, and our commenters. We'll be collecting the entire series of posts here. Do stop by and contribute to the debate.

Here is the lead Essay: Walk, Don't Run by Justin Lin

Here are the responses so far:

• Big bank advantages, by The Economist: London
• Why favour local tiddlers?, by The Economist: London
• Is small really beautiful?, by Asim Khwaja
• Passive voice, by Tyler Cowen
• Difficult trade-offs, by Abhijit Banerjee
• Leave room for growth, by Luigi Zingales
• Function, not form, by Ross Levine
• Scale matters, by Antoinette Schoar

Here is my response:

Small banks need help, by Mark Thoma: I agree with many of the points in the article regarding the potential that small and simple banks provide. But while small and simple banks can help to overcome many problems, by themselves they may not be enough fully serve the financial needs within developing countries.

There are two issues here. The first is to determine the types of financial products that best suit the needs of people and businesses within developing countries, and the second is how to best deliver those products to the people and businesses who could benefit from using them.

Small banks and microfinance of the type emphasised in the article can meet many of the financial needs in developing countries, for example the need that farmers have to borrow funds to purchase seed and fertiliser, and then repay the loans at harvest, can be met in this way. But other needs require more sophisticated financial products. The ability to hedge price risk through futures markets, the need for insurance against crop failure, the need to purchase farm equipment through pooling arrangements that share the costs among end users, and the problems brought about by seasonality require more sophisticated products and arrangements. The point is that not all of the financial needs in agricultural, small scale manufacturing, and services are simple, even in developing countries.

Can these more complex financial needs be satisfied, or are there important barriers within developing countries that prevent these products from being used?

Paul Krugman: The Stimulus Trap

Everybody makes mistakes. But not everyone can admit their mistakes, and then take the steps needed to overcome them:

The Stimulus Trap, by Paul Krugman, Commentary, NY Times: As soon as the Obama administration-in-waiting announced its stimulus plan — this was before Inauguration Day — some of us worried that the plan would prove inadequate. ...

The bad employment report for June made it clear that the stimulus was, indeed, too small. But it also damaged the credibility of the administration’s economic stewardship. There’s now a real risk that President Obama will find himself caught in a political-economic trap.

I’ll talk about that trap, and how he can escape it, in a moment. First, however, let me ... ask how concerned citizens should be reacting to the disappointing economic news. Should we be patient, and give the Obama plan time to work? Should we call for bigger, bolder actions? Or should we declare the plan a failure and demand that the administration call the whole thing off? ...

When there’s an ordinary, garden-variety recession, the job of fighting that recession is assigned to the Federal Reserve. ... Reducing rates a bit at a time, it keeps cutting until the economy turns around. At times it pauses to assess the effects of its work; if the economy is still weak, the cutting resumes. ...

Normally, then, we expect policy makers to respond to bad job numbers with a combination of patience and resolve. They should give existing policies time to work, but they should also consider making those policies stronger.

And that’s what the Obama administration should be doing..., stay calm in the face of disappointing early results,... the plan will take time to deliver its full benefit. But ... be prepared to add to the stimulus now that it’s clear that the first round wasn’t big enough.

Unfortunately, the politics of fiscal policy are very different from the politics of monetary policy. For the past 30 years, we’ve been told that government spending is bad, and conservative opposition to fiscal stimulus (which might make people think better of government) has been bitter and unrelenting even in the face of the worst slump since the Great Depression. Predictably, then, Republicans — and some Democrats — have treated any bad news as evidence of failure, rather than as a reason to make the policy stronger.

Hence the danger that the Obama administration will find itself caught in a political-economic trap, in which the very weakness of the economy undermines the administration’s ability to respond effectively. ... The question is what the president and his economic team should do now.

It’s perfectly O.K. for the administration to defend what it’s done so far. ... It’s also reasonable for administration economists to call for patience...

But there’s a difference between defending what you’ve done so far and being defensive. It was disturbing when President Obama walked back Mr. Biden’s admission that the administration “misread” the economy, declaring that “there’s nothing we would have done differently.” There was a whiff of the Bush infallibility complex in that remark, a hint that the current administration might share some of its predecessor’s inability to admit mistakes. And that’s an attitude neither Mr. Obama nor the country can afford.

What Mr. Obama needs to do is level with the American people. He needs to admit that he may not have done enough on the first try. He needs to remind the country that he’s trying to steer the country through a severe economic storm, and that some course adjustments — including, quite possibly, another round of stimulus — may be necessary.

What he needs, in short, is to do for economic policy what he’s already done for race relations and foreign policy — talk to Americans like adults.

Don't Expect a Quick Recovery

One of the reasons I've argued this recovery will be slow is that we cannot simply bounce back to where we were before the problems started as we could in some past recessions. We need to move resources out of housing, out of finance, and out of autos, and those resources need to find productive employment elsewhere in new or growing industries, and that is not very likely until things improve. Consumers need to save more and consume less, as they are starting to do, and this too will require adjustment. So does this mean we should expect a U-shaped recovery instead of a V-shaped recovery? Robert Reich says it's neither, this is an X-recovery:

When Will The Recovery Begin? Never., by Robert Reich: The so-called "green shoots" of recovery are turning brown in the scorching summer sun. In fact, the whole debate about when and how a recovery will begin is wrongly framed. On one side are the V-shapers who look back at prior recessions and conclude that the faster an economy drops, the faster it gets back on track. And because this economy fell off a cliff late last fall, they expect it to roar to life early next year. Hence the V shape.

Unfortunately, V-shapers are looking back at the wrong recessions. Focus on those that started with the bursting of a giant speculative bubble and you see slow recoveries. ... That's where the more sober U-shapers come in. They predict a more gradual recovery...

Personally, I don't buy into either camp. In a recession this deep, recovery ... depends on consumers who, after all, are 70 percent of the U.S. economy. And this time consumers got really whacked. Until consumers start spending again, you can forget any recovery, V or U shaped.

Problem is, consumers won't start spending until they have money in their pockets and feel reasonably secure. But they don't have the money, and it's hard to see where it will come from. They can't borrow. Their homes are worth a fraction of what they were before, so say goodbye to home equity loans and refinancings. ... Unemployment continues to rise, and number of hours at work continues to drop. Those who can are saving. Those who can't are hunkering down...

Don't expect businesses to invest much more without lots of consumers hankering after lots of new stuff. And don't rely on exports. The global economy is contracting.

My prediction, then? Not a V, not a U. But an X. This economy can't get back on track because the track we were on for years -- featuring flat or declining median wages, mounting consumer debt, and widening insecurity, not to mention increasing carbon in the atmosphere -- simply cannot be sustained.

The X marks a brand new track -- a new economy. What will it look like? Nobody knows. All we know is the current economy can't "recover" because it can't go back to where it was before the crash. So instead of asking when the recovery will start, we should be asking when and how the new economy will begin. ...

"Cities and Stimulus"

Did cities receive too little of the federal transportation stimulus money?:

Lisa Schweitzer on Cities and the Stimulus, by Richard Greene: From her blog:

One of my fantastic students from Virginia Tech, Eric Howard, posted this piece from today’s New York Times on Facebook. The NYT author argues that:

Two-thirds of the country lives in large metropolitan areas, home to the nation’s worst traffic jams and some of its oldest roads and bridges. But cities and their surrounding regions are getting far less than two-thirds of federal transportation stimulus money.

The reporter goes on to quote outrage from mayors. They also get information from one of my favorite experts, Rob Puentes at Brookings. As usual, Rob has a very good point here: this package isn’t just about business as usual revenue allocation–which has always had a strong rural bias due to the structure of the Federal representative system (as Owen D. Gutfreund points out). This rural strength made way more sense 150 years ago than it does now.

So, of course all of these smart people are right in that cities aren’t treated very well in the stimulus, as they aren’t treated very well in Federal politics in general.

However, we have to ask ourselves: would it really be sensible to hand out this money on a per capita basis either?

links for 2009-07-10

• Bank Stock Warrants Undervalued, Panel Says - NYTimes.com
• Index Funds and Commodity Prices... Here We Go Again - econbrowser
• The relative dearth of recent household formations - Richard Green
• Do Unemployment Claims Show Hope? (No) - Economic Perspectives
• Win Bets at Parties: Simultaneous Chess - Cheap Talk
• Clearinghouse saved foreign exchange trading from the crisis - voxeu.org
• The Public Option in Healthcare Reform - Cheap Talk
• New Issue - Oxford University Economic Studies
• Has Globalization Made Forecasting Inflation More Difficult? - FRB Dallas
• Federal Reserve independence - FRB - Kohn
• Small Steps Could Mean Big Savings on Health-Care Reform - Michael Kinsley
• Are Speculators Driving Oil Prices? - The Stash
• Tax The Rich? - Bruce Bartlett
• Myths and Realities About How States Are Using Recovery Act Funds - CBPP
• Both Obama and his critics are wrong about the stimulus package - Daniel Gross
• How US History Unravels the American Myth of Free Markets - New Deal 2.0
• The effects of lending to households and firms - voxeu.org
• Felix Salmon - links
• Credit Writedowns - links
• Across the Curve - links
• FT Alphaville - links
• Paul Kedrosky - links
• naked capitalism - links
• Abnormal Returns - links
• The Big Picture - links
• New Deal 2.0 - links
• Matthew Yglesias - links
• Ezra Klein - links

"The Fall of the Toxic-Assets Plan"

I have the same worries, so I would like to hear why we shouldn't be concerned that banks are holding overvalued assets on their balance sheets. What's the counterargument to this?:

The Fall of the Toxic-Assets Plan,  by Lucian Bebchuk, Real Time Economics: The plan for buying troubled assets — which was earlier announced as the central element of the administration’s financial stability plan — has been recently curtailed drastically. The Treasury and the FDIC have attributed this development to banks’ new ability to raise capital through stock sales without having to sell toxic assets. ...

What happened? Banks’ balance sheets do remain clogged with toxic assets, which are still difficult to value. But the willingness of banks to sell toxic assets ... has been killed by decisions of accounting authorities and banking regulators. ...

Armed with ample government funding, the private managers running funds set under the program would be expected to offer fair value for banks’ assets. Indeed, because the government’s ... non-recourse financing, many have expressed worries that such fund managers would have incentives to pay even more than fair value... The problem, however, is that banks now have strong incentives to avoid selling toxic assets at any price below face value even when the price fully reflects fair value.

A month after the PPIP program was announced, under pressure from banks and Congress, the U.S. Financial Accounting Standards Board watered down accounting rules and made it easier for banks not to mark down the value of toxic assets. For many toxic assets..., banks may avoid recognizing the loss as long as they don’t sell the assets. ...

In another blow to banks’ potential willingness to sell toxic assets,... bank supervisors conducting stress tests ... explicitly didn’t take into account the decline in the economic value of toxic loans and securities that mature after 2010 and that the banks won’t have to recognize in financial statements until then.

Together, the policies adopted by accounting and banking authorities strongly discourage banks from selling any toxic assets maturing after 2010 at prices that fairly reflect their lowered value. ... [S]elling would require recognizing losses and might result in the regulators’ requiring the bank to raise additional capital...

While the market for banks’ toxic assets will remain largely shut down, we are going to get a sense of their value when the FDIC auctions off later this summer the toxic assets held by failed banks taken over by the FDIC. If these auctions produce substantial discounts to face value, they should ring the alarm bells. ... In the meantime, it must be recognized that the curtailing of the PIPP program doesn’t imply that the toxic assets problem has largely gone away; it has been merely swept under the carpet.

"Will Europe’s Economies Regain Their Footing?"

Kenneth Rogoff on the prospects for recovery in Europe:

Will Europe’s Economies Regain Their Footing?, by Kenneth Rogoff, Commentary, Project Syndicate: What will Europe's growth trajectory look like after the financial crisis? ...

True, things are pretty ugly right now. ... Yet, ugly or not, the downturn will eventually end. Yes, there is still a real risk of hitting an iceberg, beginning perhaps with a default in the Baltics, with panic first spreading to Austria and some Nordic countries. But, for now, a complete meltdown seems distinctly less likely than gradual stabilization followed by a tepid recovery, with soaring debt levels and lingering high unemployment.

It is not a pretty picture. Some commentators have savaged Europe's policymakers for not orchestrating as aggressive a fiscal and monetary policy as their U.S. counterparts have. ...

But these critics seem to presume that Europe will come out of the crisis in far worse shape than the U.S., and it is too early to make that judgment. An epic, financial-crisis-driven recession, such as the one we are still experiencing, is not a one-year event. So policymakers' responses cannot be evaluated by short-term measures... It is just as important to ask what happens over the next five years as over the next six months, and the jury is still very much out on that.

America's hyper-aggressive fiscal response means a faster rise in government debt, while its hyper-expansive monetary policy means that an exit strategy to mop up all the excess liquidity will be difficult to execute. ... Europe's more tempered approach, while magnifying short-term risks, could pay off in the long run, especially if global interest rates rise, making it far more painful to carry oversized debt loads.

The real question is not whether Europe is using sufficiently aggressive Keynesian stimulus, but whether Europe will resume its economic reform efforts as the crisis abates. If Europe continues to make its labor markets more flexible, its financial market regulation more genuinely pan-European, and remains open to trade, trend growth can pick up again in the wake of the crisis. If European countries look inward, however, with Germany pushing its consumers to buy German cars, the French government forcing car companies to keep unproductive factories open, etc., one can expect a decade of stagnation.

Admittedly, the past year has not been a proud one for policy reform in Europe. Recessions have never proven an easy time for ... reforms. ...

The recent recession has presented challenges, but European leaders were right to avoid becoming intoxicated with short-term Keynesian policies, especially where these are inimical to addressing Europe's long-term challenges.

If reform resumes, there is no reason why Europe should not enjoy a decade of per capita income growth at least as high as that of the U.S. Moreover, with growing concerns about the sustainability of U.S. fiscal policy, the euro has a huge opportunity to play a significantly larger role as a reserve currency.

One shudders to think what will happen if Europe does not pull out of its current funk. ...

European leaders argued they didn't need to be as aggressive as the U.S. at putting new fiscal policy in place because they had much larger social safety nets that would kick in automatically as the crisis deepened. In addition, Europeans noted, they already had much higher levels of government spending as a share of output than the U.S., so it was much harder for them to increase this share further. Another way to say this is that Europeans do not believe they have an inferior short-run response, especially when it comes to labor and providing jobs.

Thus, the very thing that Rogoff believes is Europe's biggest long-run challenge - the extensive social safety net, including provisions affecting adjustment in labor markets - is the reason why Europe was able and willing to choose a different strategy relative to the U.S. to attenuate the effects of the recession. If the U.S. had European levels of debt and, more importantly, the same degree of social protections for people affected by recession, then the U.S. would not have needed or been able (politically) to increase deficit spending as much as it did. I am among those who believe Europe could have reacted more vigorously, and should have, but I don't think it's correct to say they avoided Keynesian type policy (and see this post concerning France's stimulus package).

If, in the long-run, we look back and see that Europe's more extensive protections did, in fact, smooth the adjustment to the crisis, the motivation for long run change of the type Rogoff hopes for will diminish. If having European style social protections does lower growth - and that is a debatable assertion - that may be an insurance premium people are willing to pay to avoid more severe downturns. If the opposite happens, if the social safety net does not do its job (and that cannot be measured through unemployment rates alone), then the motivation for change could become stronger. But the crisis is far from over and the jury is still out.

"The New Kaldor Facts"

What does growth theory need to explain? Has there been progress?:

The New Kaldor Facts: Ideas, Institutions, Population, and Human Capital, by Charles I. Jones and Paul M. Romer, NBER WP 15094, June 2009 [open link]: 1. Introduction ...[I]t is easy to lose faith in scientific progress. ... In any assessment of progress, as in any analysis of macroeconomic variables, a long-run perspective helps us look past the short-run fluctuations and see the underlying trend. In 1961, Nicolas Kaldor stated six now famous “stylized” facts. He used them to summarize what economists had learned from their analysis of 20th-century growth and also to frame the research agenda going forward (Kaldor, 1961):

1. Labor productivity has grown at a sustained rate.
2. Capital per worker has also grown at a sustained rate.
3. The real interest rate or return on capital has been stable.
4. The ratio of capital to output has also been stable.
5. Capital and labor have captured stable shares of national income.
6. Among the fast growing countries of the world, there is an appreciable variation in the rate of growth “of the order of 2–5 percent.”

Redoing this exercise nearly 50 years later shows just how much progress we have made. Kaldor’s first five facts have moved from research papers to textbooks. There is no longer any interesting debate about the features that a model must contain to explain them. These features are embodied in one of the great successes of growth theory in the 1950s and 1960s, the neoclassical growth model. Today, researchers are now grappling with Kaldor’s sixth fact and have moved on to several others that we list below.

links for 2009-07-09

• Is Benefit-Cost Analysis Helpful for Environmental Regulation? - Robert Stavins
• De-speculating markets - Free exchange
• Markets work, even when they don’t - macroblog
• No evidence that older workers are crowding out younger ones - Peter Coy
• 'Invisible hand' guides evolution of cooperative turn-taking - EurekAlert
• Ontology of the French Revolution - Daniel Little
• How the potato got hot - Los Angeles Times
• Credit Writedowns - links
• Abnormal Returns - links
• Marginal Revolution - links
• The Stash - links
• Matthew Yglesias - links
• Chris Martenson - links
• naked capitalism - links
• FT Alphaville - links
• Brad DeLong - links

Was it Risk Concentration or Leverage?

Ricardo Caballero hasn't given up on his argument that it was the excessive concentration or risk, not leverage, that caused problems in financial markets (and it's an argument I'm sympathetic to):

Economic Witch Hunting, by Ricardo Caballero, Commentary, Economists Forum: Perhaps one of the economic phenomena most akin to witch-hunting is the diagnostic and policy response that develops during the recovery phase of a financial crisis. Understandably, pressured politicians and policymakers rush to find culprits... All too often they find a ready supply of these in preconceptions and superficial analyses of correlations. This time around the scapegoats are global imbalances and leverage.

Global imbalances are the victim of preconceptions: Many economists and commentators argued before the crisis that large global imbalances would lead to the demise of the U.S. economy... The crisis indeed came, but rather than destabilizing the US economy, capital flows helped to stabilise it, as flight-to-quality capital sought rather than ran away from US assets. ...

The fact that the actual mechanism behind the crisis had nothing to do with that which was used to explain the forecast of doom has long being forgotten, false idols have been erected,... global imbalances have been indicted for witchcraft, and ever more exotic rebalancing and currency proposals make it to the front pages of newspapers around the world.

Leverage is the victim of superficial analyses of correlations: In my view one of the main factors behind the severity of the financial crisis was the excessive concentration of aggregate risk in highly-leveraged financial institutions. Note that the emphasis is on the concentration of aggregate risk rather than on the much-hyped leverage. The problem in the current crisis was not leverage per se, but the fact that banks had held on to AAA tranches of structured asset-backed securities which were more exposed to aggregate surprise shocks than their rating would, when misinterpreted, suggest.

Thus, when systemic confusion emerged, these complex financial instruments quickly soured, compromised the balance sheet of their leveraged holders, and triggered asset fire sales which ravaged balance sheets across financial institutions. The result was a vicious feedback loop between assets exposed to aggregate conditions and leveraged balance sheets.

The distinction emphasized in the previous paragraph may seem subtle, but it turns out to have a first order implication for economic policy... The optimal policy response to this problem is not to increase capital requirements (or to deleverage), as the current fashion has it, but to remove the aggregate risk from systemically important leveraged financial institutions’ balance sheets. This should be done through prepaid and often mandatory macro-insurance type arrangements, which can accommodate valid too-big or too-complex to fail concerns, but without crippling the financial industry with the burden of brute-force capital requirements. ...

We shouldn't assume that the next potential financial crisis will be identical to this one in terms of how it comes about or how it expresses itself, so we need to ensure that the system can withstand different types of financial shocks. Given that these shocks can come from unexpected places, it's not clear to me that insurance discussed above will stop all of the ways in which financial market problems can lead to harmful deleveraging. Hence, we may want to put the type of insurance plan Ricardo Caballero would like to see instituted in place, and then buttress that protection with enhanced capital requirements to safeguard against unexpected causes of harmful deleveraging.

One Operating System to Rule Them All?

Google is moving forward with its plans to develop an operating system:

Google Plans a PC Operating System, Helft and Vance, NY Times: In a direct challenge to Microsoft, Google announced ... it is developing an operating system for PCs that is tied to its Chrome Web browser.

The software, called the Google Chrome Operating System, is initially intended for use in the tiny, low-cost portable computers known as netbooks... Google said it believed the software would also be able to power full-fledged PCs.

The move is likely to sharpen the already intense competition between Google and Microsoft... “Speed, simplicity and security are the key aspects of Google Chrome OS,” said Sundar Pichai ... and Linus Upson ... in a post on a company blog. “We’re designing the OS to be fast and lightweight, to start up and get you onto the Web in a few seconds.”

Mr. Pichai and Mr. Upson said that the software would be released online later this year under an open-source license... Netbooks running the software will go on sale in the second half of 2010.

The company likely saw netbooks as a unique opportunity to challenge Microsoft, said Larry Augustin, a prominent Silicon Valley investor...

“Market changes happen at points of discontinuity,” Mr. Augustin said. “And that’s what you have with netbooks and a market that has moved to mobile devices.” ...

Google’s plans for the new operating system fit its Internet-centric vision of computing. Google believes that software delivered over the Web will play an increasingly central role, replacing software programs that run on the desktop. In that world, applications run directly inside an Internet browser, rather than atop an operating system, the standard software that controls most of the operations of a PC.

That vision challenges not only Microsoft’s lucrative Windows business but also its applications business, which is largely built on selling software than runs on PCs. ... Google said Tuesday night that it still had work to do to develop a full-fledged operating system. ... [Here's Google's announcement.]

I resisted moving from DOS to Windows, and then got stuck on Windows once I did move, so I'm probably not the best judge of whether the model Google is using to challenge Microsoft will be successful, and perhaps both models can survive by serving different needs. However, I've also spent time on mainframe batch and time-share systems where you interact with the mainframe computer through a terminal (screen and keyboard), and Google's vision reminds me of an internet wide version of that system (if I understand it correctly, and I may not). If I want to do simulations of a theoretical model, will it be like graduate school where I had to work very late at night when the system had enough free resources to accommodate my requests without being so slow as to be nearly unusable? PCs freed me from that constraint (but not the late night work habit). It was hard to work at home then as well. It was possible to connect through a phone, but it was very slow, and this was also something PCs changed. You didn't have to be at school to do computer work. If we go to the Google model, will the internet be available broadly and reliably enough so that there won't be frustrating periods when lack of an internet connection means you can't get things done unless you do the equivalent of "going to school where there's a terminal"? And I also like having data backed up locally on my own disks or other media rather than trusting a centralized system to keep it safe for me, and with sensitive data it feels much more secure that way. I suppose this isn't a problem for people who use their computers mainly to browse the internet or send email, But if you use your PC for tasks that require lots of computing power or use sensitive data, I think you have reason to wonder if some of the speed, flexibility, and security PCs give you might be compromised with this system. For that reason, I wonder if Google's model will be able to capture some segments of the market, e.g. those that desire lots of computing power be available nearly on demand. But as I said, if people had listened to me, we'd probably still be using DOS.

"Administrative Costs in Health Care"

A follow-up to this post on administrative costs in health care:

Administrative Costs in Health Care: A Primer, by Ezra Klein: ...Paul Krugman, Greg Mankiw, Tyler Cowen and a handful of others began arguing about [administrative costs]... I'm not convinced any of them have it right.

Administrative costs are ... confusing... What counts as an "administrative cost" for a health insurer? We all agree that paying bills counts. But does ... disease management? Advertising? A nurse who dispenses health advice over the telephone? Hard to say. But all of them get grouped under administrative costs at various times. Indeed,... there's not perfect unanimity on how to measure any of this.

But most seem to think that Medicare's administrative costs are significantly undersold... An apples-to-apples comparison would not leave you with the 2 percent of total Medicare spending often bandied about in debate. That doesn't count, for instance, Medicare's premium collection, which is done through the ... IRS. Nor does it count most of Medicare's billing, which is outsourced -- and this might surprise people -- to private insurers like Blue Cross Blue Shield and listed under vendor services rather than program administration. A more straightforward estimate ... would be in the range of 5 to 6 percent.

Nor is it easy to measure administrative costs among private insurers. For one thing, which private insurers? ... Among employer-based plans, the largest firms had the lowest costs. Plans covering companies with at least 1,000 employees had a mere 7 percent in administrative costs. Those covering companies with fewer than 25 employees spent 26 percent of premiums on administration. And the individual market was a mess: 30 percent.

This tells us ... size matters. The most important predictor of administrative costs is not whether the plan is public or private, but whether it is large. ...

But administrative costs among ... insurers ... are only part of the story. And they may not even be the most important part. The hospitals and physicians ... are spending tremendous sums of money too. Hospitals ... employ people to argue over claims and navigate the rules of the dozen or so different insurance plans they contract with. And here the experts were unanimous: The problem is that the system is fractured. There's no standardization..., every insurer is complicated in its own way. And that complexity costs a lot of money.

As of now, no one I spoke with knew of good data separating the costs of dealing with Medicare and with private insurers. But there are studies comparing Canada and the United States that show a single payer vastly reduces administrative spending. ...

But ... slashing administrative costs ... will never be a panacea... Rick Kronick, a political scientist at the University of California at San Diego,... summed the situation up quite well. "The main question," he said, "is why are health care costs going up at 2.4 percent a year faster than GDP? And most of the answers to that question have nothing to do with administrative costs. The answers are that we do more stuff and have more technology. Even if we could wring administrative savings out of the system, which ... would be a good thing, we'd still be facing the question of how to slow the rate of cost growth."

links for 2009-07-08

• Introducing the Google Chrome OS - Google Blog
• Google Plans to Introduce a PC Operating System - NYTimes.com
• Don’t say colonialism! the debate on Paul Collier - Bill Easterly
• Health Reform’s Acid Test - NYTimes.com
• On Fire - Olivia Judson
• Exclusive Wireless Carriers: A Primer - Cheap Talk
• Overhaul of Food Safety Rules in the Works - washingtonpost.com
• Reports Calling for Estate Tax Repeal Seriously Flawed — CBPP
• What would a second stimulus package look like? - Christopher Beam
• The Carnage Continues: Time To Ramp Up the Stimulus - Randall Wray
• Do we need a second fiscal stimulus? Lessons from Japan - Business Week
• The Great Synchronisation: The trade crisis of 2008-2009 - voxeu.org
• The Stash - links
• Credit Writedowns - links
• Felix Salmon - links
• Ezra Klein - links
• Matthew Yglesias - links
• Free Exchange - links
• Chris Martenson - links
• Abnormal Returns - links
• Credit Writedowns - links
• New Deal 2.0 - links
• The Big Picture - links
• Macro and Other Market Musings - links
• FT Alphaville - links
• naked capitalism - links

"Economists on Trial"

This is part of an interview of heterodox economist Michael Perelman:

Michael Perelman, on Market Myths, Past and Present, by Seth Sandronsky: ...[Seth] Sandronsky The Depression of the 1930's changed the public policy views of some in the economics profession. In brief, what were the main changes, and how do they connect with the post-bubble economy of mid-2009?

Perelman The Great Depression severely tarnished economists' reputations. For example, The Economist published an article on 17 June 1933, entitled "Economists on Trial," which described a "mock-trial - not entirely mockery -" of "the economists." The trial was staged at the London School of Economics, with Robert Boothby, M.P., representing "the state of the popular mind." He accused the economists with "conspiring to spread mental fog," charging that they "were unintelligible; that they had in general proved wrong; and that in any case they all disagreed." The economists - Sir William Beveridge, Sir Arthur Salter, Professor T. E. Gregory, and Hubert Henderson - were all highly respected in the field. They answered Boothby's charges without wholly refuting them. The article concluded, "There was never a time when the advice of an expert was so often asked and so seldom followed as the present." According to the magazine, the problem was that the authorities did not listen to the economists.

At the same time, during the New Deal economists played a very prominent role. For the most part, they had not previously been among the doctrinaire defenders of laissez-faire. But keep in mind that, until the post-World War II era, the economics profession was much more diverse. A good number of progressive economists had been purged from academia, but some progressives remained. The more elite a university was, the less diversity it had. Yet, even in elite universities there was a modicum of diversity.

Although the discipline of economics became radically more conservative after World War II, during the 1970's economists who were active during the Depression tended to give me a much more sympathetic hearing, even if they had drifted considerably to the right.

Today, the makeup of the economics profession has changed dramatically. The economists who experienced the Great Depression are gone. On virtually any campus, the economics department will be among the most conservative. Dissenting views are rarely tolerated, except in liberal arts colleges. Catholic colleges also tend to be less fearful of unorthodox views.

However, the government's stimulus plans - under both Bush and Obama - have been so inept that a good number of very conservative economists have been highly critical in ways that do not entirely differ from my own.

Perhaps what is most surprising is how little influence economists have had in the policy realm. Virtually no Congressional hearings have called upon economists, whether they are conventional or radical. How much influence economists - other than Larry Summers - have had behind closed doors is an open question. ...

What Caused the Housing Bubble?

Ed Glaeser says that if people were as smart as he is, they would have realized housing price increases were unsustainable and there wouldn't have been a housing bubble:

In Housing, Even Hindsight Isn’t 20-20, by Edward L. Glaeser: ...[Is] the housing market ... starting to hit bottom? ... One major point of economics is that predicting asset prices is extremely hard... Moreover, the last seven years should make everyone wary about predicting housing price changes. ...

The housing price volatility of the last six years has been so extreme that it confounds conventional economic explanations. Over a four-year period — from February 2002 to February 2006 — the Case-Shiller index increased ... about 50 percent in constant dollars.

Certainly, those price increases cannot be explained by increases in average income. Income growth was quite modest from 2002 to 2006. Nor can the boom be explained by a dearth of new housing supply. Construction rose dramatically during the boom...

A number of pundits place the blame for the bubble on ... Alan Greenspan. They argue that loose monetary policy caused housing prices to rise. While lower interest rates are correlated with higher prices, the relationship is far too weak to explain the price explosion that America experienced. ... To get a 50 percent real increase in housing prices, real interest rates would have had to decline by more than ...10 percentage points..., which is not what happened. ... Real rates actually rose slightly between 2002 and 2006.

While low interest rates, on their own, cannot make sense of the bubble, perhaps the increased availability of credit to subprime borrowers has more explanatory power. ... Yet the correlation between housing price growth and subprime lending across markets is as likely to indicate that lenders took more risks in booming markets as that those risks caused markets to boom. ...

The most plausible explanations of the bubble require levels of irrationality that are difficult for economists either to accept or explain.

For many years, the creators of the housing index, Chip Case and Robert Shiller, have argued that housing bubbles were fueled by irrationally optimistic beliefs about future housing price appreciation. More recently, Monika Piazzesi and Martin Schneider have documented the rise in optimistic beliefs about housing price appreciation over the recent boom. Using some elegant algebra, they suggest that overly optimistic beliefs could cause a boom even if those beliefs were held by only a small share of the population.

It is hard to argue with this view. The only way that anyone could justify spending bubble-level prices in Las Vegas was by having the incorrect belief that those prices would increase.

I once thought that the Las Vegas housing market was so straightforward (vast amounts of land, no significant regulation) that no one could be deluded into thinking that prices could long diverge from construction costs, but I was wrong. I underestimated the human capacity to think rosy thoughts about the value of a house.

Yet even if ridiculously rosy beliefs are a major part of bubbles, we cannot say that we understand those bubbles until we understand the sources of such beliefs. Economists like to link beliefs to reality, but these views weren’t grounded in sound statistics. The housing boom was a great wildfire that spread from market to market, but it is hard to make sense of its flames. ...

I don't think people believed that housing prices would never, ever go down, what they thought is that housing prices would go up in real terms, on average, over time - that housing was a good long-run investment. They knew there would be variation around that trend, but they expected the variation to be relatively mild, they didn't expect the severe variation in prices and associated problems that actually occurred.

But as Shiller argues, the belief that real housing prices rise over time is false, the evidence suggests that real housing prices are relatively flat over the long-run. Because people expected prices to rise on average when they should have expected them to remain flat, the correction - the variation in prices - was far larger than anticipated and many homeowners weren't able to simply ride out the short-run variation like they thought they would be able to do.

But this still leaves a question unanswered. Why did people have this false belief about the long-run trajectory of prices? Shiller explains that this happened because people believed that both land and building materials were becoming relatively more scarce over time, a belief he says is false, but that just pushes the "but why did they believe that" question back one step from housing prices to the prices of land and raw materials.

So let me take a quick stab at an explanation (I'm not pushing this, it's just a quick thought). People are told (or were at that time) that stock markets are a great long-run investment. If you have the time to ride out the short-run fluctuations you can earn 8% per year. Just dump your money in an index fund that duplicates the market portfolio, and forget about it until many, many years later and you will do fine. Risk adjusted real returns on assets ought to equalize across markets through arbitrage, so shouldn't housing yield a real return similar to stocks (adjusting for risk)? Shouldn't there be a real return on housing just like in stock and other asset markets, and if so, doesn't that mean real prices will rise on average over time? This still requires beliefs about long-run prices at odds with (Shiller's) evidence though.

One more note. I may be wrong to assert that people thought that housing prices would rise forever. If you know that there is a bubble in an asset market, but you believe you can sell fast enough once the market hits a turning point to still make a profit, or at least not lose much in any case, then you may be willing to make an investment that tries to exploit the short-term surge in prices. But while I think that may apply to stock markets, or other markets where assets can be sold quickly (the belief that is, the reality is quite different when everybody tries to sell at once), I'm not sure this applies to housing where sales can be notoriously slow. But it's still possible that people would know there is a bubble in housing prices, but still be willing to make an investment because they believe that housing prices would fall so slowly that, if necessary, they could sell their house before taking a loss. It just doesn't seem to me that this explanation works as well in housing as it does in stock markets.

France is "Remarkably Effective at Deploying Funds Quickly"

The "cheese-eating surrender monkeys" say that when it comes to stimulus programs, “The country that is behind is the U.S., not France.”:

France, Unlike U.S., Is Deep Into Stimulus Projects, by Nelson D. Schwartz, NY Times: French workers normally take off much of the summer, but this month,... throngs of tourists will be jostling alongside stonemasons, restoration experts and other artisans paid by the French government’s $37 billion economic stimulus program.

Their job? Maintain in pristine condition the 800-year-old palace of more than 1,500 rooms where Napoleon bid adieu before being exiled to Elba and where Marie Antoinette enjoyed a gilded boudoir.

Besides Fontainebleau, about 50 French chateaus are to receive a facelift, including the palace of Versailles. Also receiving funds are some 75 cathedrals like Notre Dame in Paris. A museum devoted to Lalique glass is being created in Strasbourg, while Marseilles is to be the home of a new 10 million euro center for Mediterranean culture.

All told, Paris has set aside 100 million euros in stimulus funds earmarked for what the French like to call their cultural patrimony. It is a French twist on how to overcome the global downturn, spending borrowed money avidly to beautify the nation even as it also races ahead of the United States in more classic Keynesian ways: fixing potholes, upgrading railroads and pursuing other “shovel ready” projects.

“America is six months behind; it has wasted a lot of time,” said Patrick Devedjian, the minister in charge of the French relance, or stimulus. By the time Washington gets around to doling out most of its money, Mr. Devedjian sniffed, “the crisis could be over.” ...

As it turns out, France’s more centralized, state-directed economy ... is proving remarkably effective at deploying funds quickly and efficiently in bad times. ...

It is easier to find money for castles and cathedrals, of course, in a country that believes “art is equal to other investments, not secondary,” as Mr. Devedjian puts it. But the largess is driven as well by President Sarkozy’s support for more spending to combat the recession, even if it means borrowing more and running up big deficits.

That contrasts sharply with the commitment by the German chancellor, Angela Merkel, to hold down stimulus spending and move as quickly as possible to curb her government’s budget deficit.

So what about the criticism that Europe is not being as aggressive as the United States in combating the global slowdown, with only tepid stimulus packages? That’s not the way the French see it.

“You lost time with changing a president and no decisions were made in the last three months of 2008,” Mr. Devedjian jibed. “Nothing happened in January 2009, and in February, there was just a speech.”

“The country that is behind is the U.S.,” he said, “not France.”

While the scale, $37 billion versus close to $800 billion, is a bit different and probably ought to be accounted for in the comparison, there does seem to be a difference not just in the speed of deployment, but also in the focus of the policy. It will be interesting to see how that difference, which seems to place somewhat more emphasis on boosting employment and aggregate demand immediately than on long-run growth in France as compared to the U.S., translates into a differential response to the fiscal policy boosts in the two countries.

"U.S. Revives Section 2 of the Antitrust Act"

Since I've argued that the enforcement of antitrust law hasn't been strict enough many times in the past -- "the idea that markets 'self-police'" anti-competitive behavior always seemed much more of a hope than a reality in my view of the evidence -- to me this is good news (but it's not good news to everyone). It's not just the textbook economic effects of monopoly power that are worrisome, it's also the ability of large and powerful firms to tilt regulation and legislation in their favor:

Sherman Stirs: U.S. Revives Section 2 of the Antitrust Act, by Ashby Jones. WSJ: For nearly 120 years, the Sherman Antitrust Act has been the main vehicle through which the government and private parties have regulated the so-called anticompetitive behavior of corporate America.

The act's two main sections target vastly different types of behavior, though each may result in both civil liability and criminal punishment.

Section 1 largely addresses situations involving anticompetitive behavior of two or more entities working in concert. Cases involving price-fixing and market-division arrangements are typically brought under Section 1.

Section 2 cases typically involve the behavior of one firm, acting alone. Section 2 cases generally require a private party or the government -- either the Department of Justice or the Federal Trade Commission -- to show that a firm with a significant market share has done something anticompetitive in order to increase or maintain its monopoly. Monopolies, without evidence of anticompetitve behavior, aren't necessarily illegal.

While Section 1 cases are fairly common, the bulk of the headline-grabbing antitrust cases have been under Section 2... John D. Rockefeller's Standard Oil Co. ... AT&T... Microsoft ...

Enforcement of Section 2 went largely dormant under President George W. Bush. Toward the end of his second term, the administration issued a report which codified its views on Section 2. It took the position that the marketplace, not government regulators or courts, provides the ideal check on anticompetitive business practices.

In May, Christine Varney, President Barack Obama's pick to run the Justice Department's antitrust division, repudiated the Bush administration report, squarely placing some blame for the country's economic problems on the Bush administration's laissez-faire regulatory policies.

"Americans have seen firms given room to run with the idea that markets 'self-police' and that enforcement authorities should wait for the markets to 'self-correct,' " Ms. Varney said at the time. "Ineffective government regulation, ill-considered deregulatory measures and inadequate antitrust oversight contributed to the current conditions ... we cannot sit on the sidelines any longer."

Antitrust experts weren't surprised by Monday's news that with an initial review of conduct by large U.S. telecom companies [such as AT&T and Verizon], the Justice Department had started dusting off Section 2. ..