Economist's View

"The World Needs a New Financial Architecture"

George Soros says we need a new world order.

After talking about the need for a new Bretton Woods conference to "establish new international rules, including treatment of financial institutions that are too big to fail and the role of capital controls," and the need for the IMF to "to reflect better the prevailing pecking order among states and to revise its methods of operation," he says:

World needs new financial architecture, by George Soros, Commentary, Project Syndicate: ...Reorganising the world order will need to extend beyond the financial system and involve the United Nations, especially membership of the Security Council. ...China and other developing countries ought to participate as equals. They are reluctant members of the Bretton Woods institutions, which are dominated by countries that are no longer dominant. ...

The system cannot survive in its present form, and the US has more to lose by not being in the forefront of reforming it. The US is still in a position to lead the world, but, without far-sighted leadership, its relative position is likely to continue to erode. It can no longer impose its will on others, as George W Bush’s administration sought to do, but it could lead a co-operative effort to involve both the developed and the developing world, thereby reestablishing American leadership in an acceptable form.

The alternative is frightening, because a declining superpower losing both political and economic dominance but still preserving military supremacy is a dangerous mix. We used to be reassured by the generalization that democratic countries seek peace. After the Bush presidency, that rule no longer holds, if it ever did.

In fact, democracy is in deep trouble in America. The financial crisis has inflicted hardship on a population that does not like to face harsh reality. President Barack Obama has deployed the “confidence multiplier” and claims to have contained the recession. But if there is a “double dip” recession, Americans will become susceptible to all kinds of fear mongering and populist demagogy.

If Obama fails, the next administration will be sorely tempted to create some diversion from troubles at home – at great peril to the world.

Obama has the right vision. He believes in international co-operation, rather than the might-is-right philosophy of the Bush-Cheney era. ...

What is lacking, however, is a general recognition that the system is broken and needs to be reinvented. ... Obama is preoccupied by many pressing problems,... reinventing the international financial system is unlikely to receive his full attention.

China’s leadership needs to be even more far-sighted than Obama is. China is replacing the American consumer as the motor of the world economy. Since it is a smaller motor, the world economy will grow slower, but China’s influence will rise very fast.

For the time being, the Chinese public is willing to subordinate its individual freedom to political stability and economic advancement. But that may not continue indefinitely – and the rest of the world will never subordinate its freedom to the prosperity of the Chinese state.

As China becomes a world leader, it must transform itself into a more open society that the rest of the world is willing to accept as a world leader. Military power relations being what they are, China has no alternative to peaceful, harmonious development. Indeed, the future of the world depends on it.

Woodford on Financial Markets

Part of an interview of Michael Woodford:

Q&A: Economist Woodford on Fed and Rate Expectations, RTE: ...Given the importance of financial stability for the wider economy, do you think financial stability should play a greater or explicit role in the Federal Reserve’s policy strategy?

Woodford: No doubt, the Fed should give greater attention to financial stability than it did in the past. One should try and set up a framework to safeguard financial stability, and it may very well be that ... central banks should play a key role. But, ideally, one would be scrutinizing the risks developing and adjust capital requirements accordingly, rather than using monetary policy to respond to these risks. You’ve got to realize that pretending you can do everything with one tool means you won’t do any of them too well.

Should the Fed be more reactive — leaning against the wind -toward sharp moves in asset prices, such as house prices and equities? Should the Fed include a broader range of asset prices in its policy strategy?

Woodford: I’m not too sympathetic of that way of putting things. Using monetary policy to prevent certain moves in asset prices wouldn’t be a terribly effective tool. And to the extent that it would be effective, it’d involve important costs for the rest of the economy. It’d be particularly bad for the Fed to be saying “we have a view on where asset prices should be, and we’re going to get them there by using monetary policy.” Instead, the focus of the Fed’s investigation should be on what kind of risks financial institutions get themselves into — not on asset prices as such.

The Fed has downgraded the role of money and credit aggregates in its policy strategy. Given the more recent developments, do you think it’s now time to reconsider, or reverse the move?

Woodford: The issue that deserves more attention is monitoring risks to financial stability and identifying possible systemic risks. Unfortunately, traditional monetary and credit statistics aren’t that closely related to the things you really ought to be measuring. For example, lending by non-bank entities has played an important role in the recent real-estate euphoria. Given the emergence of new kinds of institutions and financing arrangements, you cannot simply revert to the old statistics people used to look at decades ago. There should be more research on understanding which measures are in fact the valuable indicators.

The last section is important. Many people have said that we cannot tell when a bubble is inflating (and thus when risks are increasing), but how hard have we actually tried? Have we seriously looked at data on, to name just one element of what I have in mind, leverage cycles? Do we know how leverage cycles relate to crises, that kind of knowledge that years of hard work by a variety of researchers brings about? Some people likely know the answer to this, or at least have some idea about this, but it's not data you'll find in standard sources such as FRED. As another example, what about measures and data on the degree of financial market connectedness? This can be measured in principle, but little effort has been devoted to doing so. Even traditional measures such as P/E ratios and Q-ratios haven't received the attention they deserve.

Until we dig in and try seriously to develop new empirical measurements that can monitor and identify risks, measures intended to inform us when risks are increasing to dangerous levels, we won't know if we can identify bubbles or not. I understand that financial theory says such predictions are impossible, and this has led people to shy away from such work, but that result relies upon assumptions that may not be true. The crisis has revealed the shaky foundation those models rest upon, so it's no  longer an excuse for not trying, or, as in the past, for dismissing work along these lines as unimportant and a waste of time.

"Bernanke: Smaller Banks Not Necessarily the Answer"

Ben Bernanke does not want to lose "the economic benefit of multi-function, international (financial) firms," so he is hesitant to break large banks into smaller sized institutions. I don't have much problem with the economics, if there are efficiencies that come with bank size we should exploit them, especially if breaking up banks into smaller entities does little to reduce systemic risk but instead simply fragments the problem into many more pieces (though I'd still like to know where the minimum efficient scale is, anything larger than that is unnecessary). Obtaining resolution authority for banks in the shadow system is also very important, so I don't disagree with the emphasis on this in Bernanke's remarks.

But there seems to be the view that if they have resolution authority, higher capital requirements, etc., that will make the probability of a major breakdown small enough so that the expected benefits of size outweigh the expected costs. While I agree that obtaining resolution authority and other regulatory change is extremely important, I wouldn't bet my house, or housing and asset markets more generally, that this will eliminate the chance of a major breakdown, or make the chance small enough to justify huge, powerful, market-dominating institutions.

I would like to see more effort to measure and regulate connectedness within the system (which can be very high even with banks broken into smaller pieces) since that would add another layer of protection, the degree of leverage should come under scrutiny as well, and I would also like to see more attention to the political risks (e.g. capture of legislators and hence regulation) posed by large financial firms:

Bernanke: Smaller Banks Not Necessarily the Answer for ‘Too Big to Fail’ Dilemma, by David Wessel, WSJ: Mervyn King, governor of the Bank of England, says the solution to banks that are “too big to fail” is to have smaller banks. But Ben Bernanke, chairman of the U.S. Federal Reserve, says he isn’t convinced that’s the best answer.

Mr. Bernanke ... said he would prefer “a more subtle approach without losing the economic benefit of multi-function, international (financial) firms.” ...

Mr. Bernanke suggested alternatives such as higher capital requirements against bank trading books, higher capital for “systemically important” institutions and a congressionally created process for coping with failing big financial firms in ways other than bankruptcy or bail out.

He also expressed interest in what have been dubbed “living wills” — plans that big banks would have to maintain for winding down their operations.

The goal, Mr. Bernanke said, is to reduce “the artificial incentives for size” — including the incentive to grow large so that government bailouts are anticipated — so that financial firms instead grow to a size that is economically valuable in a global economy populated by large multinational companies.

The Fed chairman did emphasize that supervisors should have the authority and willingness to tell the management of a large institution, where appropriate, that it cannot expand unless it improves its management and risk-management capabilities.

Both in answering the question and in his prepared text, Mr. Bernanke again beseeched Congress to act soon to give regulators “resolution authority” to cope with the imminent collapse of a big financial firm other than a bank, and to address other vulnerabilities in the regulatory regime exposed during the crisis.

"How Moody's Sold its Ratings -- and Sold Out Investors"

Robert Waldmann says "This McClatchy article by Kevin G Hall seems important to me." It does seem like there was "market failure in everything" when it comes to mortgage markets, from the incentives faced by the homeowner (non-recourse loans) and real estate agent ( maximize commission income) at the very first point of contact, through other points in the system such as appraisers, mortgage brokers, and bank managers.

Maybe fixing the incentive problems at each of these steps would have stopped the problem, or at least made it much less severe, but maybe not. In any case, it's clear that markets failed to self regulate at many key points, and that there are problems that need to be fixed covering the entire spectrum from the sale of higher priced, higher profit mortgage contracts to unwary homeowners when better options were available to the incentives bank managers had to maximize short-run profits and accumulate too much risk.

But the flow of toxic paper upward through the system should have had a gatekeeper of last resort, or at least a thorough checkpoint, and that was the ratings agencies. I don't think the failure of the ratings agencies, by itself, caused the financial crisis, but it was an important contributor and it's one of the things that needs to be fixed:

How Moody's sold its ratings -- and sold out investors, by Kevin G. Hall, McClatchy Newspapers: As the housing market collapsed in late 2007, Moody's Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.

A McClatchy investigation has found that Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.

Instead, Moody's promoted executives who headed its "structured finance" division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: "toxic assets."

As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren't fully aware of what went wrong at the bond rating agencies, and so they may fail to address misaligned incentives...

The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody's and its main competitors, Fitch Ratings and Standard & Poor's,... but the full extent of Moody's internal strife never has been publicly revealed.

Moody's ... disputes every allegation against it. "Moody's has rigorous standards in place to protect the integrity of ratings from commercial considerations," said Michael Adler, Moody's vice president for corporate communications... Insiders, however, say that wasn't true before the financial meltdown.

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings. ... Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by U.S. car loans, credit card debt, student loans and, especially, mortgages. ...

Nobody cared about due diligence so long as the money kept pouring in during the housing boom. ...

One Moody's executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market. Several former Moody's executives said he made subordinates fear they'd be fired if they didn't issue ratings that matched competitors' and helped preserve Moody's market share. ...

Clarkson rose to the top in August 2007, just as the subprime crisis was claiming its first victims. Soon afterward, a number of analysts and compliance officials who'd raised concerns about the soundness of the ratings process were purged and replaced with people from structured finance. ...

Another mid-level Moody's executive ... recalls being horrified by the purge. "It is just something unthinkable, putting business people in the compliance department. It's not acceptable. I was very upset, frustrated," the executive said. "I think they corrupted the compliance department." ...

Others who worked at Moody's at the time described a culture of willful ignorance in which executives knew how far lending standards had fallen and that they were giving top ratings to risky products.

"I could see it coming at the tail end of 2006, but it was too late. You knew it was just insane," said one former Moody's manager. "They certainly weren't going to do anything to mess with the revenue machine." ...[...more...]...

"Something is Wrong with Wall Street"

One element in the creation of  bubble is people's willingness to believe that this time is different. In the present case, this time was different because of financial innovation, better monetary policy, better technology to manage shocks (e.g. digital technology reducing supply bottlenecks), and so on leading to a (supposed) reduction in overall financial risk without a corresponding reduction in returns.

But this time wasn't different, it was in many ways a rerun of the dot.com bubble, and Shane Greenstein says people are finally starting to notice. In fact, according to the argument below, the effort to address problems on Wall Street has passed the "Russ Roberts test":

This just in, something is wrong with Wall Street, by Shane Greenstein [Note: original post replaced with an updated version at the author's request]:

Please forgive the irony in the title. But I just felt like expressing sarcasm because – Ha! — many professional economists have begun to notice something is wrong with Wall Street.

Better late than never, I guess.

This recent essay/podcast from Russell Roberts is a good indication that just about everyone has noticed that Wall Street has a tin ear for its public standing, which has sunk quite low due to self-serving behavior.

In case you have not noticed what Roberts has noticed, then let me remind you. Just recently the management at Goldman Sachs announced that the firm had a very profitable quarter, which, of course, resulted in very high pay for their executives.

That is where it gets interesting. Roberts points out (correctly, IMHO) that had the government not stepped in at AIG, etc., Goldman would have gone down with everyone else. Ergo, their executives should recognize that they have a connection to taxpayer money as much as any other firm, and they should, therefore, eschew blatantly selfish and observable behavior, such as paying themselves high salaries.

Russ Roberts is normally a free market economist, but in his essay he sounds like an old fashioned populist. When a firm does something to turn Russell Roberts into a populist then — perhaps — something is actually amiss with attitudes on Wall Street.

Alright, then, so what? Well, take this observation another step or two…

What Roberts did not say

Here is what Roberts did not say, so I will. Goldman displayed a tin ear by not making any gesture at the same time they announced their profitable earnings.

What do I mean by tin ear? Here is an example. They did not announce the hiring of many (otherwise) laid off workers — as sort of a political gesture to address the need to do something about the high unemployment rate around the country.

Here is another idea. Why stop with hiring a few more employees? How about making an unusually big (I mean VERY BIG) donation to a soup kitchen — once again, as a gesture to suffering of others in these hard time.

Hmmm, here is another idea. How about doing anything mildly publicly-spirited, like buying a new fire truck for the New York city Fire Department, because the whole city is having a bad budget year? Why the New York city Fire Department? Because nobody ever has anything bad to say about firefighters in most cities, and certainly not in New York City after their sacrifice during 9/11.

Heck, once you start thinking this way, it is quite easy to find a way to spend a half billion dollars in unexpectedly large profits. But if you have a tin ear for this sort of non-selfish gesture, then the thought might never have surfaced.

And now to the point of this rant…

For those of us who live in the land of high tech, these type of observations are nothing new. The self-serving and otherwise destructive behavior of some Wall Street managers is well known…

Look, I have been around the block enough to understand that sometimes financial managers have something useful to say to high tech firms. But there is also something wrong. For example, the short-termism of Wall Street managers is legendary among high tech managers who have a long term vision for their firm but are asked to deliver revenue tomorrow. The self-serving decision making of managers who give IPOs to friends is another well known behavior (and most young firms and VCs would love to eliminate it). Another common complaint concerns the unwillingness of IPO managers to change the system if it meant a loss of control. For example, remember this? Wall Street was unwilling to conduct any IPO as an auction until Google insisted — insisted! — that the old system would not apply to them.

Enough is enough. Even guys like Roberts can see that something is amiss.

Remember the dot com madness?

It is really nothing new. Really.

Back in the late 1990s — more than a decade ago — Wall Street cheered on one of the goofiest investment bubbles I have ever seen in my lifetime (and hopefully I ever will see). It was called the dot-com boom, and, frankly, it was nuts from any rational perspective.

Yes, there are lots of explanations for the boom. There was a social dimension: Plenty of observers tried to say it was nuts. They were drowned out by crazy evangelists who ignored basic finance and who argued that price earnings ratios could be way out of whack. And it sold copy: the business media loves of a sensational story, and that did not help.

But that is why adult supervision is required in high tech. The financial professionals and auditors of this country had a professional obligation to say sober things, to ask — perhaps, insist! — that revenues align with expenses, and advise investors when such alignment has little chance of appearing. And in the late 1990s, what did the professionals do? Well, it is complicated, but, suffice to say, few of them said no to the nuttiness.

Why not? Here is a good clue in an essay by Henry Blodget.

You may recall that Blodget was a wunderkindt cheer leader for dot coms. How did he get there? Basically, he made a bold call, got himself some attention, and kept making more bold calls. His bosses saw an opportunity and replaced someone else who had the good sense to point out that the promises had considerably risk. Blodgett instead went full steam ahead because — he fully admits it — he was hired to do just that.

I do not know this fellow, nor have we ever met. I have read some of his writing. As best I can tell, Blodgett actually has a pretty smart head on his shoulders. He writes well and has the capacity to make some intelligent and deep observations.

Anyway, Blodgett eventually got himself into trouble. While I understand how someone with those sort of smarts can delude themselves enough to tempt fate for a short while — he is human, after all — nonetheless, it is beyond my capacity as a psychologist to explain how someone can do it for a long time.  And he did. For several years. Until the dot com crashed, and a scandal broke, and he got banned.

There is a deeper question behind that run of several years. How did his bosses allow Blodgett to ply this trade for so long even though the wiser adults among them surely must have suspected/concluded/known that much of it was a financial charade?

The answer, of course is quite simple: they made so much money during that time. Blodgett’s bosses had no reason to change anything.

Many years later Blodgett wrote about his time in this essay. He finds many reasons for explaining his own behavior. Blodget says he did it because if he did not others would.  He did it because his bosses wanted him to do it. He did because everyone was making huge amounts of money from focusing on the short term benefits to their firm. All in all, he did it because it seemed like a good idea at the time.

In economics-speak, all those explanations add up to the following. Henry and his bosses simply ignored the consequences for the prudent investor or for the country as a whole — even though it had occurred to them that there was a chance that something might have gone wrong.

Let’s say this in general terms. Wall Street firms had no reason to internalize the issues with systemic risk — that is, they each ignored the downside to the entire system from all of them taking on too much risk, because each of them only contributed a small amount to it. Instead, each of them pursued their own selfish interests, and made out well in the short run, sacrificing system-wide long run stability.

Summing up

Those of us who live in high tech land noticed the odd behavior of Wall Street a while ago. Finally, it seems, the macroeconomics policy crowd has started to notice the same issues, and has started to argue that — perhaps — it is time to reign this in a bit. When a free market guy like Roberts notices, you know that the sensible people are finally thinking this one through.

Like I said, better late than never.

Now, on to the serious conversation: what to do about it….I am not sure what the right answers are, but limits on executive bonuses seems like a band-aid for a systemic issue. It is too much to ask a manager who makes several million dollars a year to stop gaming the system, but it might be reasonable to ask for better auditing, more transparency for investors, tighter capital requirements for firms taking risky actions, and a few others unpleasant measures that might help us all avoid these system-wide problems.

Oh yes… until then, the executives at Goldman might consider a public spirited gesture or two, such as — I dunno’ — donating a fraction of their recent profits to the New York Fire Department.

"Even guys like Roberts can see that something is amiss." So this time is different?

I want to believe that, I really do.

"The Chamber of Commerce Has It Backwards"

Simon Johnson:

The Chamber of Commerce Has It Backwards, by Simon Johnson: The US Chamber of Commerce is opposing the administration’s proposed Consumer Financial Protection Agency, on the grounds that it would hurt small business.  Their argument is that this agency will extend the dead hand of government into every small business.

For the Chamber of Commerce, government is the enemy of small business and should always and everywhere be fought to a standstill.  Chamber Senior Vice President (and former Fred Thompson campaign manager) Tom Collamore sees this as “advocacy on behalf of small businesses, job creators, and entrepreneurs”...

Somewhere, the Chamber’s senior leadership missed the plot.  What brought on the greatest financial crisis since the 1930s?  What has hurt, directly and indirectly, small business of all kinds to an unprecedented degree over the past 12 months?  What is killing small and medium-sized banks at a rate not seen in nearly 80 years?

It’s the behavior of the financial sector, particularly big banks and their close allies – by consistently mistreating consumers.  And the letter and spirit of the regulatory regime let them get away with it. ...

The state of knowledge regarding how to persuade people to buy stuff is impressive, the degree of potential manipulation for consumer preferences is simply stunning, and the “innovations” in this area are not slowing down.

The scope for taking advantage of consumers in subtle ways, or outright duping them, is probably higher for finance than for any other sector.  For fairly obvious reasons, people are more likely to misunderstand credit than, say, furniture. ...

Unscrupulous Finance has brought us down and will do it again.  Those most damaged now and in the future include small and medium-sized business owners who are trying to treat customers fairly.

The Chamber of Commerce ... small business membership should wake up to the current reality and press the Chamber hard to change its position before it is too late. ...  The Chamber of Commerce is arguing that unfettered finance is good for small business.  They are wrong.

Another case of mixing up the difference between "free markets" and markets that behave optimally:

Markets are Not Magic, by Mark Thoma: To listen to some commentators is to believe that markets are the solution to all of our problems. Health care not working? Bring in the private sector. Need to rebuild a war-torn country? Send in the private contractors. Emergency relief after earthquakes, hurricanes, and tornadoes? Wal-Mart with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats government every time. Or so we are told. But this is misplaced faith in markets. There is nothing special about markets per se - they can perform very badly in some circumstances. It is competitive markets that are magic, though even then we have to remember that markets have no concern whatsoever with equity, only efficiency, and sometimes equity can be an overriding concern.

In order to work their magical efficiency, markets need very special conditions to be present. There must be full information available to all participants. Product quality, locations and prices of alternative suppliers, every relevant piece of information must be known. Not quite sure if the wine is good or not? That's an information problem. Not sure if the used car has problems? Don't know where any gas stations are except the ones beside the freeway in a strange town? No way to monitor the quality of the building built in Iraq with U.S. aid? No way to be sure if consultants are worth the amount they are being paid? Information problems are common and they can cause substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single buyer or seller's decisions can affect the market price. For example, if a firm can affect the market price by threatening to limit supply, the market does not satisfy this condition. If, as some claim, CEOs are in such short supply that they can individually negotiate their compensation, then the market is not producing an efficient outcome. Whenever there are a small number of participants on either side of the market - suppliers or demanders - this is potentially problematic.

In order for markets to work their magic, the product must be homogeneous. That is, the product or input to production sold by all firms in the market must be perfectly substitutable so that as far as the buyer is concerned, one is as good as the other. If some buyers favor one brand over another, if CEOs are perceived to have different and unique talents, if government favors one contractor over another due to political contributions, this condition does not hold. In many cases the variety may be worth the inefficiency, not many of us would want just one style and color of shirt to be available in stores, but the inefficiency is there nonetheless.

In order for markets to work their magic there must be free entry and exit. Most people understand free entry, but free exit is sometimes less evident, so let me try to give an example. Starting a blog on Blogger or TypePad is easy. Entry is a snap and you can be up and running in no time at all. It's easy to join the competition and start supplying posts. But suppose that later you decide you want to switch to, say, TypePad from Blogger (or the other way around). That is not so easy. There is no way, at least no simple and convenient way, to export all of your old posts from Blogger and import them into TypePad, a significant barrier to exit if a large number of posts must be moved. Whenever barriers exist in markets that prevent free movement into and out of the marketplace or between firms within a market (on either side - there are sometimes barriers to purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can be no externalities, no public goods, no false market signals, no moral hazard, no principle agent problems, and, importantly, property rights must be well-defined (and I probably missed a few). In general, the incentives that the market provides must be consistent with perfect competition, or nearly so in practical applications. When the incentives present in the marketplace are inconsistent with a competitive outcome, there is no reason to expect the private sector to be efficient.

Markets don't work just because we get out of the way. When government contracts are moved to the private sector without ensuring the proper incentives are in place, there will be problems - waste, inefficiency, higher prices than needed, etc. There is nothing special about markets that guarantees that managers or owners of companies will have an incentive to use public funds in a way that maximizes the public rather than their own personal interests. It is only when market incentives direct choices to coincide with the public interest that the two sets of interests are aligned.

If there is no competition, or insufficient competition in the provision of government services by private sector firms, there is no reason to expect the market to deliver an efficient outcome, an outcome free of waste and inefficiency. Why would we think that giving a private sector firm a monopoly in the provision of a public service would yield an efficient outcome? If the projects are of sufficient scale, or require specialized knowledge so that only one or a few private sector firms are large enough or specialized enough to do the job, why would we expect an ideal outcome just because the private sector is involved? If cronyism limits the participants in the marketplace, why would we expect an outcome that maximizes the public interest?

There is nothing inherent in markets that guarantees a desirable outcome. A market can be a monopoly, a market can be perfectly competitive, a market can be lots of things. Markets with bad incentives produce bad outcomes, markets with good incentives do better.

I believe in markets as much as anyone. But the expression free markets is often misinterpreted to mean that unregulated markets are all that is required for markets to work their wonders and achieve efficient outcomes. But unregulated is not enough, there are many, many other conditions that must be present. Deregulation or privatization may even move the outcome further from the ideal competitive benchmark rather than closer to it, it depends upon the characteristics of the market in question.

For government goods and services, when incentives consistent with a competitive outcome are present, we should get government out of the way and privatize, and there are lots of circumstances where this will be appropriate. There is no reason at all for the government to produce its own pencils and pens, buying them from the private sector is more efficient so long as the bids are competitive.

When competitive conditions are not met but can be regulated, the regulations should be put in place and the private sector left to do its thing (e.g.  mandating that sellers disclose problems with a house to prevent asymmetric information or mandating that government funded projects be subject to competitive bidding and monitoring to ensure contract terms are met). There's no reason for government to do anything except ensure that the incentives to motivate competitive behavior are in place and enforced.

But rampant privatization based upon some misguided notion that markets are always best, privatization that does not proceed by first ensuring that market incentives are consistent with the public interest, doesn't do us any good. There are lots of free market advocates out there and I am with them so long as we understand that free does not mean the absence of government intervention, regulation, or oversight, even libertarians agree that governments must intervene to ensure basics like private property rights. Free means that the conditions for perfect competition are approximated as much as possible and sometimes that means the presence - rather than the absence - of government is required.

[Update: I should have added that perhaps the Chamber fully understands the difference between free markets and competitive markets, and simply wants to preserve the "freedom" to take advantage of customers.]

Can Better Logistics Ease Harsh Labor Market Conditions in Developing Countires?

This argues that better workflow logistics can be an effective means of alleviating harsh working conditions:

Saving labor, by Peter Dizikes, MIT News Office: The existence of harsh labor conditions in factories around the world is a pressing moral issue. But to improve those conditions, we should regard it as a logistical issue, too.

Consider the case of ABC, a giant clothing manufacturer whose products are made in more than 30 countries, and the subject of a new study led by Richard Locke ... of the MIT Sloan School of Management. After being accused of poor labor practices in the early 1990s, Locke notes, ABC became a leader among corporations in addressing labor conditions. The firm adopted a code of conduct for all factories providing it with goods, including those owned and run by local suppliers. ABC developed a system to monitor labor conditions, and hired a large compliance staff to enforce its policies world-wide.

And yet for all of its efforts, just 24 percent of the roughly 200 factories in ABC's global supply chain met its own labor standards in 2006, as Locke and some colleagues reveal in a recently published paper based on a study of the firm's own audit data and practices. Garment workers at plants supplying ABC in the Dominican Republic were exposed to noxious chemicals and forced to work in overheated conditions, according to Locke and his co-authors; as they detail it, other laborers, from Honduras to India, were asked to work overtime shifts in excess of ABC's own established limits.

The traditional system of setting labor standards and attempting to enforce them, through periodic checks by corporate compliance officers, has not worked well enough, Locke and his colleagues conclude. ... "My original view was that the compliance system could make conditions better, if it were just better-designed or better-funded," says Locke. "In the process of research, I realized that just checking on factories and threatening them doesn't work." In this view, multinational firms cannot just diagnose factory problems and expect them to vanish, but must take the lead in changing them. ...

Basic policing of factories has "yet to deliver on its promise of sustained improvement in labor rights," the authors say, while by contrast, factory monitors who take a problem-solving approach, have created "sustained improvements in working conditions and labor rights" around the world.

The authors were able to conduct the study because ABC (a pseudonym chosen to protect its identity) allowed them to study its data on labor conditions, and granted the researchers access to numerous factories where ABC's suppliers actually make its clothes.

While evaluating the firm, Locke, Amengual, and Mangla saw with their own eyes evidence that a pragmatic, trouble-shooting mode of enforcement has rapid effects. To solve the problems of exposure to fumes overheating in the Dominican Republic, for instance, compliance officers suggested moving the relevant equipment to the edge of the building space. Ventilation improved and the problem diminished significantly.

To help the factory in Honduras, ABC persuaded its management to re-orient its machinery and workers' schedules, to better handle the short-term "rapid replenishment" orders that had led to excess overtime. The improved logistics cost the factory little financially and let it comply with ABC's standards. The MIT researchers found a similar result at a factory supplying ABC in Bangalore, India, where better workflow logistics also eliminated an overtime problem.

"We know from years of research that when you implement certain kinds of systems in the advanced industrial countries, you get better results," says Locke. But the managers of factories supplying ABC, he notes, often lack "real training or understanding of production techniques and high-performance systems."

Labor-rights advocates applaud Locke's ideas. "People have looked to codes and auditing as a way to force accountability," says Chris Jochnick, director of Private Sector Development at Oxfam America. "But Rick was one of the first people to see that the way improvement happens is probably a lot more nuanced. His work is a valuable way of looking at the problem."

As Locke notes, this logistics-based approach to factory violations is just one piece of a still larger problem; the demands global brands put on local factories must be addressed as well. And as he readily acknowledges, some practical solutions could be expensive for factories, making managers reluctant to implement them. In those cases, a hard-line approach may yet be useful. "Sometimes you do need a bit of a threat," he says. "It's that blend that seems to matter." ...

Later this month, Locke will host a conference of executives both from non-governmental organizations and athletic-wear firms — including Nike, Adidas, New Balance, Puma and Asics — to discuss ways to use this problem-solving approach. ...

Firms must have the desire to set a code of conduct that they are serious about enforcing (as opposed to using the code to gain positive publicity with no real intent of forcing firms to comply), and they must also have the means to enforce compliance. This focuses on the ability to enforce or induce compliance, but the incentive to establish the code and then make a serious attempt to change things when suppliers are in violation of the rules is another important aspect of the problem.

In a competitive marketplace where buyers do not consider the labor market conditions of suppliers when purchasing a good, and where there are no regulations preventing firms from transacting with suppliers who are in violation of minimal standards (something that would be difficult to monitor), firms will have no incentive beyond their own moral values to enforce labor market standards.

I'm sympathetic to the argument that low wage jobs in many developing countries provide opportunities that wouldn't exist otherwise, but there are bounds that shouldn't be crossed.

"How the Servant Became a Predator: Finance’s Five Fatal Flaws"

I am not as negative about banking and financial intermediation as William Black, I think intermediaries perform essential functions that, for example, pools risk across individuals, pools deposits over time (i.e. allows long-term loans with short-term deposits), pools small deposits to allow large loans, they help to overcome adverse selection and moral hazard problems by providing monitoring of loans and expertise on the ability of buyers to repay loans that individuals do not have. By providing pooling functions, solving asymmetric information problems, and so on, financial intermediaries allow productive activity to take place that wouldn't occur otherwise, and we are better off because of it.

So, for instance, on point one below that "The financial sector harms the real economy," I would state it differently. I would say that the net effect of the financial sector is unambiguously positive, without it there would be far fewer loans and a corresponding reduction in output and employment, but some parts of it have detracted from the overall good (significantly recently), and those parts do need to be fixed. But I cannot sign on to a general statement that the financial sector is harmful. Even given the large problems it has caused recently and in the past, we would not be better off if it didn't exist at all. I think this is implicit in the points made below, e.g. there is a call to return to the simple banking of the past, but we differ on the value of developments since that time. I don't see all complex financial products as bad or harmful, some provide essential functions. The trick is to weed out the bad parts, the bad incentives, etc., but save the good, and there are a lot of good parts to the system. I have been one of the stronger proponents of regulating the financial system and reining in the excesses, but it is possible to go too far:

How the Servant Became a Predator: Finance’s Five Fatal Flaws, by Bill Black: What exactly is the function of the financial sector in our society? Simply this: Its sole function is supplying capital efficiently to aid the real economy. The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

1. The financial sector harms the real economy.

Even when not in crisis, the financial sector harms the real economy. First, it is vastly too large. The finance sector is an intermediary — essentially a “middleman”. Like all middlemen, it should be as small as possible, while still being capable of accomplishing its mission. Otherwise it is inherently parasitical. Unfortunately, it is now vastly larger than necessary, dwarfing the real economy it is supposed to serve. Forty years ago, our real economy grew better with a financial sector that received one-twentieth as large a percentage of total profits (2%) than does the current financial sector (40%). The minimum measure of how much damage the bloated, grossly over-compensated finance sector causes to the real economy is this massive increase in the share of total national income wasted through the finance sector’s parasitism.

Second, the finance sector is worse than parasitic. In the title of his recent book, The Predator State, James Galbraith aptly names the problem. The financial sector functions as the sharp canines that the predator state uses to rend the nation. In addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining capital in ways that harm the real economy in order to reward already-rich financial elites harming the nation. The facts are alarming:

"So Much Happening in Washington and So Little To Show for It"

Robert Reich is not pleased with the proposals from congress for health care reform, financial regulation, environmental legislation, and job creation, all of which come up far short of what is needed, and he says lobbyists are to blame:

So Much Happening in Washington and So Little To Show for It, So Far, by Robert Reich: The Senate Finance Committee is set to vote Tuesday on a healthcare bill that just got a seal of approval from the Congressional Budget Office and is very likely to garner the vote of Republican Senator Olympia Snowe -- a twofer that gives the bill preeminence over four other healthcare bills that have emerged from House and Senate committees... Unlike those bills, though, the Senate Finance bill won't it have a public insurance option to compete with private insurers. Nor does it allow Medicare to use its bargaining power to negotiate lower drug prices, or adequately subsidize millions of middle-class families who will be required to buy health insurance that will be hard for them to afford. In short, it's a great deal for private insurers and Big Pharma but not such a great deal for middle-class Americans.

Meanwhile, the House Banking Committee is quietly circulating a draft set of reforms of financial markets... Barney Frank, who heads the Committee, is a thoughtful progressive. But the draft has gaping loopholes that will let most financial firms escape -- such as one that exempts corporations that deal in financial derivatives from any requirements for capital, business conduct, record-keeping, and reporting if they use derivatives for the purpose of "risk management," which is the very thing they all claim they're doing. Neither the draft bill, nor the Committee, nor anyone on the Hill having anything to do with financial regulation, is ... resurrecting the Glass-Steagall Act that once separated commercial from investment banking, and applying antitrust laws to the remaining five biggest Wall Street banks so none is "too big to fail."

At the same time, environmental legislation is now slinking its way through Congress..., but the bills are, frankly, far short of what's needed. ...

And what's happening on the job's front? Nothing except a blip of interest in tax credits to small businesses that create new jobs. That's not a bad move (I suggested it myself), but it's rather like bailing out the ocean with a teacup. If that's all there is, we're headed toward two years of double-digit unemployment. No one on the Hill or in the Administration is yet willing to say openly and clearly that the stimulus plan must be larger, and continued through 2010 and 2011.

My friends in the Administration and on the Hill repeatedly tell me "don't make the perfect the enemy of the better," or words to that effect. Politics is the art of the possible, blah blah blah. True. But in each of these areas -- healthcare, financial regulation, environment, and jobs -- the "better" is really not that much better. Forget perfect; anything that offered real reform would suffice for now. But in every case, what should be the centerpieces of reform are being left out.

Why? Congress is overwhelmed with corporate and Wall Street lobbyists (far too many of whom are former Democratic office holders). The White House is trying best it can to push ... in the right direction but there's too much going on, too many arenas where private interests are framing the debate and stifling major reform, and too many friends of friends and relations of relations who are making tons of money working for the other side. The public doesn't know what's going on because the national media would rather report on the sexual escapades of famous people... And progressives -- that is, progressive organizations in our nation's capital -- have been remarkably and consistently outgunned, outmaneuvered, or just plain ineffectual. This is largely due to the fact that they're sitting in Washington rather than organizing and mobilizing the rest of the country.

And I haven't even brought up Afghanistan.

Do Regulators Have Distorted Incentives?: Beatrice Weder di Mauro Roundtable at Free Exchange

I'm participating in a roundtable discussion at Free Exchange. The lead article by Beatrice Weder di Mauro argues that regulators need better incentives:

• The dog that didn't bark, by Beatrice Weder di Mauro

Here's my response:

• Prioroties at the Top, by Mark Thoma

Here are other responses:

• Devil in the details, by Charles Goodhart
• No perfect solution, by Daron Acemoglu
• The Danger of Capture, by Simon Johnson
• Remove the culpable, by Raghuram Rajan
• Better Regulators Needed, by Harvey Pitt
• Uncomfortable Institutions, by Tyler Cowen
• Not just a failure of markets, by Albert Alesina

"Why the Lehman Failure Did Change Everything"

There's a lot of revisionism going on over the consequences of the Lehman's collapse. The standard view is that allowing Lehman to fail was a mistake, and hence government intervention could have lessened the severity of the crisis. Government intervention wouldn't have avoided problems altogether, but the problems wouldn't have been as bad as what we experienced. 

However, a few people are now pushing the idea that the failure of Lehman wasn't a primary contributor to the problems that financial markets and the economy experienced. According to the revisionist view, government intervention would not have made any difference, the problems would have been just as bad either way. The notion that government intervention would not have helped is, of course, the main point that this group wishes to emphasize. However, the revisionist view does not hold up to closer examination:

Why the Lehman failure did change everything, by Richard Robb, Economists' Forum: For anyone who was engaged in the financial markets during the week of September 15, 2008, Lehman changed everything. It was obvious. So what could be more tempting to finance professors than to overturn this conventional wisdom? Descartes described the man of letters who takes more pride in his speculations “the more they are removed from common sense,” and so showing that the Lehman collapse was inconsequential has spawned a minor literature.

The latest contribution by John Cochrane and Luigi Zingales, like others before them, rests partly on misunderstanding of the data. The authors deduce that Lehman wasn’t the main cause of last autumn’s turmoil by inspecting the daily movements in the spread between Overnight Interest Rate Swaps and three-month Libor, which they define as “the rate at which banks can borrow unsecured for three months.”

But a better definition of Libor under the circumstances was “the rate at which banks said they can borrow”. Libor is the result of a survey, not a measure of actual transactions. In the week of September 15 last year, big banks refused to settle foreign exchange with each other. They were not lending interbank for three month terms, so Libor during that week tells us little.

We could say the same thing for OIS. Volume was light to nonexistent in the week of September 15 last year. What we do know is that three-month T-bills traded at 0.04 per cent on September 17, down from 1.47 per cent on Friday September 12. These are real data that ought to impress the professors that the market was breaking down as fast as it knows how.

John Taylor, the father of the Lehman-was-no-big-deal thesis, wrote in a Wall Street Journal op-ed last year that spreads between T-bills and Libor “remained in that range [of the previous year] through the rest of the week” after Lehman’s demise. In fact, in the year prior to Lehman’s collapse, the peak spread was 2.05 per cent; on September 17, 2009 it reached 3.00 per cent. (Of course, any conclusions based on Libor that week are equally unreliable.)

The other principal mistake of the Lehman deniers is their assumption that the incident unfolded entirely on September 15, 2008 and any effect had to be observable by that morning. But during the final two weeks of September, the market still had to absorb the news that the Securities and Exchange Commission had no plan for an orderly transfer of client assets in the US, while Lehman Brothers International Europe would be handed over to an administration process designed for liquidating grocery stores. ...

There is plenty of room to debate the larger counterfactual: if the government had never bailed out Bear Stearns and other too-big-to-fail firms that followed, would Lehman have mattered? If the government had never bailed out anyone at all, would we be better off? But given the bailouts that preceded the Lehman failure, the Lehman failure did in fact change everything. Sometimes things that are obvious turn out to be true.

"An Inside Look at How Goldman Sachs Lobbies the Senate"

I am not as negative toward naked short-selling as Matt Taibbi (feel free to convince me I'm wrong), but his insights into the lobbying effort against financial reform are useful, and I share his concerns about the distortions (e.g. regulatory capture) this brings to the reform process:

An Inside Look at How Goldman Sachs Lobbies the Senate, by Matt Taibbi: ...Later on this week I have a story coming out in Rolling Stone that looks at the history of the Bear Stearns and Lehman Brothers collapses. The story ends up being more about naked short-selling and the role it played in those incidents than I had originally planned..., but it turns out that there’s no way to talk about Bear and Lehman without going into the weeds of naked short-selling...

It’s the conspicuousness ... that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn’t a better example of “regulatory capture” ... than this issue.

In that vein, starting tomorrow, the SEC is holding a public “round table” on the naked short-selling issue. What’s interesting about this round table is that virtually none of the invited speakers represent shareholders or companies that might be targets of naked short-selling, or indeed any activists of any kind in favor of tougher rules against the practice. Instead, all of the invitees are either banks, financial firms, or companies that sell stuff to the first two groups.

In particular, there are very few panelists — in fact only one, from what I understand — who are in favor of a simple reform called “pre-borrowing.” Pre-borrowing is what it sounds like; it forces short-sellers to actually possess shares before they sell them.

It’s been proven to work, as last summer the SEC, concerned about predatory naked short-selling of big companies in the wake of the Bear Stearns wipeout, instituted a temporary pre-borrow requirement...

The lack of pre-borrow voices invited to this panel is analogous to the Max Baucus health care round table last spring, when no single-payer advocates were invited. So who will get to speak? Two guys from Goldman Sachs, plus reps from Citigroup, Citadel (a hedge fund that has done the occasional short sale, to put it gently), Credit Suisse, NYSE Euronext, and so on.

In advance of this panel and in advance of proposed changes to the financial regulatory system, these players have been stepping up their lobbying efforts... Goldman Sachs in particular has been making its presence felt.

Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss’s office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.

Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman’s fact sheet.

Now, the mere fact that two different congressional aides were so disgusted by Goldman’s performance that they both called me on the same day — and I don’t have a relationship with either of these people — tells you how nauseated they were.

I would later hear that Senate aides between themselves had discussed Goldman’s lobbying efforts and concluded that it was one of the most shameless performances they’d ever seen from any group of lobbyists, and that the “fact sheet” ... was, to quote one person familiar with the situation, “disgraceful” and “hilarious.” ...

"Crunch Time: The Fight to Fix the Financial System"

Simon Johnson and James Qwak wonder how much political capital the administration is willing to use to meaningfully reform the financial system:

It's Crunch Time: The Fight to Fix the Financial System Comes Down to This, by Simon Johnson and James Kwak, Commentary, Washington Post: The next couple of months will be crucial in determining the shape of the financial system for decades to come. And so far, the signs are not encouraging.

The Obama administration is trying to refocus our attention on regulation, beginning with the president's speech in New York two weeks ago. ... Barney Frank, chairman of the House Financial Services Committee, says that he still plans to pass a regulatory reform bill before the end of the year.

But in a clear indication of trouble ahead, Frank signaled his intention last week to scale back the proposed Consumer Financial Protection Agency, one of the pillars of the administration's reform proposals. ...

We have criticized the administration's reform proposals, in particular for not going far enough to address the problem of financial institutions that are "too big to fail." But we support much of what was in the original package... The question now is how hard Obama and Geithner will fight for it.

Financial regulation, like health care reform, has entered the phase where speeches and proposals matter less than arm-twisting and horse-trading on Capitol Hill. With health care, President Obama attempted to go over the heads of Congress, directly to the American people. With financial regulation, that is no longer an option, given the extent to which it has faded from public consciousness. Instead, the administration is playing on the home turf of the banking industry and its lobbyists. ... Is Obama up for this fight? ...

Elections have consequences, people used to say. This election brought in a popular Democratic president with reasonably large majorities in both houses of Congress. The financial crisis exposed the worst side of the financial services industry to the bright light of day. If we cannot get meaningful financial regulatory reform this year, we can't blame it all on the banking lobby.

The initial bill needs to be as strong as possible, and I agree that the administration needs to do what it can to prevent the bill from being scaled back. However, the initial legislation won't be as strong as I'd like even if the administration does prevail. But I hope we aren't thinking that we'll take one stab at financial reform and then we'll be done with it. Like climate change and health care, it will require a series of bills to achieve effective reform.

When You Believe in Things That You Don't Understand...

Robert Shiller defends financial innovation:

In defense of financial innovation, by Robert Shiller, Commentary, Financial Times: Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity. ... They do have a point. Unnecessary complexity can be a problem ... if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. ...

But any effort to deal with these problems has to recognize that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

The advance of civilization has brought immense new complexity to the devices we use every day. ... People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.

Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.

Why have financial products remained mostly so simple? I believe the problem is trust. ... People are ... worried about hazards of financial products or the integrity of those who offer them. ... When people invest for their children’s education or their retirement, they ... may not be able to rebound from mistaken purchases of faulty financial devices...

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. ... They must ... be open to ... complex ideas ... that have the potential to improve public welfare.

Unfortunately, the crisis has sharply reduced trust in our financial system..., people do not trust some good innovations that could protect them better. ... I have proposed ... “continuous workout mortgages”...[to] protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future. ...

Another innovation that is underused is retirement annuities... There are ... annuities that protect people against outliving their wealth,... that protect against inflation,... that protect against having problems in old age... and generational annuities that exploit the possibilities of intergenerational risk sharing. But most people do not make use of any of these.

Ideally, all of these protections for retirement income should be rolled into a unified product. Such products are not generally available yet. Certainly, people might be mistrustful of committing their life savings to such a complex new product at first even if it were available. So, such products are not offered and people often do nothing to protect themselves against most of these risks.

Behind the creation of any such new retail products there needs to be an increasingly complex financial infrastructure... It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. ... Regulatory agencies need to be given a stronger mission of encouraging innovation. ...

Something has to assure people that these product are safe before they will purchase them. We might have expected the market to regulate risk not so long ago, and trusted it to do so, but that seems like a bad bet now. An "interface with consumers that is simple enough to make [the products] comprehensible" could build trust if people could believe that the person doing the simplifying had considered and understood every possible risk that is attached to the product, but did anybody really comprehend the big picture in our most recent crisis? If there were such people, there weren't very many of them, not enough to inspire confidence and trust more generally.

Another method of building confidence is ratings agencies, but they won't be trusted again any time soon. Regulators that make the public confident that nothing can go wrong would help too, but building that kind of trust in regulators after what just happened is a tall order. Private insurance of some sort is an option, but absent some sort of government guarantee, can private insurance companies be trusted with your life savings if there is a severe financial meltdown? People have even lost faith in government's ability to insure people against medical and financial calamity in old age, so when it comes to providing financial insurance, government is not the solid, trusted institution it was not so long ago.

As you tick down the list of ways trust might be restored, you find one failure after another in terms of providing reliable information on the risks of particular financial products or strategies, and no matter what regulators or anyone else tries to do to rebuild the trust in financial institutions and products that has been lost, recent track records make it likely that this will be a long, drawn out process. Given that forgetting about such risks over time seems to be an ingredient in the development of bubbles, I'll let you decide whether that's good or bad.

"Barney Frank Talks Back"

Ezra Klein interviews Barney Frank about financial reform:

Barney Frank Talks Back, Washington Post: ...What's the most important part of financial regulation?

Limiting securitization. I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan. ...

Do you worry that the banks that are "too big to fail" have gotten even bigger?

Banks do fail. Wachovia failed. The problem is not banks but non-banks. The answer is: We will be restricting their activities. They will not be as big, as they will need much more capital. And if they do get big, they will not be so leveraged. It's not the size of the institution that's the issue, it's the amount of leverage.

Sen. Dick Durbin recently said that the big banks "frankly own the place" after they killed "cramdown" bankruptcy legislation in the Senate. Won't banks brush off financial regulation reform?

No. The big banks have been somewhat discredited. That's why the credit card bill went in pretty easily over their objections. I believe reining in derivatives and reducing leverage at high levels will be somewhat easy to do.

What killed the primary-residence bankruptcy bill [cramdown] was not the big banks but the community banks and credit unions. They do have a lot of clout. And they have a legitimate grievance: They have not been behind the abuses. If we only had community banks and credit unions, we wouldn't be in this problem. And it's important to note that they're not just powerful because they have money, but because they're in everybody's district, and they're responsible and thoughtful citizens.

So you think the big banks really have lost their power on the Hill?

Look at the credit card bill. Small banks don't do credit cards. ...

Should the administration have started on financial regulation sooner?

No! They were busy. I understand the media always wants to have bad things to say. But they were working on undoing where we were. They were working to put liquidity back. The problem was that 2008 took longer to end than we thought it would. It didn't really end till April of 2009. The early months of the Obama administration were spent trying to dig out of the hole. Let me ask you a question. What harm came from waiting?

The argument is that you won't get as much regulation because the banks are stronger now.

That's nonsense. ...

Is executive compensation a big part of the problem?

Absolutely. The problem is not just the amount. Shareholders will deal with that. It's the incentive. People had incentives to take risks because they got paid off if the risk paid off and paid no penalty if the risk blew up. They were taking risks free of the consequences of failure. Heads they won, tails they broke even. ...

You became a YouTube celebrity a few weeks ago for snapping at a town hall protester who held up a picture of Barack Obama with a Hitler moustache. You said that arguing with her would be like debating a dining room table. Why don't more of your colleagues yell back?

So the question is, you're asking me, who yelled back, why other people don't yell back? ... I don't know. Ask them.

I hope he's right, but I expect the fight will be tougher than implied above. Just about everybody has a credit card, and lowering fees on the cards, etc., is an easy sell to legislators looking to gain or maintain votes. Other proposals may not enjoy the same broad based support and appeal, especially after lobbyists and others spin the legislation as opposed to the best interests of the very people the legislation is trying to protect.

How Should Regulators be Chosen?

At CBS Money Watch:

How should regulators be chosen?, by Mark Thoma

I argue that most people do not feel like their interests are represented when policy decisions are made about regulation, bailouts, and other matters, including decisions by the Federal Reserve on setting the target interest rate, and that needs to change.

Cynics, not Whiners?

Bruce Judson says effective financial reform is essential to restoring trust in government:

Restoring Trust in Our Economic System and the Institutions of Our Democracy, by Bruce Judson: The Financial Crisis Inquiry Commission (FCIC), which started work last week, will have a significant impact on the health of our democracy. When the FCIC completes its efforts, we will either be stronger or weaker as a nation. There is no middle ground. ...

The work of the Commission is important for two reasons. First, by openly educating the public about the causes of the financial crisis it will pave the way for reform. Existing interests will inevitably resist change. Reform becomes far easier when its advocates can point to a roadmap of specific problems that must be addressed. ...

Second, America is becoming an angry nation, with diminished faith in its institutions. There is a growing sense among all but the wealthiest Americans that “the game is rigged” against them. The public perception of the work of the FCIC will inevitably affect, for better or worse, our basic level of trust in the nation’s democratic system.

Have Plans Ready Next Time

I have another post at CBS Money Watch:

Why We Need Plans To Break Up Too-Big-to-Fail Banks, by Mark Thoma

This reiterates that we need to have plans ready to dissolve systemically important financial firms. What I didn't say is that we should also do our best to prevent firms from becoming a danger to the system due to their size of connectedness.

Financial Reform: The Consolidation of Regulatory Authority

Here's something I wrote for CBS Money Watch:

Who Should Oversee the Financial System?, by Mark Thoma

I expect many of you will disagree.

Paul Krugman: Reform or Bust

The administration needs to take a more forceful approach to financial sector reform, especially reform that places limits on how executives can be paid:

Reform or Bust, by Paul Krugman, Commentary, NY Times: In the grim period that followed Lehman’s failure, it seemed inconceivable that bankers would, just a few months later, be going right back to the practices that brought the world’s financial system to the edge of collapse. ...

But now that we’ve stepped back a few paces from the brink — thanks, let’s not forget, to immense, taxpayer-financed rescue packages — the financial sector is rapidly returning to business as usual. Even as the rest of the nation continues to suffer from rising unemployment and severe hardship, Wall Street paychecks are heading back to pre-crisis levels. And the industry is deploying its political clout to block even the most minimal reforms.

The good news is that senior officials in the Obama administration and at the Federal Reserve seem to be losing patience with the industry’s selfishness. The bad news is that it’s not clear whether President Obama himself is ready, even now, to take on the bankers.

Credit where credit is due: I was delighted when Lawrence Summers ... lashed out at the campaign the U.S. Chamber of Commerce, in cooperation with financial-industry lobbyists, is running against the proposed ... agency to protect consumers against financial abuses... The chamber’s ads, declared Mr. Summers, are “the financial-regulatory equivalent of the death-panel ads...”

Yet protecting consumers from financial abuse should be only the beginning of reform. If we really want to stop Wall Street from creating another bubble,... we need to change the industry’s incentives — which means ... changing the way bankers are paid. ... In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren’t correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking...

The Federal Reserve, now awakened from its Greenspan-era slumber,... is considering ... requiring that banks “claw back” bonuses in the face of losses and link pay to long-term rather than short-term performance. ... But the industry — supported by nearly all Republicans and some Democrats — will fight bitterly against these changes. And while the administration will support some kind of compensation reform, it’s not clear whether it will fully support the Fed’s efforts.

I was startled last week when Mr. Obama ... questioned the case for limiting financial-sector pay: “Why is it,” he asked, “that we’re going to cap executive compensation for Wall Street bankers but not Silicon Valley entrepreneurs or N.F.L. football players?”

That’s an astonishing remark — and not just because the National Football League does, in fact, have pay caps. Tech firms don’t crash the whole world’s operating system when they go bankrupt; quarterbacks who make too many risky passes don’t have to be rescued with hundred-billion-dollar bailouts. Banking is a special case — and the president is surely smart enough to know that.

All I can think is that this was another example of ... Mr. Obama’s visceral reluctance to engage in anything that resembles populist rhetoric. And that’s something he needs to get over.

It’s not just that taking a populist stance on bankers’ pay is good politics — although it is: the administration has suffered more than it seems to realize from the perception that it’s giving taxpayers’ hard-earned money away to Wall Street, and it should welcome the chance to portray the G.O.P. as the party of obscene bonuses.

Equally important, in this case populism is good economics. Indeed, you can make the case that reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis... It’s time for the president to realize that sometimes populism, especially populism that makes bankers angry, is exactly what the economy needs.

Toxic Assets in the 18th Century

An example of a "toxic asset” from the past, the inconvertible bank note, that shows the need for the government to identify financial sector risks, and then provide the regulation necessary to keep the financial sector functioning normally:

Toxic assets in the 18th century, by Oren Levintal and Joseph Zeira, Vox EU: The global financial crisis has revived the old debate on optimal regulation in the money and credit markets. The current debate is centred on how to regulate highly sophisticated financial markets, yet the pros and cons are similar to those observed a few centuries ago, when paper money emerged and became the state of the art in the money market. Actually, problems of regulation appear whenever financial innovations change the ways capital markets operate. Looking at this history, e.g. the study of Davis (1896) on banking in Massachusetts, can help us understand the turbulent recent developments. In recent work, we touch on these issues by studying the evolution of paper money and its influence on economic efficiency and financial stability (Levintal and Zeira 2009).

The Response to Climate Change "Can Be Gradual—and Affordable"

When the topic of climate change legislation comes up, Republicans predictably respond with "but what about small business?," though the concerns generally extend to big business as well. Again and again we hear that any attempt to reduce carbon emissions will significantly reduce economic growth. For example, tomorrow's Wall Street Journal asks "Can Countries Cut Carbon Emissions Without Hurting Economic Growth?"

Taking the no we can't side of the debate, a side I disagree with, is Steven Hayward of the American Enterprise Institute. Taking the yes we can side is Robert Stavins of Harvard (see here too). He argues, persuasively in my opinion, that objections to climate change legislation based upon what it will do to business, small or large, and what it will do to the economic growth rate suffer from "basic errors":

Yes: The Transition Can Be Gradual—and Affordable, by Robert Stavins, WSJ [podcast of debate]: ...Critics argue that the legislation passed earlier this year by the U.S. House of Representatives—to cut U.S. emissions 80% below 2005 levels by 2050—will mean big, disruptive changes to our infrastructure and untold economic damage. But they make a couple of basic errors. For one thing, they seem to think we'd have to replace the entire infrastructure quickly, paying trillions of dollars to shift to cleaner power. They also seem to assume that we have to choose between much more expensive energy and no energy at all.

The move to greener power doesn't have to be completed immediately, and it doesn't have to be painful. ... How would this work? One way is via a combination of national and multinational cap-and-trade systems. ... The effect would be to send price signals through the market—making use of less carbon-intensive fuels more cost-competitive, providing incentives for energy efficiency and stimulating climate-friendly technological change, such as methods of capturing and storing carbon.

More Efficient

True, in the short term changing the energy mix will come at some cost, but this will hardly stop economic growth. ... Consider this: From 1990 to 2007, while world emissions rose 38%, world economic growth soared 75%—emissions per unit of economic activity fell by more than 20%.

Critics argue we can't possibly increase efficiency enough to hit the 80% goal. In a very limited sense, that's true. Efficiency improvements alone ... won't get us where we need to go by 2050. But this plan doesn't rely solely on boosting efficiency. It brings together a host of other changes,... What's more, making gradual changes means we don't have to scrap still-productive power plants...

[click here for larger version]

As for how much this will cost, the best economic analyses—including studies from the U.S. Congressional Budget Office and the U.S. Energy Information Administration—say such a policy in the U.S. would cost considerably less than 1% of gross domestic product per year in the long term, or up to $175 per household in 2020. (That's the cost of one postage stamp per household per day.)

In the end, we would be delaying 2050's expected economic output by no more than a few months. And bear in mind that previous environmental actions, such as attacking smog-forming air pollution and cutting acid rain, have consistently turned out to be much cheaper than predicted.

Critics ... challenge the price estimates the experts have set out. ... In particular, they say, developing nations won't sign onto plans for curbing emissions, for fear of losing their economic momentum. Indeed, we do need a sensible international arrangement in place..., and the economic pain will be much greater if we don't set up an international carbon market. But it can be done. ...

Road to Cooperation

For instance, the U.S. and China have been involved in intense talks about climate policy. If the two nations come together in a bilateral agreement—a real possibility—they would have much more leverage to persuade other major nations to join. From there, developing nations could be brought on board by giving them targets that reduce emissions without stifling growth. Advanced nations might agree to more-severe emissions cuts and allow developing nations to make gradual cuts in the early decades as they rise toward the world's average per-capita emissions. With the right incentives, developing countries can and will move onto less carbon-intensive growth paths.

The longer we put off serious action, the more aggressive our future efforts will need to be... For every year of delay before moving to a sustainable emissions path, the global cost of taking necessary actions increases by hundreds of billions of dollars. ... [A]cting sooner ... will lower the ultimate costs of achieving the target, because there will be more time allowed for gradual transition—which is what keeps costs down. Perhaps most important, the costs of failing to take action—the damages of climate change—would be substantially greater. ...

"The Essential Pillars of a New Climate Pact"

Sheila Olmstead and Robert Stavins argue that three essential elements must be present in the successor to the 1997 Kyoto Protocol:

The essential pillars of a new climate pact, by Sheila M. Olmstead and Robert N. Stavins, Commentary, Boston Globe: The climate change summit at the United Nations on Tuesday is aimed to build momentum for ... a successor to the 1997 Kyoto Protocol, which expires in 2012. To be successful, any feasible successor agreement must contain three essential elements: meaningful involvement by a broad set of key industrialized and developing nations; an emphasis on an extended time path of emissions targets; and ... policy approaches that work through the market, rather than against it.

Consider the need for broad participation. Industrialized countries have emitted most of the ... man-made carbon dioxide in our atmosphere, so shouldn’t they reduce emissions before developing countries are asked to contribute? While this seems to make sense, here are four reasons why the new climate agreement must engage all major emitting countries - both industrialized and developing.

First, emissions from developing countries are significant and growing rapidly. ... Second, developing countries provide the best opportunities for low-cost emissions reduction... Third,... industrialized countries may not commit to significant emissions reductions without developing country participation. Fourth, if developing countries are excluded, up to one-third of carbon emissions reductions ... may migrate to non-participating economies through international trade, reducing environmental gains...

The second pillar of a successful post-2012 climate policy is an emphasis on the long run..., and major technological change is needed to bring down the costs of reducing CO2 emissions. The economically efficient solution will involve firm but moderate short-term targets to avoid rendering large parts of the capital stock prematurely obsolete, and flexible but more stringent long-term targets.

Third, a post-2012 global climate policy must work through the market rather than against it. ... One market-based approach, known as cap-and-trade, is emerging as the preferred approach ... among industrialized countries. ...

Cap-and-trade systems can be linked directly, which requires harmonization, or indirectly by linking with a common emissions-reduction credit system; indeed, this is what appears to be emerging... Kyoto’s Clean Development Mechanism allows parties in wealthy countries to purchase emissions-reduction credits in developing countries by investing in emissions-reduction projects. These credits can be used to meet emissions commitments...

A new international climate agreement missing any of these three pillars may be too costly, and provide too little benefit, to represent a meaningful attempt to address the threat of global climate change.

"Regulating for an Independent Media"

This research says that advertising has "seriously interfered with the quality, accuracy, and breadth of content and programming in the media." The proposed solution is to ensure that there is "vigorous competition in media markets," and to provide "public funding of informative media as a public good":

Regulating for an independent media: The problems of political and commercial bias, by Matthew Ellman and Fabrizio Germano, Vox EU: There is a crisis in media and journalism, and policymakers have to tackle both political and commercial influence in the media.

A Model for Reform?

The financial reform enacted after the Great Depression didn't come without effort:

In Original Reformer, a Model, by Brady Dennis, Washington Post: The last time Washington enacted sweeping financial reform, more than 75 years ago, the catalyst was a cigar-smoking, Sicilian-born immigrant named Ferdinand Pecora.

A former New York prosecutor, Pecora was the last in a series of investigators hired to examine the causes that led to the stock market crash of 1929 for the Senate Committee on Banking and Currency. In early 1933, the newly-elected Democratic president, Franklin D. Roosevelt, gave the bulldog lawyer his blessing to dig deep into the excesses that had plunged the nation into the Great Depression.

The result was a relentless investigation, 12,000 pages of transcripts that laid bare abuses on Wall Street and failures of Washington to adequately regulate the nation's financial system. Pecora's efforts provided a basis for reforms that would alter Wall Street and maintain relative stability in the banking industry until the recent crisis. These included legislation that for the first time regulated the sale of securities and helped establish the Federal Deposit Insurance Corp. and the Securities and Exchange Commission. ... [...continue reading...] ...

The last three paragraphs of the article and the last sentence in particular give the key to making financial reform work:

... Whatever regulatory changes ultimately emerge from Congress, they alone may not be enough. In his book, Pecora -- who went on to become an SEC commissioner under its inaugural chairman, Joseph P. Kennedy Sr., and later a New York Supreme Court judge -- warned that laws themselves "are no panacea; nor are they self-executing."

On the day that Franklin Roosevelt signed the Securities Exchange Act into law in 1934, Pecora was in attendance. At one point, the president turned to Pecora and asked, "Ferd, now that I have signed this bill and it has become law, what kind of law will it be?"

"It will be a good or bad bill, Mr. President," Pecora said, "depending upon the men who administer it."

Update: Another lesson.

"Financial Rescue and Reform"

[Text]

"For All Obama's Talk of Overhaul, the US has Failed to Wind in Wall Street"

Joseph Stiglitz is not impressed with the administration's response to the financial crisis:

For all Obama's talk of overhaul, the US has failed to wind in Wall Street, by Joseph Stiglitz, Comment is Free: What went wrong? Have the right lessons been learned? Could it happen again? The anniversary of the Lehman Brothers' bankruptcy and the freezing of the credit markets that followed is an occasion for reflection. I fear that our collective response has been mistaken and inadequate – that we may just have made matters worse.

The financial sector would like us to believe that if only the Federal Reserve and the Treasury had leapt to the rescue of Lehmans all would have been fine. Sheer nonsense. Lehmans was not a cause but a consequence: a consequence of flawed lending practices, and of inadequate oversight by regulators.

"The Most important First Step is to Limit Leverage"

Update: Here is a link to the discussion (it's in the comments to the post).

I will be hosting a Firedoglake Book Salon for Robert Frank's The Economic Naturalist’s Field Guide today from 2:00 - 4:00 PST, and this column touches upon several of the topics likely to come up in the discussion (I'll add an update with a link to my opening comments when it begins, questions are encouraged and can be entered in comments at the link I'll provide):

Flaw in Free Markets: Humans, by Robert H. Frank, Commentary, NY Times: There is broad agreement that Alan Greenspan ... was wrong to have believed that market forces alone would insulate society from excessive financial risk. ...[C]ritics fault Mr. Greenspan for having overestimated the strength of competitive forces, a point he essentially conceded... But the financial crisis was not caused by a shortfall in competition..., it was fueled by competition’s growing strength.

Adam Smith’s theory of the invisible hand, which says that market forces harness self-serving behavior for the common good, assumes that markets are competitive... The invisible hand, however, requires not just strong competition but also two other preconditions. The economic models that spawned Mr. Greenspan’s former optimism simply assume those conditions, despite compelling evidence of their absence.

First, those models assume that rewards depend only on absolute performance, but ... payoffs are often tightly linked to relative performance. When a valuable new piece of information becomes available to the investment community, for example, the lion’s share of the gain goes to whoever trades on it first. For an individual firm..., it is thus completely rational to invest millions of dollars in computer systems that can execute stock trades even a few seconds faster than others. But rivals inevitably respond with similar investments. Taken together, these expenditures are wasteful in the same way that military arms races are.

A second problematic assumption of standard economic models is that people are properly attentive to all relevant costs and benefits... In fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift. ...

During the recent bubble, unregulated wealth managers created mortgage-backed securities that enabled investors to magnify their returns through financial leverage...

Many experienced analysts had warned for years that those derivative securities were vastly overpriced, but Mr. Greenspan assumed that prudent concerns about the future would prevent investors from taking foolish risks. ...

Wealth managers faced a tough choice..., many customers would desert them if they failed to offer the higher-paying, but riskier, investments. Managers also knew that if markets turned against them, penalties would be limited by the fact that almost everyone had been following the same strategy. The resulting collapse was all but inevitable.

Memories are short. Immediately after a severe flood, most people are reluctant to build on a flood plain. But land on flood plains is cheaper, and the prospect of short-term advantage quickly lures many to abandon their caution. That is why many jurisdictions adopt strict regulations against building on flood plains.

The same logic dictates regulation to limit the damage caused by financial bubbles. The ... most important first step is to limit leverage. ... Relaxed regulation and increased competition now confront investors with temptations that growing numbers of them are ill-equipped to resist.

Alan Greenspan’s erstwhile faith in the invisible hand notwithstanding, it was never reasonable to have expected market forces to protect society from the consequences of this risky behavior.

"The Wait for Financial Reform"

Alan Blinder is worried that the will to reform the financial sector is fading:

The Wait for Financial Reform, by Alan S. Blinder, Commentary, NY Times: ...We are barely emerging from the greatest financial crisis since the 1930s. From last September to March, it was downright frightening. Yet by the time Congress left town for its summer recess, financial reform appeared to be losing steam. ... Why is the pulse of reform so faint? I see five main reasons:

IT’S YESTERDAY’S PROBLEM People have an amazing capacity to forget. Our financial system is now functioning much better than it was in March or last fall. ... You can see public attention shifting elsewhere... I want to scream, “Stop!” The financial regulatory system needs fixing, and to accomplish it, Congress will have to hold a lot of feet to a lot of fires. It’s not clear that many members have the stomach for that.

LOST IN THE CROWD The problem of short attention spans has a first cousin: the overcrowded legislative agenda... There is a budget to pass, health insurance to reform, energy to cap and trade, schools to overhaul, two wars to watch over and others to avoid — and more. Amid all of this, the Treasury has sent Congress 16 pieces of financial reform legislation... What are the chances that these 16 bills will surface to the top of the legislative agenda?

THE MOTHER OF ALL LOBBIES Almost everything becomes lobbied to death in Washington. In the case of financial reform, the money at stake is mind-boggling, and one financial industry after another will go to the mat to fight any provision that might hurt it. ...

BUREAUCRATIC INFIGHTING Industry lobbyists are not the only problem. Regulatory deck chairs need to be rearranged, and various government agencies are scrambling to maintain or expand their turfs. ..The bureaucratic turf wars have grown intense...

A LACK OF FOCUS Perhaps worst of all, it’s hard to keep the public engaged in something as complex, arcane and — frankly — as boring as financial regulation. ... Today, the electorate has a vague sense that it has been ripped off and that change is needed. But the sentiment is unfocused and inchoate — with these two exceptions: People clearly want greater consumer protection and restrictions on executive pay.

By no coincidence, those are the two pieces of financial reform that seem most likely to survive the Congressional sausage grinder. Don’t get me wrong; we need both. But the two don’t constitute the entirety of reform, or even its most important parts.

I’d attach greater importance to at least three major Treasury proposals that may wind up on the cutting-room floor:

First, we need a systemic risk monitor or regulator. ... In my last column, I explained ... why the Fed should get the job.

Second, we need a new mechanism to euthanize or rehabilitate giant financial institutions whose failure could threaten the whole system. ...

Third, something serious must be done to tame — though not to destroy — the derivatives markets. ...

And there is a great deal more... So let’s get on with the job...

Here's my view on the tension between imposing regulation before the will to do so fades, and delaying to avoid upsetting already unsettled financial markets and to carefully consider the changes before putting them into place:

While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people ... arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

"What is the Future of Coal?"

Robert Stavins says there are considerable uncertainties regarding the future of coal:

What is the Future of U.S. Coal?, by Robert Stavins: ...At the center of much political attention in the United States is “the future of coal”... CO₂ emissions from coal consumption accounted for 30 percent of U.S. greenhouse gas emissions in 2005, and nearly all resulted from coal’s use in generating electricity. According to EIA forecasts, the vast majority of coal demand over the coming decades will be from existing power plants, with currently existing plants still accounting for two-thirds of total demand in 2030. Therefore, while much attention has been given to how climate policy and technological advances may affect new power plants, over the next two decades a policy that affects both existing and new coal-fired power plants would have far greater impacts than a policy that affects only new plants.

Potential climate policies can be grouped into four major categories: standards, subsidies or credit-based programs, carbon taxes, and cap-and-trade (like Waxman-Markey). The cost of retrofitting existing plants to meet CO₂ emission standards would likely be so high that standards could be imposed only on new plants..., standards would be unlikely to affect operations of existing plants. In fact, by increasing the cost of new plants, such standards can encourage generators to extend the life of existing plants. Hence, new source standards hold little promise in this domain.

Likewise, while subsidies or credit-based programs ... may displace some new coal-fired generation with other types of generation, they will have little, if any, effect on the operation of existing coal-fired power plants. And carbon taxes are opposed by the regulated community because of the additional costs they would place on private industry, and are opposed by environmentalists because of the political challenges.

This leaves cap-and-trade. Such a system would cover both new and existing emission sources, and could have a more pervasive effect on coal use than standards, subsidies, or credit-based programs. For this and other reasons, most policy attention in the United States has been focused on potential cap-and-trade systems.

Coal combustion generates the most CO₂ emissions per unit of energy. As a result, a cap-and-trade system’s effect on the cost of coal use would be significantly greater than its effect on the cost of gasoline or natural gas consumption. For example, a $100 per ton of CO₂ allowance price would increase the average cost of electricity generation from coal-fired power plants by about 400%, the average cost of electricity generation from natural gas plants by about 100%, and gasoline prices by about $1.00 per gallon.

The competitiveness of conventional coal-fired electricity generation relative to other technologies diminishes as the stringency of an emissions cap increases. Therefore, much attention is being given to opportunities to employ carbon-capture-and-storage (or CCS) technologies, which would separate carbon dioxide from other stack gases, liquify it, and store it underground for long periods of time.

Three important caveats about CCS should be considered. First, it is likely that CCS will be economically practical only for new plants, and only when CO₂ allowance prices exceed $100 per ton of CO₂ for early adopters (cost estimates have increased over the past few years, as technological and institutional challenges have become clearer). Second, there is significant uncertainty about the cost of CCS, because it has not yet been commercially demonstrated. And third, CCS significantly reduces, but does not eliminate, CO₂ emissions from coal-fired generation.

In light of the growing momentum toward a mandatory U.S. climate policy, the anticipated impacts of such policies on coal use are an important issue. But the remaining uncertainties are great. Impacts of a climate policy on coal use will depend upon the type of climate policy employed, the stringency of the policy, the future price of natural gas, the future cost and penetration of nuclear and renewable technologies, and the cost of coal-fired generation with carbon capture and storage technologies. ...

"IMF Needs to Coordinate Reform of Global System"

Barry Eichengreen says the IMF shouldn't let the crisis go to waste:

IMF needs to co-ordinate reform of global system, by Barry Eichengreen, Commentary, Project Syndicate: The International Monetary Fund (IMF) has been one of the few beneficiaries of the global economic crisis. Just two years ago, it was being downsized, and serious people were asking whether it should be closed down. Since then, there has been a renewed demand for IMF lending. Members have agreed to a tripling of its resources. It has been authorised to raise additional funds by selling its own bonds. The Fund is a beehive of activity.

But the crisis will not last forever. Meanwhile, the IMF’s critics have not gone away; they have merely fallen silent temporarily. The Fund only encourages their criticism by failing to define its role. It needs to do so while it still has the world’s sympathetic ear.

The IMF’s first role is to assist countries that, as a result of domestic policies, experience balance-of-payments crises. Their governments have no choice but to borrow from the Fund. To ... be sure that its shareholders are paid back – the Fund must demand difficult policy adjustments... The problem is that the IMF has bought into the rhetoric of its critics by agreeing to “streamline” its conditionality. ... By seeming to give ground on this point in the effort to win friends and influence people, the IMF has created unnecessary confusion.

A second role for the IMF is to act as a global reserve pool. Countries have accumulated large reserves in order to insure against shocks. This is costly for poor economies... The IMF has moved in this direction by creating a Short-Term Liquidity Facility (STLF)... But the STLF still requires a burdensome application process...

A third role for the IMF is macro-prudential supervisor... National supervisors may be reluctant to surrender this responsibility to a multilateral organisation. If so, this is shortsighted. Financial markets and institutions with global reach need a global macro-prudential regulator, not just a loosely organised college of supervisors. Or it could be that national policymakers don’t trust the IMF, given that it essentially missed the global financial crisis. If so, the Fund needs to win back their confidence.

This brings us to the IMF’s fourth role, namely using its bully pulpit to warn of risks created by large-country policies. Small countries are subject to market discipline, as any Latvian will tell you. But when large economies whose currencies are used internationally need more resources, they can just print more money. Not only do they feel less market discipline, but they are subject to less IMF discipline, since they are not compelled to borrow from the Fund.

But, as the sub-prime mortgage debacle reminds us, large countries’ policies can place the global financial system at risk. The Fund, wary of biting the hand that feeds it, has been reluctant to issue strong warnings in such instances. But if the IMF is to have a future,... [t]here can be no more mincing of words.

Finally, the IMF needs to co-ordinate reform of the international system. If, in the long run, a supra-national unit ... is to replace national currencies in international use, then the Fund will need to guide its development. ...

So far,... the ... Fund has been notable mainly for its silence. The crisis is not yet forgotten, but the window is closing. ... If the Fund does not provide a clear vision of its future by then, the opportunity will have been missed.

Bernanke and Regulation of the Financial Sector

Economics of Contempt says I gave in too easily:

Bernanke's Reappointment, by Economics of Contempt: Bernanke's reappointment seems to be the topic of the day, so I suppose I'll weigh in as well. I think Bernanke absolutely deserves a second term. He reacted early and aggressively when strains in the funding markets first appeared back in the fall of 2007, after the two Bear Stearns hedge funds failed and the ABCP market shut down, and he's kept his foot on the gas ever since.

Everyone seems to be praising Bernanke for his "creativity" in responding to the financial crisis. While the Fed's various liquidity facilities have indeed been creative, they were almost certainly designed by the New York Fed's markets desk, not Bernanke. What Bernanke deserves credit for is his willingness to use these new and decidedly non-traditional facilities without hesitation. Like Paul Krugman said, a different Fed chairman might well have balked at these new facilities. Bernanke's willingness to approve the AMLF—the most creative of the new lending facilities—probably saved the entire prime money market fund sector, which was experiencing a full-blown bank run. (The Fed pumped $122 billion into money market funds in the first 7 days of the AMLF—and bear in mind that only money funds that were experiencing specified redemption pressures were even eligible for the AMLF in the first place.)

People who, like Kevin Drum, oppose Bernanke based on his regulatory views, simply haven't been paying attention. Drum claims that Bernanke "inherited and then perpetuated weak regulation of consumer loan products, something that aggravated the housing bubble." It's true that Bernanke inherited weak regulation of mortgages, but it's simply not true that he perpetuated that weak regulation. That sounds more like what Drum thinks Bernanke probably did (if he had to guess, and without looking at the record). In reality, the Fed adopted new regulations on subprime mortgages over a year ago, and there was nothing "light touch" about them. The Fed started the process of adopting new regulations on subprime mortgages way back in 2006, and the explicit focus from the beginning was on curbing the abuses of 2004/2005.

But a Fed chairman can't just wave his magic wand and have new regulations appear in Federal Register—the rulemaking process takes time. And when it comes to something like Reg Z, which is both controversial and complex, it often takes even longer than normal. Bernanke can't be blamed for sweeping the regulatory effort under the rug either. He devoted the bulk of his semiannual Humphrey-Hawkins testimony—the most high-profile testimony a Fed chairman gives—to the need for more regulation of subprime mortgages in July 2007. (He made the case for subprime mortgage regulation again a few months later, in even longer testimony.) The Board of Governors approved the final rule in July 2008.

Mark Thoma, who previously argued that Bernanke will be an effective regulator, actually concedes Drum's point, saying that his argument is probably "based more on hope than on evidence." Don't give up so easily, Professor Thoma! If anything, Thoma's argument is the one based on evidence, while Drum's seems to be based on a flawed memory.

[Read Barry Ritholz's post on disingenuous Bernanke bashing as well.]

Rogoff: We Need to Regulate Banks

Kenneth Rogoff warns us not to believe those who argue that the crisis was largely due to government failure, and hence that regulating the financial sector is counterproductive and unnecessary:

Why we need to regulate the banks sooner, not later, by Kenneth Rogoff, Commentary, Financial Times: When in doubt, bail it out,” is the policy mantra ... after the ... collapse of Lehman Brothers. With the global economy tentatively emerging from recession, and investors salivating over the remaining banks’ apparent return to significant profitability, some are beginning to ask: “Did we really need to suffer so much?”

Too many policymakers, investors and economists have concluded that US authorities could have engineered a smooth exit from the bubble economy if only Lehman had been bailed out. Too many now believe that any move towards greater financial regulation should be sharply circumscribed since it was the government that dropped the ball. Stifling financial innovation will only slow growth, with little benefit in terms of stemming future crises...

Certainly the US and global economy were already severely stressed at the time of Lehman’s fall, but better tactical operations by the Federal Reserve and Treasury, especially in backstopping Lehman’s derivative book, might have stemmed the panic. Indeed, with hindsight it is easy to say the authorities should have acted months earlier to force banks to raise more equity capital. The March 2008 collapse of the fifth largest investment bank, Bear Stearns, should have been an indication that urgent action was needed. Fed and Treasury officials argue that before Lehman, stronger measures were politically impossible. There had to be blood on the street to convince Congress. ...

[C]ommon sense dictates the need for stricter controls on short-term borrowing by systemically important institutions, as well as regularly monitored limits on oversized risk positions, taking into account that markets can be highly correlated in a downturn. ... There should also be more international co-ordination of financial supervision, to prevent countries using soft regulation to bid for business and to insulate regulators from political pressures.

...The view that everything would be fine if Hank Paulson, then US Treasury secretary, had simply underwritten a $50bn bail-out of Lehman is dangerously misguided. The financial system still needs fundamental reform...

I think that even if Lehman had been bailed out the economy would still have been bad, just not as bad, so either way there are substantial economic costs and a case for regulation.

"Odd WSJ Story on Vermont"

Tim Duy turns from Fed Watcher to Press Watcher. Will more regulation in mortgage markets lead to outcomes like Vermont's?:

Odd WSJ Story on Vermont, by Tim Duy: The Wall Street Journal has an odd piece on the Vermont mortgage market today. Odd in that the thesis appears to be completely unsupported by the rest of the piece. The story begins:

In plenty of other states, Andrea Todd would have been a homeowner years ago. Here, she bought just this month -- a difference that helps explain how Vermont avoided the housing bust, and shows the possible pitfalls in President Barack Obama's plan to tighten mortgage regulation…

...Vermont's strict mortgage-lending laws largely prevented the state's residents from signing the types of dubious home loans written in other markets across the country. Its 1990s legislation made mortgage lenders warn customers when their rates were relatively high, and put the brokers who arranged loans on the hook if their customers defaulted. Now, by at least one measure, the state has the lowest foreclosure rate in the U.S.

It came at a cost. The rules also kept some Vermonters like Ms. Todd from buying homes, keeping this rural corner of New England on the sidelines of the housing boom and the economic bonanza that came with it. Vermont's 10-year growth trails the national average.

The tenor of the article is that Vermont has overregulated the mortgage market preventing…wait for it…the unforgivable error of restricting loans to those who can prove an ability to repay. Worse yet, consumers receive explicit notice of high rates and brokers are held accountable:

In laws passed between 1996 and 1998, Vermont required lenders to tell consumers when their rates were substantially higher than competitors', with notices printed on "a colored sheet of paper, chartreuse or passion pink." And in what officials believe is the first state law of its kind, Vermont declared that mortgage brokers' fiduciary responsibility was to borrowers, not lenders. This left Vermont brokers partly on the hook for loans gone sour.

The insanity. The horror. Encourage personal responsibility? Hold people accountable for their behavior? Unthinkable. While of course such policies would limit defaults, the economic consequences would be disastrous:

Vermont's economy grew 60% in the 10 years ending in 2008, just behind the 63% rate nationally, according to the Commerce Department. Vermont lagged Arizona, Nevada and California over the decade but outpaced most of its New England neighbors.

That's right, Vermont's growth trails the national average by an astounding 3 percentage points over a decade. They truly missed the economic boom. Why surely Vermont would have outpaced Arizona had it not been for the stunningly tight mortgage markets. The snow didn't have anything to do with it.

Of course, homeownership rates in Vermont are dismal. A state of renters, virtual serfs in this medieval land. The author forges bravely ahead:

Vermonters didn't see the same sharp rise in home ownership that swept much of America in recent decades, which, despite the bust, buoyed economic growth. And while part of the increase in U.S. home ownership reflected excesses in lending and borrowing, some of it represented real progress in the form of more Americans achieving the cherished goal of getting -- and keeping -- a home of their own. By 2007, the percentage of owner-occupied households as a whole reached 68.1%, up from 63.9% in 1990, according to U.S. Census data. Vermont started at a higher base but saw ownership rise just 1.1 percentage points in that span, to 73.7%.

The according to the article, the "pitfalls" amount to: Informed consumers, fewer foreclosures, healthier banks, higher rates of homeownership, and virtually no impact on average growth. Those are some "pitfalls" - truly, greater consumer financial protection would spell ruin for us all.

"A Missed Opportunity on Climate Change"

In discussing proposed climate change legislation below, Greg Mankiw says:

To those who view climate change as an impending catastrophe and the distorting effects of the tax system as a mere annoyance, an imperfect bill is better than none at all. To those not fully convinced of the enormity of global warming but deeply worried about the adverse effects of high current and prospective tax rates, the bill is a step in the wrong direction.

He then goes on to say "As for me, I hope the president refuses to sign a bill that fails to auction most of the allowances..., sometimes good is not good enough" which, given his categorization of those supporting and opposing the bill, I interpret to mean that he is more worried about distortions from taxes than he is about global warming:

A Missed Opportunity on Climate Change, by N. Gregory Mankiw, Commentary, NY Times: During the presidential campaign of 2008, Barack Obama distinguished himself on the economics of climate change, speaking far more sensibly about the issue than most of his rivals. Unfortunately, now that he is president, Mr. Obama may sign a climate bill that falls far short of his aspirations. Indeed, the legislation making its way to his desk could well be worse than nothing at all. ...

The textbook solution for dealing with negative externalities is to use the tax system to align private incentives with social costs and benefits. ... A carbon tax is the remedy for climate change that wins overwhelming support among economists and policy wonks.

When he was still a candidate, Mr. Obama did not exactly endorse a carbon tax. He wanted to be elected... What Mr. Obama proposed was a cap-and-trade system for carbon, with all the allowances sold at auction. ... Such a system is tantamount to a carbon tax. The auction price of an emission right is effectively a tax on carbon. ...

So far, so good. The problem occurred as this sensible idea made the trip from the campaign trail through the legislative process. Rather than auctioning the carbon allowances, the bill that recently passed the House would give most of them away to powerful special interests.

"Reality Pricks Corn Ethanol's Bubble"

Does corn ethanol have a future? Let's hope not:

Reality Pricks Corn Ethanol's Bubble, by Doug Struck, Miller-McCune: ...Corn-based ethanol was seen as such an ideal solution for our transportation fuel that Congress leaped to write it into law. In ... 2007, Congress mandated a fivefold increase in biofuels — 42 percent of it from corn — in 15 years.

An industry quickly sprang up: Nearly 200 ethanol refineries have been built..., and an estimated 70 percent of gas sold in the United States contains at least some ethanol.

But as its limitations became clearer, the long-term future of corn ethanol has been clipped. Investors have concluded the industry can only be a niche player, engineers question the practicality of the fuel, scientists doubt its usefulness in reducing global warming, and the federal government is seeking to stop the industry's growth. ...

[T]he first real splash of cold water on ethanol fever came from the market. Last summer, the price of corn peaked above $6 a bushel, and many ethanol producers were locked into high-priced contracts for their raw material. Then the price of gasoline plummeted..., and suddenly ethanol refiners found themselves struggling to break even. As the deepening recession cut off business credit, the industry plunged into wholesale bankruptcies. ...

Even as the survivors in the industry slowly begin to emerge from last year's squeeze — gasoline prices are inching up and their input costs have eased — ethanol faces a limitation from the "blend wall," a federal rule that limits ethanol to 10 percent of gasoline.

The alcohol in ethanol burns hot and is tough on gaskets, hoses and the computers of modern cars, a danger that prompted the 10 percent limit. That rule effectively caps ethanol production... Ethanol producers are lobbying Congress hard to increase the blend wall, but automotive engineers are raising red flags. ... Congress watchers say, at best, the ethanol industry will get a slight increase in the blend wall. ...

To add to its problems, the ... EPA has proposed a rule to enforce a congressional provision in the 2007 Energy Bill, largely ignored under the Bush administration, requiring any new biofuel to be at least 20 percent lower in greenhouse gas emissions than the gasoline it replaces. The rule requires that a new fuel, including ethanol, must account for all of its far-flung carbon impact, including that of forests cut down in distant lands by farmers replacing lost food crops.

It is a startlingly bold rule ... and the industry is crying foul. ... The administration has offered corn ethanol refiners ... a grandfather clause that will exempt the existing refiners from the rule... But new corn ethanol production ... would not pass the greenhouse gas test, according to EPA calculations. ... The EPA is following a path pioneered by California that reflects accumulating research that finds corn-based ethanol is unlikely to reduce greenhouse gases. ...

The ethanol industry complains the research counting indirect costs assumes too direct a link from U.S. corn growers to land cleared by farmers in, say, Africa. ... In a bow to that argument, the administration is setting up a scientific panel to review the question..., prompting head-shaking among environmentalists. ...

But cold-eyed Wall Street already has pronounced its verdict. While the administration's grandfather clause will prop up the value of the existing ethanol plants, financiers are not putting money into any further growth of the industry.

"I think what this does is really sets a defined end to the corn era," said Sander Cohan, transportation fuels analyst at Energy Security Analysis Inc., near Boston. "There's going to be a very active market in controlling and owning the plants that are grandfathered in. Those plants are going to have an enormous premium. But you can't build any more of these old corn ethanol plants."

The ethanol industry isn't giving up:

Ethanol producers have ... regrouped and are striking back by taking a page from the EPA’s playbook.

The EPA, charged by the U.S. Congress with calculating carbon pollution from fuels, maintains that the ethanol industry is responsible for more than just the emissions generated from producing ethanol and burning it in vehicles.

Ethanolcould have another environmental impact. That is, by taking corn out of the global food supply, ethanol producers are indirectly inducing people in other places, such as the Amazon rainforest, to clear forests to plant more crops to replace the lost corn. ...

Now the ethanol industry is saying oil-based gasoline has its own indirect effects in places like Canada’s oil sands, where oil companies burn through massive amounts of energy to extract and refine gunky oil.

In a recent report, the Renewable Fuels Association, ethanol’s main industry trade group, argues that the corn-based fuel’s environmental credentials should be measured against gasoline made with that kind of oil, not with the lighter and more easily refined crude grades, which are becoming scarcer. That comparison makes ethanol look a lot greener. ...

The issue is far from settled—the EPA is waiting for public comment before making its final determination...

Corn ethanol provides an excuse to avoid conservation.

Paul Krugman: Rewarding Bad Actors

Is what’s good for Wall Street also good for America?:

Rewarding Bad Actors, by Paul Krugman, Commentary, NY Times: Americans are angry at Wall Street, and rightly so. First the financial industry plunged us into economic crisis, then it was bailed out at taxpayer expense. And now, with the economy still deeply depressed, the industry is paying itself gigantic bonuses. If you aren’t outraged, you haven’t been paying attention. ...

Consider two recent news stories. One involves ... high-speed trading: some institutions, including Goldman Sachs, have been using superfast computers to get the jump on other investors... Profits from high-frequency trading are one reason Goldman is earning record profits and likely to pay record bonuses.

On a seemingly different front,... Andrew J. Hall, who leads an arm of Citigroup that speculates on oil and other commodities ... has made a lot of money recently... Mr. Hall is owed $100 million.

What do these stories have in common?

The politically salient answer ... is that ... both ... firms ... were major recipients of federal aid. Citi has received around $45 billion...; Goldman has repaid the $10 billion it received..., but it has benefited enormously both from federal guarantees and from bailouts of other financial institutions. What are taxpayers supposed to think when these welfare cases cut nine-figure paychecks?

But suppose we grant that both Goldman and Mr. Hall are very good at what they do, and might have earned huge profits even without all that aid. Even so, what they do is bad for America.

Just to be clear: financial speculation can serve a useful purpose. It’s good, for example, that futures markets provide an incentive to stockpile heating oil before the weather gets cold...

But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.”

It’s hard to imagine a better illustration than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses... But it’s hard to see how traders who place their orders one-thirtieth of a second faster than anyone else ... improve that social function.

What about Mr. Hall? The Times report suggests that he makes money mainly by outsmarting other investors, rather than by directing resources to where they’re needed. Again, it’s hard to see the social value...

And there’s a good case that such activities are actually harmful. For example, high-frequency trading [is] ... a kind of tax on investors who lack access to ... superfast computers — which means that the money Goldman spends on those computers has a negative effect on national wealth. As ... Kenneth Arrow put it in 1973, speculation based on private information imposes a “double social loss”: it uses up resources and undermines markets. ...

And soaring incomes in the financial industry have played a large role in sharply rising income inequality.

What should be done? Last week the House passed a bill setting rules for pay packages at a wide range of financial institutions. That would be a step in the right direction. But it really should be accompanied by much broader regulation of financial practices — and, I would argue, by higher tax rates on supersized incomes.

Unfortunately, the House measure is opposed by the Obama administration, which still seems to operate on the principle that what’s good for Wall Street is good for America.

Neither the administration, nor our political system in general, is ready to face up to the fact that we’ve become a society in which the big bucks go to bad actors, a society that lavishly rewards those who make us poorer.

[See also Back to the Good Times on Wall Street: Looking at "nine large financial institutions that received substantial TARP support from the government," "the firms’ post-crisis pay policies appear to be ... even more lucrative to the firms’ employees than pre-crisis policies.]

Plain Vanilla Mortgages

Should the government mandate that lenders offer "plain vanilla" mortgage contracts as an option?:

Thaler Responds to Posner on Consumer Protection, by Paul Solman: Paul Solman: Earlier this month, I was pleased to learn that ... the University of Chicago's Richard Thaler ... had entered the rotation of the NYT's weekly "Economic Scene" column. His initial public offering, Mortgages Made Simpler, applied his gargantuan expertise in behavioral economics ... to home mortgage regulation. ...

A mere 17 days after Thaler's NYT debut, I opened the Wall St. Journal op-ed page and spotted an essay by ... Richard Posner... I was all eyes, and the headline -- Treating Financial Consumers as Consenting Adults ... intrigued me. ...

[W]hat dumbfounded me, and occasions this post, was the extent to which Posner took personal aim at Thaler and his argument. ... So I emailed Thaler to see if he had written a rejoinder. When I found that he hadn't, I invited him to do so, promising that I'd publish it. And so, here it is.

The Courage to Click

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

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

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

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

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

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

Sigh.

Sigh.

Sigh.

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

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

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

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

Jeebus save us...

The Fed as Systemic Risk Regulator?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Approaches to Reducing Systemic Risk

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

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

The Case for a Macro System Stabilizer

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

Systemically Important Institutions

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

"Two Ideas for Appraisal Reform"

These seem like reasonable ideas to me:

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

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

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

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

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

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

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

"Three Myths about the Consumer Financial Product Agency"

Elizabeth Warren responds to some of the worries about creating a Consumer Financial Product Agency:

Three Myths about the Consumer Financial Product Agency, by Elizabeth Warren: I’ve written a lot about the creation of a new Consumer Protection Financial Agency (CFPA)... Today, though, I’d like to post specifically about some of the push back that has developed on this issue.  In particular, I’d like to focus on three big myths – myths designed to protect the same status quo that triggered the economic crisis.

MYTH #1:  CFPA Will Limit Consumer Choice and Hinder Innovation

Innovative Financial Shennanigans

Isn't this special?:

Cashing In, Again, on Risky Mortgages, by Peter Goodman, NYTimes: ...Jack Soussana delivered staggering numbers of mortgages to homeowners during the real estate boom, amassing a fortune. By Mr. Soussana’s own account, his customers fared less happily. He specialized in the exotic mortgages that have proved most prone to sliding into foreclosure, leaving many now scrambling to save their homes.

Yet the dangers assailing Mr. Soussana’s clients have yielded fresh business for him: Late last year, he and his team — ensconced in the same office where they used to broker mortgages — began working for a loan modification company [called FedMod]. For fees reaching $3,495, with most of the money collected upfront, they promised to negotiate with lenders to lower payments on the now-delinquent mortgages they and their counterparts had sprinkled liberally across Southern California. ...

Despite making promises of relief to homeowners desperate to keep their homes, FedMod and other profit making loan modification firms often fail to deliver, according to a New York Times investigation...

“Our job was to get the money in and then we’re done,” said Paul Pejman, a former sales agent... He recounted his experience, he said, because “I really feel bad.”

“I had people calling me crying, and we were telling them, ‘You can pay me or you can lose your house,’ ” Mr. Pejman said. “People were giving me every dime they had, opening credit cards. But I never saw one client come out of it with a successful loan modification.” ...

FedMod is among dozens of similar companies that have been accused by state and federal authorities of fraudulent business practices. ... Many of the companies formerly operated as mortgage brokers... The three original partners brought in [a lawyer] to gain a crucial asset: his law license. Having a lawyer in charge enabled them to market their venture as a law firm and thus collect upfront payments under California rules. ...

Mr. Pejman, 22, ... had worked at three wholesale mortgage brokerages. Now, a trainer emphasized he was at a law center.

“Our big sales pitch was that an attorney could do a better job with your loan modification,” Mr. Pejman said. “If you told them these were basically washed-up people from the mortgage industry, or just people sending in paperwork, they would say, ‘Well, why bother? I might as well do this myself.’ ” He went on: “It was misleading to the client. Attorneys never touched those files.”

Among the 700-plus full-time employees who worked for FedMod this spring, only nine were lawyers...

Mr. Pejman and his fellow agents urged homeowners to send FedMod $3,495; the agents were promised a 30 percent commission for fees they took in. ... “They basically told us, ‘Do whatever you need to do,’ ” he said. “ ‘It’s a sales floor. You’re here to sell.’ People would quote success rates and just pull them out of thin air. People would say 60 percent, 80 percent, 90 percent. ...

“I’d hear people say, ‘Would you pay $1,000 to save your home? To save your marriage? Your kids’ education?’ ” he recalled. “I’d hear people say, ‘Yeah, we’re the federal government.’ There were a lot of corrupt people working there.” ...

Each case manager was responsible for as many as 200 files at a time... “You’re paying the sales agent upfront,” ... “So what motivation does he have to get it closed?” ...

See, the anti-regulation types are right. A Consumer Financial Protection Agency might stifle valuable innovation like this and prevent these companies from giving consumers the value that they pay for.

I might have that backwards.

"Why Toxic Assets Are So Hard to Clean Up"

John Taylor and Kenneth Scott argue that "sheer complexity" is at the heart of the financial crisis:

Why Toxic Assets Are So Hard to Clean Up, by Kenneth Scott and John Taylor, Commentary, WSJ: Despite trillions of dollars of new government programs, one of the original causes of the financial crisis -- the toxic assets on bank balance sheets -- still persists and remains a serious impediment to economic recovery. Why are these toxic assets so difficult to deal with? We believe their sheer complexity is the core problem and that only increased transparency will unleash the market mechanisms needed to clean them up.

The bulk of toxic assets are based on residential mortgage-backed securities (RMBS), in which thousands of mortgages were gathered into mortgage pools. The returns on these pools were then sliced into a hierarchy of "tranches" that were sold to investors as separate classes of securities. ...

But the process didn't stop there. Some of the tranches from one mortgage pool were combined with tranches from other mortgage pools, resulting in Collateralized Mortgage Obligations (CMO). Other tranches were combined with tranches from completely different types of pools, based on commercial mortgages, auto loans, student loans, credit card receivables, small business loans, and even corporate loans that had been combined into Collateralized Loan Obligations (CLO). The result was a highly heterogeneous mixture of debt securities called Collateralized Debt Obligations (CDO). The tranches of the CDOs could then be combined with other CDOs, resulting in CDO2.

Each time these tranches were mixed together with other tranches in a new pool, the securities became more complex. Assume a hypothetical CDO2 held 100 CLOs, each holding 250 corporate loans -- then we would need information on 25,000 underlying loans to determine the value of the security. But assume the CDO2 held 100 CDOs each holding 100 RMBS comprising a mere 2,000 mortgages -- the number now rises to 20 million!

Complexity is not the only problem. Many of the underlying mortgages were highly risky, involving little or no down payments and initial rates so low they could never amortize the loan. ...

With so much complexity, and uncertainty about future performance, it is not surprising that the securities are difficult to price and that trading dried up. Without market prices, valuation on the books of banks is suspect and counterparties are reluctant to deal with each other. ...

The latest disposal scheme is the Public-Private Investment Program (PPIP). ... But the pricing difficulty remains and this program too may amount to little. The fundamental problem has remained untouched: insufficient information to permit estimated prices that both buyers and sellers find credible. Why is the information so hard to obtain? ... CDOs were sold in private placements with confidentiality agreements. ...

This account makes it clear why transparency is so important. To deal with the problem, issuers of asset-backed securities should provide extensive detail in a uniform format about the composition of the original pools and their subsequent structure and performance, whether they were sold as SEC-registered offerings or private placements. By creating a centralized database with this information, the pricing process for the toxic assets becomes possible. Making such a database a reality will restart private securitization markets and will do more for the recovery of the economy than yet another redesign of administrative agency structures. ...

I am becoming convinced, after reading articles like this and from other research on this issue, that forcing these transactions through organized exchanges that monitor and mitigate counterparty risk is a good idea. Here's a discussion of the issues:

On the derivatives side, the administration had already indicated that it would push for all standardized derivatives to be traded through an organized exchange or cleared through a clearing house. ... Exchanges bring a real benefit from transparency about the pricing and volume of trades, as well as making it easier for regulators to track trading positions of major parties. In contrast, much of the trading volume in derivatives now takes place “over the counter,” between two counterparties who are not generally required to report details of the trade and who take each other’s credit risk in regard to the transaction. This credit risk is often mitigated by requiring collateral, but it is clear in retrospect that this process was not well-managed in many cases, leaving a large number of institutions very exposed to the credit risk of AIG, for example.

The major exchanges dealing in derivatives use central clearing houses that act as the counterparty to both sides. ...

It should be noted that using a clearing house does not eliminate counterparty risk altogether. The clearing house could become insolvent itself if enough of its counterparties fail to meet their obligations. This should still represent a diminution of the total credit risk in the system, since clearing houses are well-capitalized and operate in a clearly defined business..., but there could be extreme circumstances where a government rescue would be required.

The big controversy with derivatives is what to do about customized derivatives. The use of derivatives to manage risk by sophisticated corporations is pervasive. Sometimes those derivatives are significantly cheaper or more effective if they cover the exact risk rather than using one or more standard derivatives to approximate the desired protection. It would be a great shame to lose those efficiencies altogether by banishing customized derivatives, but there is also a fear that financial firms will deliberately sell slightly non-standard derivatives in order to avoid the tougher rules on standardized ones.

This is another area where the devil is in the details. The trick will be to provide incentives or requirements to use standard derivatives where possible, while leaving the ability to use customized ones where they serve a genuine need. The administration’s proposal attempts to strike this balance. It will be interesting to see what comes out the other end of the legislative process...

One solution is to subject transactions for customized derivatives (which have their uses) that cannot go through organized exchanges or clearinghouses to discouragingly strict margin and capital requirements.

"Financial Invention vs. Consumer Protection"

Robert Shiller says that while a Consumer Financial Protection Agency is a good idea, it wouldn't have prevented the housing bubble:

Financial Invention vs. Consumer Protection, by Robert J. Shiller, Commentary, NY Times: James Watt, who invented the first practical steam engine in 1765, worried that high-pressure steam could lead to major explosions. So he avoided high pressure and ended up with an inefficient engine. It wasn’t until 1799 that Richard Trevithick ... created a high-pressure engine that opened a new age of steam-powered factories, railways and ships.

That is how innovation often proceeds — by learning from errors and hazards and gradually conquering problems through devices of increasing complexity...

Our financial system has essentially exploded... We need to invent our way out..., and, eventually, we will. That invention will proceed mostly in the private sector. Yet government must play a role, because civil society demands that people’s lives and welfare be ... protected from overzealous innovators who might disregard public safety and take improper advantage of nascent technology.

The Obama administration has proposed a ... Consumer Financial Protection Agency, which would be charged with safeguarding consumers against things like abusive mortgage, auto loan or credit card contracts. The new agency is to encourage “plain vanilla” products that are simpler and easier to understand. But representatives of the financial services industry have criticized the proposal as a threat to innovation...

If a consumer agency had been set up 20 years ago, would the subprime mortgage crisis have been prevented? We don’t know, but it seems improbable. Such an agency would most likely have slowed some abusive practices... That ... would have reduced the severity of the crisis, and that is no small thing.

On the other hand, unless these regulators were extremely vanilla in approach and just said no to any innovation, or unless they had an unusually deep understanding of speculative bubbles, I think they would have allowed most of those subprime mortgages. And they probably wouldn’t have had the detailed knowledge they would have needed to halt the decline of lending standards on prime mortgages in a timely way. In all likelihood, we would still be in this financial crisis.

In short, the new agency seems a good idea, and, if it is created, it should ... support innovation and ...be staffed by people who know finance..., including some who appreciate that human behavior must be understood and factored into financial design.

But that leaves us with the deeper quandary: Our society needs financial innovation, and still seems vulnerable to ... speculative bubbles that create truly big problems. Even if they can be mitigated, periodic crises may not be preventable, at least not by banning abusive credit cards or even by throwing the bad guys in jail. ...

The effectiveness of our free enterprise system depends on allowing business people to manage the myriad risks — including the risk of asset bubbles — that impinge on their operations in the long term. And this process needs constant change and improvement.

Complexity is not in itself a bad thing. ... A laptop computer is an immensely complex instrument... Yet it can be designed well so that it seems plain vanilla to the ultimate user.

And as for steam engines, the modern turbine high-pressure versions are not plain vanilla in any sense. They are sophisticated triumphs of engineering. They help generate most of our electric power with very few accidents.

I'm not sure his example works. If a modern turbine engine fails, it doesn't threaten the broader economy. If the engines were interconnected, so interconnected that the failure of one could bring them all down (beyond a single set at a given geographical location), then they might threaten the entire economy and be more like financial innovation.

The point is, because the costs of a steam or turbine engine blowing up are mostly localized, we can allow innovation to occur with very little regulation within the private sector without too much concern. Of course, we need to make sure that, say, a steam engine blowing up in a garage doesn't harm the neighbors, or harm any employees who might be there, and we also want to protect the inventors from themselves to some extent, but since the threat from an explosion is localized, we can allow innovation to proceed in the private sector under relatively light regulation without incurring great risks.

Suppose, however, that the turbine engines were interconnected and the failure of a single engine anywhere in the system could bring the whole system down, and not just for a day or two, but for months and months, and that the loss of so much power for so long would wreck the economy. In such a case, how much trust would you be willing to place in an unregulated private sector development of a new engine type for the grid? How much complexity would you be comfortable with? How much testing would you want the engines to undergo before being allowed in use? Would the fact that they have "very few accidents" as Shiller notes be of comfort?

When the dangers are great, we need to be careful. The financial grid is interconnected in just this way, and we need to do all that we can to ensure that new innovations do not become engines of destruction yet again.

"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.

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).

"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.

"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.

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.