Economist's View

Melvyn Krauss: Don't Crucify Labor on a "Cross of Moral Hazard and No-Bailouts"

I like this, perhaps because it echoes and provides a foundation for some of the points I've been making. It's from Melvyn Krauss, a senior fellow at the Hoover Institution:

Sub-Prime Economic Theory, by Melvyn Krauss, Project Syndicate: The possibility that the European Central Bank may raise interest rates in the midst of a financial crisis recalls the great American orator William Jennings Bryan’s famous “cross of gold” speech in 1896. Referring to the international gold standard’s deflationary bias, Bryan railed: “You shall not press down upon the brow of labor a crown of thorns. You shall not crucify mankind upon a cross of gold.”

In other words, ordinary people should not be made to suffer for the foibles of policymakers enthralled by some defunct economic theory.

Today, the defunct economic theory is that a rapid shift in preferences – colorfully called a “reduced appetite for risk” – is the key reason behind the current sub-prime mortgage and financial crisis. To avoid future increases in this appetite, policymakers and pundits have focused on the so-called “moral hazard problem”: the “bad guys” must pay for their mistakes, lest they make them again.

One would have expected the modern-day William Jennings Bryan to be warning central bankers not to crucify mankind on a “cross of moral hazard and no-bailouts.” But, surprisingly, the opposite is occurring.

Test Marketing and Salesmanship: The Propaganda Battle for War with Iran

I think everyone should know that you may soon be subjected to a marketing blitz promoting war with Iran. Like the author of the post below, I don't know whether this is true or not, but "it’s worth a heads-up":

Bubbles and Traditional Economics

Greg Ip reports from the Federal Reserve conference at Jackson Hole on the tension between those who believe in bubbles and those who believe in more traditional explanations of rapid price escalation:

The Tension Between Traditional Economics and Bubbles, by Greg Ip, WSJ Economics blog:  Economists, in particular those at the Federal Reserve, are loathe to believe asset markets have become bubbles because bubbles seem inconsistent with rational investor and consumer behavior, the bedrock of economic analysis. “The notion of a speculative bubble is inherently sociological or social-psychological, and does not lend itself to study with the essential toolbag of economists,” says Yale University’s Robert Shiller in a paper presented Friday at the Federal Reserve Bank of Kansas City’s research symposium in Jackson Hole.

Mr. Shiller has made a career out of trying to incorporate irrationality, psychology and bubbles into economic thinking. His book Irrational Exuberance was a timely warning on the stock bubble. For some years he has made similar warnings about the housing market. In his new paper he cites several historic episodes in which surges in real-estate values coincided with an intensifying public belief in ever-rising prices: in U.S. houses in the 1950s, in U.S. farmland in the 1970s.

For the latest decade, he argues that because home prices have so rapidly outstripped the growth in rent and construction costs, they must be “driven largely by extravagant expectations for future price increases.”

Yet Mr. Shiller’s paper may not convince skeptics. He does marshal interesting examples of how popular obsession with real-estate prices coincides with bubbles. ... He cites surveys he and a colleague conducted in both 1988 and 2006 that found attitudes in Los Angeles about future price gains in that city were highly correlated with recent history at the time.

But it isn’t surprising that expectations of prices — whether for real estate, stocks or goods and services — are heavily influenced by the recent past. The real question is, is that expectation itself an overwhelming factor in continuing to drive prices yet higher, the essence of a bubble? Perhaps, but he presents no empirical evidence of that. To be sure, designing an economic experiment that proves how a state of mind affects economic outcomes is hard. Perhaps that simply proves Mr. Shiller’s point: proving or disproving bubbles is still, for now, beyond the ability of mainstream economics.

Jim Hamilton has more on the conference, and he can be counted as among the skeptical:

...Yale Professor Robert Shiller ... struck fiercely iconoclastic tones...:

...a significant factor in this boom was a widespread perception that houses are a great investment, and the boom psychology that helped spread such thinking. In arguing this, I will make some reliance on the emerging field of behavioral economics. This field has appeared in the last two decades as a reaction against the strong prejudice in the academic profession against those who interpret price behavior as having a psychological component....

These principles of psychology include psychological framing, representativeness heuristic, social learning, collective consciousness, attention anomalies, gambling anomalies such as myopic loss aversion, emotional contagion, and sensation seeking.

One thing I have never understood is the source of Shiller's confidence that he is able to rise above these cognitive pitfalls in a way that market participants can not. Nor does his quantitative evidence help me to understand his position any more clearly. He notes for example a 1988 survey which found that the median new homebuyer in Los Angeles expected 11% price appreciation over the next 12 months, whereas the median buyer in Milwaukee expected only 5%. Since the OFHEO house price index shows a 13.9% appreciation for Los Angeles and a 6.2% appreciation for Milwaukee during 1989, it's hard for me to see how these survey results are supposed to convince us of people's lack of rationality. I also am unsure how Shiller's concept of real estate price bubbles in "superstar" cities is to be reconciled with the fact that the problems with mortgage defaults initially proved to be most serious in rustbelt areas where there had been very little real estate price inflation. ...

"The Historical Setting of the Austrian School of Economics"

According to the Ludwig von Mises Institute website, this essay "was first published in 1969. It was one of the last pieces Mises wrote." Here's a few passages along with the table of contents and links to the full essay (I've been assigned to teach The History of Economic Thought this fall, something I haven't done for quite awhile, and I am going to try to do more on the Austrian school than I've done in the past):

FRBSF: Changing Productivity Trends

Bharat Trehan of the San Francisco Fed examines changing productivity trends:

Changing Productivity Trends, by Bharat Trehan, Economic Letter. FRBSF: As important as productivity growth is to the health of the economy, much remains to be understood about how and why its trend growth rate changes. This Economic Letter discusses some of the points of debate in the research on these issues.

Paul Krugman: Katrina All the Time

Paul Krugman says the administration may find success through its failures:

Katrina All the Time, by Paul Krugman, Commentary, NY Times: Two years ago today, Americans watched in horror as a great city drowned, and wondered what had happened to their country. Where was FEMA? Where was the National Guard? Why wasn’t the government of the world’s richest, most powerful nation coming to the aid of its own citizens?

What we mostly saw on TV was the nightmarish scene at the Superdome, but things were even worse at the New Orleans convention center, where thousands were stranded without food or water. The levees were breached Monday morning — but as late as Thursday evening, The Washington Post reported, the convention center “still had no visible government presence,” while “corpses lay out in the open among wailing babies and other refugees.”

Meanwhile, federal officials were oblivious. “We are extremely pleased with the response ... to this terrible tragedy,” declared Michael Chertoff, the secretary for Homeland Security, on Wednesday. When asked the next day about the situation at the convention center, he dismissed the reports as “a rumor” or “someone’s anecdotal version.”

Today, much of the Gulf Coast remains in ruins. Less than half the federal money set aside for rebuilding ... has actually been spent... On the other hand, generous investment tax breaks, supposedly designed to spur recovery in the disaster area, have been used to build luxury condominiums near the University of Alabama’s football stadium..., 200 miles inland.

But why should we be surprised by any of this? The Bush administration’s response to Hurricane Katrina — the mixture of neglect of those in need, obliviousness to their plight, and self-congratulation in the face of abject failure — has become standard operating procedure. These days, it’s Katrina all the time.

Consider the White House reaction to new Census data on income, poverty and health insurance. By any normal standard, this week’s report was a devastating indictment of the administration’s policies. ... What the data show ... is that 2006, while a good year for the wealthy, brought only a slight decline in the poverty rate and a modest rise in median income, with most Americans still considerably worse off than they were before President Bush took office.

Most disturbing of all, the number of Americans without health insurance jumped. ... Yet the White House ... declared that President Bush was “pleased” with the new numbers. Heckuva job, economy! ...

The question is whether any of this will change when Mr. Bush leaves office.

There’s a powerful political faction in this country that’s determined to draw exactly the wrong lesson from the Katrina debacle — namely, that the government always fails when it attempts to help people..., as if the Bush administration’s practice of appointing incompetent cronies to key positions and refusing to hold them accountable no matter how badly they perform — did I mention that Mr. Chertoff still has his job? — were the way government always works.

And I’m not sure that faction is losing the argument. The thing about conservative governance is that it can succeed by failing: when conservative politicians mess up, they foster a cynicism about government that may actually help their cause.

Future historians will, without doubt, see Katrina as a turning point. The question is whether it will be seen as the moment when America remembered the importance of good government, or the moment when neglect and obliviousness to the needs of others became the new American way.

_________________________
Previous (8/27) column: Paul Krugman: A Socialist Plot
Next (9/3) column: Paul Krugman: Snow Job in the Desert

"Cross-Country Comparisons of Inequality in Market and Disposable Income: Policy Matters"

Stephen Gordon looks at the relationship between inequality and government policy:

Cross-country comparisons of inequality in market and disposable income: Policy matters, Worthwhile Canadian Initiative: This graph is taken from a recent Luxembourg Income Study (LIS) working paper (45-page pdf):

Click on graph to enlarge

The countries are arranged in ascending order of inequality in disposable income, and  the Nordic countries take four of the top five positions. What strikes me is the extent to which this is due to government policy: the Gini coefficient for market income in Canada is the same as Denmark's, and is quite a bit lower than in Sweden. Indeed, Sweden is closer to the US than it is to any of the other Nordic countries.

A recurrent theme in discussions of the Nordic model takes the form of "That's all very well, but those policies won't work here without [insert some feature of Nordic countries here]." Libertarian types who would otherwise approve of the free market dynamism of the Nordics assert that the Nordic model can only work in small, homogeneous countries. As a general argument, I'm not convinced - but I can see why it would be hard to export the Nordic model to the US.

At the other end of the spectrum - those who would otherwise approve of Nordic levels of spending on social programs - some (eg: this commenter) point to the role of trade unions. But it's hard to conclude from this chart that union density matters much when it comes to reducing inequality. For example, look at Germany (where unions play a crucial role in setting wages) and the US (where they are decidedly less important): both have identical levels of inequality of market income. The distribution of disposable income is lower in Germany because of its redistributive policies, not because unions are more powerful.

That's not to say that cross-country institutional/cultural idiosyncrasies aren't important; they are. But there's little reason to believe that these factors have to be  changed before the Nordic model can work.

Central Bank Independence in the US and other Countries

Willem Buiter says "the US has become one of the least operationally independent of the central banks in the industrial world":

A Fed Chairman's lot is not a happy one (happy one), by Willem Buiter: Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee ... and by Hank Paulson, US Treasury Secretary, Fed Chairman Ben Bernanke looked more like a Taliban hostage than an independent central banker at his August 21 meeting in Dodd’s office. The letter from Bernanke to Senator Charles Schumer, circulated around Washington DC on Wednesday August 29, 2007, in which the Governor of the Federal Reserve offered reassurances that the Federal Reserve was “closely monitoring developments” in financial markets, and was “prepared to act” if required, reinforces the sense of a Fed leant upon and even pushed around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures...

[T]he fact that the Fed is a creature of Congress, and can be abolished or effectively amended out of existence with simple majorities in both Houses, has acted as a significant constraint on what the Fed can do and say. ...

To illustrate the difference between the degree of operational independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So the ECB just went ahead and declared that an annual inflation rate of just below but close to 2 percent per annum on the CPI index, would be compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the ... goals of monetary policy. ... Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than a weak Chairman like Alan Greenspan, but even the most independent-minded and strong-willed Fed Chairman is much more subject to political influences and constraints than the President of the ECB or the Governor of the Bank of England.

Both populism and special interest representation are key driving forces in the US Congress. Preventing large numbers of foreclosures on madcap home mortgages taken out especially since 2003, unites the forces of populism and special interest representation, although they tend to part company when it comes to who will pay the bill for the bail-out. ...

Policy rate cuts are justified if and only if the legally mandated objectives of the monetary authority require it. ... Credit crunches and liquidity crises therefore matter only to the extent that they affect these ... goals, now or in the future. Fortunately, instruments exist with which credit squeezes and liquidity crises can be addressed effectively, and without creating moral hazard (such as the MMLR at punitive prices described above) that do not involve changing the monetary policy rate.

I hope and expect that if and when the Fed perceives that real economic activity is likely to weaken materially going forward and/or that inflation is likely to undershoot its comfort zone ..., rates will be cut decisively and without delay.

I also fear and expect that, because of the relentless pressure being brought to bear on the Fed by all branches of the Federal Government (with the exception, as far as I know, of the Supreme Court), the Fed will be convinced to cut the Federal Funds target rate, probably as soon as the September meeting. I fear this could be not because this is the best way to guarantee the optimal trade-off between its three macroeconomic goals, but because this is the only way to salvage some measure of future independence for the Fed, in the face of irresistible pressure for a cut now from a lobby for a lower Federal Funds rate that includes special interests ranging from low income households unable to service their wildly inappropriate mortgages to extremely high net worth hedge fund managers facing massive losses and early retirement.

I hope I’m wrong on the last point.

Just one comment. In the US, the intent is not for the Fed to be completely politically independent, there are mechansims in place that allow various political interests be represented in the deliberations over monetary policy. Though power has been centralized over time so that some of these mechansims are now relatively weak, the set up of the system tries to ensure that banking, business, and the public interests are repersented on the monetary policy committee, that power is distributed geographically, and the structure is such that the executive branch has political influence over the chair of the Fed (e.g. four year terms). Whether or not this is the best way to set up the central bank is something to consider - I favor more independence than we have now - but the fact that there is political influence and representation is not at odds with the design of the Federal Reserve system.

links for 2007-08-31

• Effect of investment promotion on FDI inflows - vox
• Iraq ‘meets only 3 out of 18 US goals’ - FT.com
• How much will you pay to live near people like you? - EurekAlert
• Inshoring - Federal Reserve Bank of Richmond
• Investment Homes Make Up Large Proportion of Defaults - WSJ Economics Blog
• New research challenges previous knowledge about the origins of urbanization - EurekAlert
• Calculating Probabilities of Fed Rate Moves, a Primer - Economics Blog
• Time to Do the Wrong Thing - knzn
• Bush Plans Steps to Help Troubled Borrowers - New York Times
• A Tribute: Dr. Kurt Richebacher - Safehaven
• Bank Lending and Property Prices - Journal of Interest
• Cheney & Iran: Here We Go Again? - Informed Comment

Tommaso Monacelli: An Extensive But Benign Crisis?

Here's a follow-up that reinforces some of the points I have been making. I could have saved a lot of ink by simply posting this. The only comment I have is that I am not quite as certain as he is that the crisis is, and will continue to be, contained:

An extensive but benign crisis?, by Tommaso Monacelli, Vox EU: The public and (especially) the press seem to have overreacted to the current turmoil in financial markets. ... However, if it is a financial turmoil that we are facing, it is most likely to involve an “extensive/benign” scenario rather than an “intensive/malign” scenario. An extensive/benign scenario is one in which a specific and quantitatively limited type of risk ... is spread out extensively across investors and countries for risk-sharing purposes (the benign phenomenon) via the instruments of financial diversification. An intensive/malign scenario, by contrast, is one associated with a large amount of risk concentrated with some investors (possibly geographically), whose deterioration usually leads to large default losses (the malign phenomenon).

In the last twenty years, financial markets have changed dramatically... This has been synonymous with increased ability of risk diversification. ... The physical link between the primary borrower (the family seeking a mortgage) and the lender, via a plethora of instruments of financial diversification..., has weakened considerably. At the same time, technological improvements in the risk assessment process have substantially reduced monitoring costs for lenders.

In this context, the fact that lenders (loosely speaking) have been assuming an increasing amount of risk (“the subprime loans”) is a natural implication of the deepening of financial diversification. In the specifics of mortgage markets, home-ownership projects that were turned down ten years ago have now become eligible for finance. With falling monitoring costs and increased ability of diversification, financing riskier categories of borrowers can be perfectly consistent with profit maximisation by lending institutions. On the other hand, for previously constrained families, this process of financial diversification has meant a loosening of their borrowing constraints. Overall, and from the viewpoint of economic theory, it is hard to identify this as a malign phenomenon.

It is sometimes argued that, along the financial diversification chain, it may become increasingly difficult to identify where the risk exactly lies. Certainly true, yet isn’t this exactly what financial diversification is all about? ...

From a different angle, many critics have pointed out ... “excessive lending” or “excessive amount of risk” as necessary drawbacks of increased financial diversification. From the standpoint of economic theory, though, “excessive” is meaningful only if “inefficient”. In this case, one can formally identify an inefficiency if either of two phenomena arises: (i) an increased “adverse selection” and/or (ii) an increased “moral hazard” problem. Possibly, only the latter qualifies as concrete in this context.

Adverse selection and moral hazard

Isn’t it worrying that ... “nowadays nobody is denied a mortgage”, virtually any family – including the most risky ones – decides to show up in a bank and ask for a loan? Not really, to the extent that the risk associated to this borrower is priced correctly (with this being more likely as monitoring costs fall) and is diversified through the system. After all, once again, this is what financial risk-sharing is all about.

Nobody Likes Me, Everybody Hates Me...

Poor president Bush. Victor Davis Hanson is upset because nobody, but nobody likes the president, except, apparently, him. He argues that the critics have it wrong, that the president deserves some respect for his dogged pursuit of Osama Bin Laden and his followers. Is he serious? Credit for the pursuit of Bin Laden?:

The Many Enemies of George Bush, by Victor Davis Hanson, Real Clear Politics: George Bush is not a very popular fellow. ... Let's start with the hard left... They hate George Bush. ... The mainstream Democratic Party has been pretty vocal in its dislike, too. ...

However venomous this current Democrat attack machine, it is somewhat similar to what Republicans did to Bill Clinton in the 1990s. That's what rough-and-tumble two-party politics is about. Of course, there are even Bushophobes among Republicans and right-wingers.

Ultra-conservatives don't like open borders or the president's big increases in federal spending. As neo-isolationists, they don't think Iraq is worth one dead Marine. Now even mainstream Republicans are inching away...

Overseas, the president continues to get no love. ... Arab reformers aren't fans of the president, either...

Finally, there is at least one group whose hatred of Bush is more than welcome: bin Laden and his al-Qaida terrorists. ... But why ... does bin Laden hate George Bush so passionately? ... Al-Qaida terrorists no doubt hate every American president. But bin Laden's venom for feisty George Bush is special, galvanized by the president's success...

Are Bubbles Always Bad?

I'm not sure where I'm headed with this, so I am going to do something I don't usually do and just start writing. Hopefully, I'll find a point along the way. Vaguely, I want to connect "bubbles" to the invisible hand concept identified with Adam Smith, i.e. to the process that moves resources to their most efficient uses. [...continue...]

"Bernanke Breaks Greenspan Mold"

Greg Ip says that, unlike Alan Greenspan, Ben Bernanke draws a clear distinction between financial market instability and instability in the overall economy and this gives him a different approach to policy:

Bernanke Breaks Greenspan Mold Managing Crisis, Fed Chief Dulls Notion That Turmoil In Market Leads to Rate Cut, by Greg Ip, WSJ: ...Ben Bernanke ... promised to "maintain continuity with the policies and policy strategies established during the Greenspan years." But in handling his first financial crisis, Mr. Bernanke shows signs of a break with Alan Greenspan...

That shift is important in understanding why Mr. Bernanke hasn't cut the Fed's main interest rate yet, and it could alter investors' expectations of how the Bernanke Fed will function. The Fed historically has had two major economic duties. Maintaining financial stability is one. Controlling inflation while preventing recession is the other.

To Mr. Greenspan, market confidence and the economy's growth prospects were so intertwined as to make the Fed's two duties almost inseparable. He cut rates after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term Capital Management in 1998...

By contrast, Mr. Bernanke distinguishes between the central bank's two functions. So, on Aug. 17, the Fed ... action was aimed at restoring the normal functioning of disrupted credit markets, not primarily at boosting growth. The Fed, meanwhile, hasn't cut the far more economically important federal-funds rate...

To be sure, all central bankers see a link between financial and economic stability. ... But, "There's no doubt they were trying to draw a distinction between using the main tool of monetary policy, which is the federal-funds rate, and aiming the discount rate at restoring the plumbing," says Alan Blinder, a former Fed vice chairman.

To be sure, if Mr. Bernanke eventually cuts the federal-funds rate, as markets anticipate, the contrast with Mr. Greenspan will be less sharp. Mr. Bernanke will elaborate on the outlook tomorrow at the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyo. ...

Mr. Bernanke's approach to the credit crunch is, in part, an effort to undo perceptions fostered by Mr. Greenspan's rate-cutting interventions. Though successful, they drew allegations of "moral hazard" -- that is, of encouraging investors to act more recklessly because they think the Fed will protect them.

Neither Mr. Bernanke nor his closest colleagues ... believe there ever was a "Greenspan put," a reference to a contract that protects an investor from loss. Yet officials acknowledge the perception that the Fed has bailed out investors in the past. ...

Mr. Bernanke may yet have to cut rates. But the longer he waits, the more likely he can break investors of the assumption that market convulsions lead to interest-rate cuts. ...

If Bernanke has a similar emphasis in his remarks tomorrow, will expectations for a rate cut shift? As mentioned earlier, it will be interesting to see if there is any attempt to soften the widely held expectation that rates will be cut at the next meeting.

John Berry: Markets Are Normalizing, Causing Dilemma for Fed

John Berry says the Fed faces a tough decision on whether to cut the target rate:

Markets Are Normalizing, Causing Dilemma for Fed, by John M. Berry, Commentary, Bloomberg: Federal Reserve officials' decision to provide liquidity to credit markets rather than an interest- rate cut appears to be paying off.

With the Fed supplying funds to relieve the sudden cash crunch, investors have had time to begin to distinguish good credits from bad. As a result, large portions of the market have begun to normalize.

That's good news for Fed officials, because it's clear they would prefer not to lower their 5.25 percent target for the overnight lending rate. And they certainly have no intention of doing so before the Sept. 18 meeting...

The normalization process, which has a long way to go, is even occurring in the market for mortgage-backed securities. ...

The effective overnight lending rate has moved close to the 5.25 percent target after Fed injections of cash kept it well below that level for most of two weeks. Treasury bill yields, which had plunged in the middle of this month, have bounced up by more than a percentage point.

And this improvement has come against a background of lessening concern that a major U.S. financial institution might be brought down by losses related to subprime mortgages. Banks are going to take a hit on earnings, not anything more than that.

Economist Paul Ashworth of Capital Economics in London said yesterday that the Fed now faces a dilemma over what to do about the lending-rate target.

''The markets have a 25 basis point cut fully priced in for the meeting on Sept. 18 and anticipate further cuts after that,'' Ashworth said. ''But equity and credit markets have begun to normalize...

''The recovery means that the immediate need to cut the Fed funds rate has receded. If the Fed fails to deliver a rate cut, however, markets could go into a tailspin again,'' Ashworth said.

Another Tailspin? Would they? ...

Markets are likely to remain volatile regardless of the outcome of the meeting, and officials aren't going to let that fact sway their decision.

What will matter most -- ... assuming no new credit- market meltdown -- will be their assessment of how much the economic outlook has changed.

In a statement issued Aug. 17, the committee said that because of the big change in financial market conditions ''the downside risks to growth have increased appreciably.'' So already the FOMC had swung from emphasizing the risk that core inflation would not moderate as expected to worrying about slowing growth.

Among the risks, of course, are that the problems in the housing market, including falling home prices, and declining stock prices will hurt consumer spending. Consumer confidence is dropping after all.

On the other hand, employment is still rising, as are wages, and when household incomes go up, spending usually does.

Just as the earlier concern about core inflation didn't trigger a rate increase, shifting to concern about growth doesn't mean a rate cut is foreordained. ...

Nothing about the choice on Sept. 18 will be simple. Nor will be the full normalization of credit markets. ...

I still don't think the Fed will make a move contrary to expectations, and as of now a rate cut is widely expected, so it will be interesting to see if there are any signs that Ben Bernanke is trying to shift those expectations in his speech later today.

"A Rigged Report on U.S. Voting?"

Things like this are no longer surprising, though they should be. This isn't the first rigged report from this administration, and it won't be the last:

A Rigged Report on U.S. Voting?, by By Tova Andrea Wang, Commentary, Washington Post: After the 2000 Florida election debacle, Congress established ... the Election Assistance Commission to improve voting and democracy in this country. Two years ago, the commission approached me about doing a project that would take a preliminary look at voter fraud and intimidation...

Because my approach to election issues tends to be more closely aligned with Democrats, I was paired with a Republican co-author. To further remove any taint of partisanship, my co-author and I convened a bipartisan working group to help us. We spent a year doing research and consulting with leaders in the field to produce a draft report. What happened next seems inexplicable. After submitting the draft in July 2006, we were barred by the commission's staff from having anything more to do with it. ...

In all the time we were doing our research and drafting the report, neither the staff nor the commissioners, who were continually advised of our ... work, raised any concerns...

Yet, after sitting on the draft for six months, the EAC publicly released a report -- citing it as based on work by me and my co-author -- that completely stood our own work on its head.

Consider the title. Whereas the commission is mandated by law to study voter fraud and intimidation, this new report was titled simply "Election Crimes" and excluded a wide range of serious offenses that harm the system and suppress voting but are not currently crimes under the U.S. criminal code.

We said that our preliminary research found widespread agreement among ... experts from all points on the political spectrum that allegations of fraud through voter impersonation at polling places were greatly exaggerated. ... The commission chose instead to state that the issue was a matter of considerable debate. And while we found that problems of voter intimidation were still prevalent in a variety of forms, the commission excluded much of the discussion of voter intimidation.

We also raised questions about the way the Justice Department was handling complaints of fraud and intimidation. The commission excised all references to the department that might be construed as critical -- or that Justice officials later took issue with. And all of the suggestions we received from political scientists and other scholars regarding methodologies for a more scientifically rigorous look at these problems were omitted. ...

What was behind the strange handling of our report? It's still unclear, but it is worth noting that during the time the commission was holding our draft, claims about voter fraud and efforts to advance the cause of strict voter identification laws were at a fever pitch in Congress and the states. And it has been reported that some U.S. attorneys were being fired because they failed to pursue weakly supported voter fraud cases with sufficient zeal.

We have learned that several Republican officials, including a state official, a former political appointee at the Justice Department and current Federal Election Commission member (Hans Von Spakovsky), and a Capitol Hill staffer complained about our project, particularly about my role in it. Officials at Justice were actively involved in the report throughout ... and even exerted some degree of editorial control... And it is evident from the commission's "document dump" that its Republican general counsel assumed primary control over the rewriting of the report. ...

This is not the way an institution created to promote democracy should function. A government entity that seeks democratic progress should be transparent. It should not be in the business of suppressing information or ideas. Such an institution must be thoroughly insulated from political interference from outside operatives or other parts of the executive branch.

We need an institution like the Election Assistance Commission to provide guidance and research information to the states, election officials, elected leaders and voters. But this agency's structure and procedures need to be seriously reexamined in light of this episode...

links for 2007-08-30

• Poverty, Income, and Health Insurance trends in 2006 - EPI
• Active-duty US troops become outspoken critics of Iraq war - csmonitor.com
• Text of Bernanke's Letter to Schumer - WSJ Economics Blog
• Employment protection legislation: new evidence - Vox EU
• A Guide to Media Manipulation, Republican Style - The American Prospect
• Patients Turn to No-Interest Loans for Health Care - New York Times

Robert Reich: Don't Blame Ronald Reagan or Corporate Greed

Is Labor Day anything more to you than a long weekend, if it's even that? Will you be taking a moment to reflect on the "social and economic achievements of American workers"?:

What Happened to Labor Day?, by Robert Reich: ...Most young people today have no memory of a time when Walter Reuther of the UAW and John L. Lewis of the United Mine Workers were household names, ... when productivity gains pushed wages up, and when more than a third of the American workforce was unionized.

Now fewer than 8 percent of America's private sector workers are in unions, median wage gains have fallen far behind productivity gains, and for most of us Labor Day means a long weekend.

What happened? Some say it started in the early 80s after Ronald Reagan fired the nation's air-traffic controllers for striking - something they had no legal right to do - and thereby legitimized a wave of corporate union busting. Others blame it on a more pervasive "greed is good" aggressiveness that engulfed corporate suites starting right about then. ...

But don't blame Ronald Reagan or corporate greed. Blame us - you and me. You see, starting about 30 years ago and with increasing efficiency, technologies have given us consumers a world of choice - low priced goods and services that often depend on low wages here and elsewhere. ...

In other words, we as a nation have traded off lower priced goods and services, in place of a unionized workforce with the bargaining clout to get higher wages. So now, a lot of us get good consumer deals and lousy paychecks.

No one trumpeted this choice. It's happened gradually. But is it the right choice? That's what we ought to be asking ourselves -- at least once a year, on Labor Day.

"But don't blame Ronald Reagan or corporate greed." To explain the decline of unions, do we only get to choose one item from the list, or can we also cite, say, Reagan too? My choice is all of the above.

Glenn Rudebusch and John Williams: Using the Yield Curve to Forecast Recessions

The WSJ Economics blog notes this paper from the San Francisco Fed on the usefulness of the yield curve as an indicator of coming recessions. It may be more useful than we thought:

Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve, by Glenn D. Rudebusch and John C. Williams, July 2007: Abstract We show that professional forecasters have essentially no ability to predict future recessions a few quarters ahead. This is particularly puzzling because, for at least the past two decades, researchers have provided much evidence that the yield curve, specifically the spread between long- and short-term interest rates, does contain useful information at that forecast horizon for predicting aggregate economic activity and, especially, for signalling future recessions. We document this puzzle and suggest that forecasters have generally placed too little weight on yield curve information when projecting declines in the aggregate economy.

Here's more from the introduction:

1. Introduction The word "recession" conjures a variety of fears -- for workers who suffer job losses, for investors who endure asset price declines, for entrepreneurs who risk bankruptcy. Recessions are periods of greater dislocation and anxiety, higher unemployment and suicide rates, and lower output and profits. In the United States, recessions have become less frequent and less severe in the past two decades; however, non-recessionary episodes have also become more stable, so in relative terms, as the market sensitivity in the epigraph suggests, recessions appear to many to be as perilous as before. Therefore, any ability to predict recessions remains highly profitable to investors and very useful to policymakers and other economic agents. Accordingly, there remains a keen and widespread interest in predicting recessions, and our paper examines what economic forecasters know about the likely occurrence of a recession and, most importantly, when do they know it.

Alex Tabarrok: Krugman on Socialized Medicine

Alex Tabarrok brings up the health care waiting time issue once again:

Krugman on socialized medicine, by Alex Tabarrok:

Systems of actual socialized medicine, like Britain's, are actually very good at saying no: there's a limited budget, and the medical professionals who run the system set priorities. That's the reason British health care delivers results better than ours, at only 40 percent the cost — there are long waits for elective surgery, but that's because doctors think that it's not a high priority...

Krugman gets points for a mostly honest description but he is a lousy salesman. Is there any doubt that most people reading this will say "no way, not in America."?

If we look at just one statistic rather than comparing the systems overall, then we can get a distorted picture. Suppose you are in Britain, Canada, France. etc. and you are debating whether to adopt a market-driven system. Though the U.S. is far from a pure market-driven system,  something often overlooked in these discussions, when you do look at the U.S. and find out that waiting times for cosmetic surgery are longer shorter than for medically necessary care, is that the kind of market-driven priorities you want in the system?:

"Shorter Waits for Botox Than Examinations of Moles, by Natasha Singer, NY Times: Patients seeking an appointment with a dermatologist to ask about a potentially cancerous mole have to wait substantially longer than those seeking Botox for wrinkles, says a study published online today by The Journal of the American Academy of Dermatology. ...

“The difference in wait times between medical dermatology and cosmetic dermatology patients is clearly real,” said Dr. Jack S. Resneck Jr., the lead author of the study... In Boston, the median Botox wait was 13 days, versus 68 days for a mole examination. ...

Tax and Transfer Programs Reduce Poverty

Steven Pearlstein on poverty:

On Poverty, Maybe We're All Wrong, by Steven Pearlstein, Commentary, Washington Post: ...As it happens, each spring the Census Bureau gets around to computing an alternative after-tax measure of disposable income that includes ... various tax and transfer programs... This supplemental report gets little attention, but the adjustments are ... significant. In 2005, for example, they dropped the poverty rate from 12.6 percent to 10.3 percent, with the biggest improvement coming in a four-percentage-point reduction in child poverty.

At the same time, these revisions help put the lie to the right-wing conceit that government tax and transfer policies only make poverty worse. Conservatives are left to fall back on the argument that government handouts and social insurance programs, while appearing to lift some out of poverty, have created a permanent underclass by discouraging work and thrift and fostering a culture of dependence.

Much better, conservatives say, to do away with all those patronizing and inefficient social welfare schemes that create perverse incentives and "empower" the poor to act in their own best interest using the same traditional market mechanisms as everyone else.

The best refutation of this argument that I've seen in a long time is contained in a new book, "The Persistence of Poverty," by ... Charles "Buddy" Karelis ... at George Washington University. Karelis isn't an economist or social welfare expert but a philosopher... And after doing lots of reading and giving it extensive thought, Karelis concluded that the reason ... the poor are poor is that they are more likely to not finish school, not work, not save, and get hooked on drugs and alcohol and run afoul of the law. Liberals tend to blame it on history (slavery) or lack of opportunity (poor schools, discrimination), while conservatives blame government (welfare) and personal failings (lack of discipline), but both sides agree that these behaviors are so contrary to self-interest that they must be irrational.

After all, the reason we study, work, save and generally behave ourselves is that these behaviors allow us to earn more money, and more money will improve our lives. And, by logic, that must be particularly true of the poor, for whom each extra dollar to be earned or saved for a rainy day is surely more valuable than it is for, say, Bill Gates. ...

But what if this iron law of economics is wrong? What if it doesn't apply at every point along the income scale? If you and everyone around you are desperately poor, maybe it's perfectly rational to think that an extra dollar or two won't make much of a difference in reducing your misery. Or that you won't be able to "study" your way out of the ghetto. Or that if you find a $100 bill on the street, maybe it's logical to blow it on one great night on the town rather than portion it out a dollar a day for 100 days.

On the other hand, maybe the point at which people are most willing to work hard, save and play by the rules isn't when they are very poor, or very rich, but in the neighborhoods on either side of ... a motivational sweet spot that, in statistical terms, might be defined as between 50 percent ($24,000) and 200 percent ($96,000) of median household income. And if that is so, then maybe the best way to break the cycle of poverty is to raise the hopes and expectations of the poor by putting them closer to the goal line.

Admittedly, this is only a theory, supported by logic and anecdote. But if Karelis is right, it could provide a solid economic argument to replace the old moral ones for spending more money on programs like food stamps, subsidized child care and the earned income tax credit...

Do we need new arguments? I can come up with economic arguments to justify intervention as it is (e.g. market failures), so we don't have to rely on purely normative arguments. And whether the model is true or not, I don't see how it changes the morality anyway. All it does is change the shape of a function to something resembling an inverted u-shape. That is, it doesn't say the government should intervene, it only specifies the form of the intervention should the government wish to do so.

"The Lost Year"

President Bush appears confident he can continue to ignore congress:

Bush Wants $50 Billion More for Iraq War, by Thomas E. Ricks, Washington Post: President Bush plans to ask Congress next month for up to $50 billion in additional funding for the war in Iraq, a White House official said yesterday, a move that appears to reflect increasing administration confidence that it can fend off congressional calls for a rapid drawdown of U.S. forces.

The request -- which would come on top of about $460 billion in the fiscal 2008 defense budget and $147 billion in a pending supplemental bill to fund the wars in Afghanistan and Iraq -- is expected to be announced after congressional hearings scheduled for mid-September featuring the two top U.S. officials in Iraq. Army Gen. David H. Petraeus and Ambassador Ryan C. Crocker will assess the state of the war and the effect of the new strategy the U.S. military has pursued this year.

The request is being prepared now in the belief that Congress will be unlikely to balk so soon after hearing the two officials argue that there are promising developments in Iraq but that they need more time to solidify the progress they have made, a congressional aide said. ... The decision to seek about $50 billion more appears to reflect the view in the administration that the counteroffensive ... will not be shortened by Congress. ...

The revised supplemental would total about $200 billion, indicating that the cost of the war in Iraq now exceeds $3 billion a week. The bill also covers the far smaller costs of the war in Afghanistan. ...

In a speech yesterday to the convention of the American Legion in Reno, Nev., Bush gave an optimistic assessment of recent events in the war, now in its fifth year. "There are unmistakable signs that our strategy is achieving the objectives we set out," he said. "The momentum is now on our side."

Yes, Mission Nearly Accomplished -- we've heard that before. Since the administration line that "the surge is working, it just needs more time" is being reported uncritically, here's more:

The Lost Year, by Dan Froomkin, Commentary, washingtonpost.com: A new national intelligence estimate concludes that President Bush's troop surge shows no signs of accomplishing its goal of encouraging political reconciliation in Iraq. ...

These and other developments take us back in some ways to December 2006. It was then, in the wake of the November election and the report of the Iraq Study Group, that the debate in Washington finally appeared to be shifting away from how to achieve victory and toward how to cut our losses.

Instead, Bush ignored public sentiment, overruled his military commanders and opted for escalation. And now it appears that the only thing the surge has bought him is time -- nine months or maybe a year, during which he was able to postpone the inevitable.

What has that year cost America -- and Iraq? For starters, a year in Iraq translates to over 1,000 more dead American soldiers; over $100 billion more in direct appropriations; over 15,000 more dead Iraqi civilians; and countless grievous wounds and shattered families both here and there.

In light of the costs, having bought a year of time may not seem like much of an accomplishment. But if Bush can drag things out another year or so, he can wash his hands of the whole mess and leave it for his successor to deal with...

Warren P. Strobel and Leila Fadel write for McClatchy Newspapers: "A new assessment of Iraq by U.S. intelligence agencies provides little evidence that the American troop 'surge' has accomplished its goals and predicts that the U.S.-backed government of Prime Minister Nouri al-Maliki will become 'more precarious' in the months ahead.

"A declassified summary of the report released Thursday said that violence remains high, warns that U.S. alliances with former Sunni Muslim insurgents could undercut the central government and says that political compromises are 'unlikely to emerge' in the next 12 months."

Mark Mazzetti writes in the New York Times: "The assessment, known as a National Intelligence Estimate, casts strong doubts on the viability of the Bush administration strategy in Iraq. It gives a dim prognosis...

One of the main reasons for the troop surge was to allow for a political reconciliation, and that hasn't happened. So, in essence, the argument is that the strategy hasn't worked, so we need to do more of it.

links for 2007-08-29

• Map: Where Do the Nastiest Hurricanes Emerge? - Discover Magazine
• Minutes of Federal Open Market Committee, August 7, 2007
• Calls Grow for Foreigners to Have a Say on U.S. Market Rules - New York Times
• A Sobering Census Report: Bleak Findings on Health Insurance - New York Times
• The Economic Catch-22 - Robert J. Samuelson
• Japan's Warp-Speed Ride to Internet Future - washingtonpost.com

Children Left Behind

Some of you might be tired of hearing about mortgage markets, financial crises, how the Fed should react, etc., so here's something different:

New research suggests that the US incentive system built around test scores almost guarantees that academically disadvantaged children do not benefit and may actually be harmed. Policy-makers should take incentive design issues more seriously or follow the lead of many private sector firms and look for other ways to monitor and motivate teachers.

Here's the write-up of the research:

Many U.S. Children are Left Behind by Design, by Derek Neal and   Diane Whitmore Schanzenbach, Vox EU: Roughly two decades ago, education policy makers in the United States began to rely more heavily on standardized test scores as performance metrics for teachers and schools. During the late 1980s and through the 1990s, many states adopted test-based accountability systems that spelled out rewards and sanctions for teachers and principals as a function of the performance of their students on standardized tests, and when the federal government adopted the No Child Left Behind Act (NCLB) of 2001, test-based accountability became a nation-wide policy. The proponents of this development cite the need to bring "business practices" into public schools and the need to make schools "data driven" in ways that mirror the practices of private-sector companies.

Fed Intervention and Moral Hazard

Imagine living a world with no insurance, there's no health insurance, fire insurance, auto insurance, unemployment insurance, Social Security, nothing of this sort at all. As we know from countries such as China, when insurance is not widely available households tend to increase their savings, i.e. to increase their precautionary saving balances.

But in a world with insurance, consumers are able to reduce these precautionary savings considerably. In doing so, they can be more exposed to risk from large shocks. If you are relying upon your insurance company to pay for the loss if your house burns down, your car is wrecked, or you have a costly health problem, etc., and hence have not left sufficient available liquidity to cover these contingencies yourself, and if the insurance company does not pay off as expected, things could be pretty tough. With insurance, people do not leave as much margin for error along a lot of fronts, they reduce their precautionary balances, and failure of an insurance company to payoff as expected could cause severe financial distress, distress that might not have occurred without the dependence on insurance.

This is different than another way of increasing risk, moral hazard. If I get fire insurance, I can reduce my precautionary balances as described above, and this leaves me more exposed than before if the insurance company fails. But if I then start to use real candles on my Christmas tree, don't bother to get the fireplace cleaned, don't bother to clear the dry brush around the house, etc., then that is moral hazard.

Moral hazard is a form of market failure and, as such, we need to avoid it. One way is not to provide insurance at all. No insurance, no moral hazard, simple. But there are other ways of dealing with the problem that can reduce its negative effects without causing us to give up on providing insurance. For example, co-payments and deductibles are both ways of reducing moral hazard. The idea is to make the insured pay part of the cost when there is a payout so that they will reduce the incidence of avoidable risks.

Turning to mortgage and financial markets, I see nothing at all wrong with participants in those markets expecting the Fed to stabilize the macroeconomy. In essence, the Fed is providing insurance against volatility in the overall economy and of course traders are going to anticipate that if the economy turns downward, the Fed will adjust rates. They should expect that and take it into account in their decisions.

But just as with regular insurance, this can induce moral hazard and that seems to be what most of the discussion surrounding whether the Fed should intervene is about - by providing the insurance to the macroeconomy does the Fed also provide the motivation for moral hazard behavior (excessive risk taking)?

There is that chance, and likely that reality, but just as with regular insurance the solution is not to withhold coverage, i.e. for the Fed to do nothing in the face of an apparently weakening economy to avoid creating poor incentives going forward. We know a lot about how to solve moral hazard problems and there's no reason at all those cannot be applied to these markets to reduce this problem.

When necessary, the Fed needs to intervene to stabilize the macroeconomy, moral hazard or not. Just as you would anticipate your insurance company paying off if there was a fire, and just as you might face bankruptcy if it did not pay, participants in financial markets anticipate the Fed will provide insurance to the macroeconomy (as it always does), and they may face financial difficulties if it does not.

There's nothing wrong with financial market participants expecting a stable environment, and reducing their precautionary balances (e.g. their cash positions) in response just as you would reduce your precautionary saving. It's the moral hazard part we want to avoid and, as I noted above, there are many, many ways to intervene into these markets to reduce market failure from moral hazard in the future, and those can and should be applied whether the Fed intervenes now or not.

There is an exception to when insurance should pay off, of course, and that is if (for example) you willfully burn down your own house. I want to be careful here. If I have insurance, and a behavior is not ruled out and it causes a payoff, I have not crossed any moral lines, I have simply acted according to the economic constraints that are in place. If there's no deductible on my auto insurance and no co-pay, if everything is 100% covered, then I won't be so careful about how I park or about getting small dents, etc., they're covered. If the insurance company's customers then take excessive risks, and payouts are so high that the insurance company crashes, that is not the customers fault. The incentives need to be fixed to make the insurance viable.

Did participants in mortgage markets do the equivalent of burning down their own houses, or were they simply acting according to the constraints the insurance company (i.e. the Fed) had in place? I'm sure there were some who set the place afire themselves, but I believe the preponderance were simply behaving according to the rules of the game.

Payoff now, as promised, i.e. stabilize the economy if needed and don't worry about who gets bailed out in the process (but prosecute the arsonists). It may look like a big bailout, the Fed may have to intervene before signs of problems in the overall economy are evident due to lags in monetary policy, but there should be no hesitation about intervening to stabilize economic conditions.

We need to fix the markets so that the incentive to engage in moral hazard type behavior in the future is substantially reduced, no doubt about it. But what we shouldn't do is withhold insurance altogether just because we are worried about creating moral hazard problems in the future. That's not the best way to fix the problem.

Update: In comments, knzn adds:

We don't just want to prevent people from taking excessive risks; we also want to encourage people to take appropriate risks. In fact, the latter is what we mostly want to do: Because risk often cannot be sufficiently diversified, the risk-takers experience personal costs of failure that are not matched by the social costs.

Update: Martin Wolf and Robert Reich discuss the same issue. Martin Wolf first:

Central banks should not rescue fools, by Martin Wolf, Commentary, Financial Times: ...Ben Bernanke ... said ... he would use “all the tools” at his disposal to contain market turmoil and prevent it from damaging the economy. The Fed has its orders: save Main Street and rescue Wall Street.

Such panic-driven politicisation is almost certain to lead to both overreaction and the creation of bad precedents. What then would be the right response to this latest scrape that supposedly sophisticated financial markets have fallen into?

Who Should Pay the Price for the Popped Real Estate Bubble?

I want to make a simple point in response to so many people calling for heads to roll over the turmoil in financial markets, and to suggestions that the Fed should not cut rates if doing so bails out financial markets and prevents participants from fully realizing the costs associated with past behavior.

Recessions, popped bubbles and the like do not have to be somebody's fault and, as such, we don't necessarily have to extract blood from anyone to avoid it happening again. Perfectly reasonable actions a priori - in the sense of responding to the economic incentives that are in place - can still lead to bad ex-post outcomes. The people acting in the economic environment didn't write the rules, they're simply maximizing given the rules that are in place, so why punish them?

I don't mean to absolve those who committed fraud, etc., nor do I mean to absolve those who did fall down on the job - the rule makers and the ratings agencies - from any responsibility for the outcome. But I doubt that the people writing the rules intended to cause a meltdown, and it's possible they did the very best they could with the information they had. And it can be argued, credibly, that ratings agencies simply responded to the economic incentives that were in place (i.e. responded as expected to being paid by those they were rating).

We made mistakes in the regulatory environment, no doubt about it, and I hope we learn and fix the problems, but this Victorian call for someone to pay the price if there are problems seems overwrought, and it's getting in the way of talking about how to help people.

Here's something by Paul Krugman on this issue that I've posted before, and is worth repeating:

The Hangover Theory, by Paul Krugman: A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted--for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression--with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world's depressed economies at this very moment.

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover. ...

The hangover theory ... turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone--horrors!--printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. ... But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others...

We don't need a recession. If the Fed determines an interest rate cut is needed to keep the economy moving toward full employment, then it shouldn't hesitate to implement the policy because it believes it would send the wrong signal to financial market participants. I hope we don't get so caught up in our zeal to make sure people learn the right lessons from all of this that we allow "bad investments in the past" to bring about "the unemployment of good workers in the present."

Laurence Kotlikoff: We Are All Uninsured Now

A plan to reform health care:

We are all uninsured now, by Laurence J. Kotlikoff, Commentary, Boston Globe: Big numbers, like 45 million uninsured Americans, are hard to grasp. But ... the rest of us with health coverage are also uninsured. We too face terrible, albeit more remote, healthcare risks -- the risk that our employer will drop our plan, that Medicare will go bust, that our plan won't cover our needs, that premiums will eat us alive, that our doctor will stop taking our insurance, that long-term care will wipe us out, and that our uninsured friends and family members will need major financial help.

These risks are entirely avoidable. We can have an efficient, transparent system that includes everyone; treats everyone fairly; covers all the basics, including prescription drugs, home healthcare, and nursing home care; and costs little more than what we now spend. But we can't get there via the piecemeal reforms that President Bush, most of his would-be successors, and our state governors are advocating.

Bush first pushed health savings accounts -- a knuckle-brained scheme to get the uninsured to save for all their healthcare costs short of catastrophic care. When that didn't stop 5 million more Americans from becoming uninsured, the president proposed letting the uninsured deduct the cost of their health plans if they buy private coverage ..., but it won't help much. Most of the uninsured are in too low a tax bracket or pay too little in taxes for it to make any difference. ...

Most of the Democratic and several of the Republican presidential candidates ... end game would be a balkanized healthcare system with the old in Medicare, the poor in Medicaid, most workers in employer plans, and the losers -- the otherwise uninsured -- in highly subsidized, limited-coverage plans. Loser plans.

This won't work. First, Medicare and Medicaid are already on a course to bankrupt the nation. Keeping these programs intact is fiscal suicide. Second, many employers are fed up with healthcare spending and are heading for the exit. ... And the more attractive loser insurance becomes, the quicker employers will drop their plans.

Third, loser insurance requires a major federal bureaucracy (think Hillarycare) and unaffordable subsidies. Fourth, this "solution" does nothing to reduce the administrative costs that consume a fifth of our healthcare dollars. Fifth and most damning, making loser policies available doesn't guarantee their purchase. Millions will remain uninsured.

My solution is called the Medical Security System. It would eliminate Medicare, Medicaid, and (by dropping the tax breaks) employer-based healthcare. The government would give everyone a voucher each year for a basic health plan. The size of the voucher would be based on one's health status. Those in worse health would get bigger vouchers, leaving insurers no incentive to cherry-pick. Furthermore, insurers would not be permitted to refuse a voucher or otherwise deny coverage.

The government would set the total voucher budget as a fixed share of gross domestic product and determine what a basic plan must cover. We would choose our own health plans. If we cost the insurer more than the voucher, he would lose money. If we cost him less, he would make money. Insurers would compete for our business and could tailor provisions, like co-pays and incentives to stop smoking, to limit excessive use of the healthcare system and encourage healthy behavior.

Nothing would be nationalized. Virtually all of the cost would be covered by redirecting existing government healthcare expenditures as well as tax breaks. Doctors, hospitals, and insurers would continue to market their services on a competitive basis.

This is not a French, British, or Canadian solution. It's an American, market-based solution that Republicans should love. It's also a progressive solution that Democrats should love. (Democratic presidential candidate Mike Gravel has endorsed it.) The poor, who are, on average, in worse health, will receive, on average, larger vouchers. The rich will lose their tax breaks.

Why can't a country as rich as ours come up with a system that works?...

Not the way I'd put the system together, but just wanted to point out that this says "[Mr. Kotlikoff] is serving as an economic adviser to Mike Gravel." It seems to me that should be made clear, especially given the implicit and explicit potshots taken at the "loser" plans of the other candidates.

links for 2007-08-28

• Subprime crisis: Progress report and more FAQs - Stephen Cecchetti
• Study finds married men do less housework than live-in boyfriends - EurekAlert
• The Great Iraq Swindle - Rolling Stone
• Why gazillionaires, conservatives, and industrialists are begging the Fed to cut interest rates. - By Daniel Gross
• Useful Mutants, Bred With Radiation - New York Times
• In Online World, Pocket Change Is Not Easily Spent - New York Times
• Through Analysis, Gut Reaction Gains Credibility - New York Times
• Protecting Exports - Poole Speech - St. Louis Fed
• In Washington, Aid to Homeowners Debated - New York Times
• This is Your Brain on Food (extended version) -- Scientific American
• Bernanke Opts for Tough Love and Targeted Cure - Caroline Baum
• How the neoliberals stitched up the wealth of nations for themselves - George Manbiot
• Strange Statistic of the Day: Red State More Obese? - Open Left

Gonzales: Why Resign Now?

Why did Gonzales step down now after so much resistance to doing so and public vows that it would not happen? Here's one view, but I still wonder if there isn't more to it than this:

Why did Gonzales resign?, by Sidney Blumenthal, Salon: ...Alberto Gonzales swiftly turned heel on the stage at the Department of Justice... What is he not telling about his resignation?

David Card on Immigration and U.S. Cities

David Card on "How Immigration Affects U.S. Cities". Here is the abstract, introduction, and conclusion:

How Immigration Affects U.S. Cities, by David Card, June 2007 [via]: Abstract In the past 25 years immigration has re-emerged as a driving force in the size and composition of U.S. cities. This paper describes the effects of immigration on overall population growth and the skill composition of cities, focusing on the connection between immigrant inflows and the relative number of less-skilled workers in the local population. The labor market impacts of immigrant arrivals can be offset by outflows of natives and earlier generations of immigrants. Empirically, however, these offsetting flows are small, so most cities with higher rates of immigration have experienced overall population growth and a rising share of the less-skilled. These supply shifts are associated with a modest widening of the wage gap between more- and less-skilled natives, coupled with a positive effect on average native wages. Beyond the labor market, immigrant arrivals also affect rents and housing prices, government revenues and expenses, and the composition of neighborhoods and schools. The effect on rents is the same magnitude as the effect on average wages, implying that the average “rent burden” (the ratio of rents to incomes) is roughly constant. The local fiscal effects of increased immigration also appear to be relatively small. The neighborhood and school externalities posed by the presence of low-income and minority families may be larger, and may be a key factor in understanding native reactions to immigration.

Introduction The U.S. is once again becoming a country of immigrants. Immigrant arrivals – currently running about 1.25 million people per year – account for 40% of population growth nationally, and a much larger share in some regions.[1] The effects of these inflows are controversial, in part because of their sheer size and in part because of their composition. Something like 35-40% of new arrivals are undocumented immigrants from Mexico and Central America with low education and limited English skills (Passel, 2005). Although another quarter of immigrants – from countries like India and China – are highly skilled, critics of current immigration policy often emphasize the presumed negative effects of lower-skilled people in the overall economy (e.g., Rector, Kim and Watkins, 2007). Moreover, even the most highly skilled immigrants are predominately non-white, contributing to the growing presence of visible minorities in the U.S. population.

Paul Krugman: A Socialist Plot

Paul Krugman attempts to "dispel the fog of obfuscation right-wingers use to obscure the true nature of their position on children’s health":

A Socialist Plot, by Paul Krugman, Commentary, NY Times: Suppose, for a moment, that the Heritage Foundation were to put out a press release attacking the liberal view that even children whose parents could afford to send them to private school should be entitled to free government-run education.

They’d have a point: many American families with middle-class incomes do send their kids to school at public expense, so taxpayers without school-age children subsidize families that do. And the effect is to displace the private sector: if public schools weren’t available, many families would pay for private schools instead.

So let’s end this un-American system and make education what it should be — a matter of individual responsibility and private enterprise. Oh, and we shouldn’t have any government mandates that force children to get educated, either. As a Republican presidential candidate might say, the future of America’s education system lies in free-market solutions, not socialist models.

O.K., in case you’re wondering, I haven’t lost my mind, I’m drawing an analogy. The real Heritage press release, titled “The Middle-Class Welfare Kid Next Door,” is an attack on proposals to expand the State Children’s Health Insurance Program. ... And Rudy Giuliani’s call for “free-market solutions, not socialist models” was about health care, not education...

The truth is that there’s no difference in principle between saying that every American child is entitled to an education and saying that every American child is entitled to adequate health care. It’s just a matter of historical accident that we think of access to free K-12 education as a basic right, but consider having the government pay children’s medical bills “welfare,“ with all the negative connotations that go with that term.

And conservative opposition to giving every child in this country access to health care is, in a fundamental sense, un-American.

Here’s what I mean: The great majority of Americans believe that everyone is entitled to a chance to make the most of his or her life. Even conservatives usually claim to believe that...

But a child who doesn’t receive adequate health care, like a child who doesn’t receive an adequate education, doesn’t have the same ... chances in life as children who get both these things. And insurance is crucial to receiving adequate health care...

So how can conservatives defend the indefensible, and oppose giving children the health care they need? By trying the old welfare queen in her Cadillac strategy (albeit without the racial innuendo that made it so effective when Reagan used it). That is, to divert public sympathy from people who really need help, they’re trying to change the subject to the supposedly undeserving recipients of government aid. Hence the emphasis on the evils of “middle-class welfare.”

Proponents of an expansion of children’s health care have, as they should, responded to this strategy with facts and figures. Congressional Budget Office estimates show that S-chip expansion would, in fact, primarily benefit those who need it most: the great majority of children receiving coverage under an expanded program would otherwise have been uninsured.

But the more fundamental response should be, so what?

We offer free education, and don’t worry about middle-class families getting benefits they don’t need, because that’s the only way to ensure that every child gets an education — and giving every child a fair chance is the American way. And we should guarantee health care to every child, for the same reason.

_________________________
Previous (8/24) column: Paul Krugman: Seeking Willie Horton
Next (8/31) column: Paul Krugman: Katrina All the Time

links for 2007-08-27

• Hello I Must be Going - MaxSpeak
• The Healthier Poor - Jefferey Sachs
• The After-Effects of Tet - pgl
• From equity to equality (Equanomics, a project that will focus on racial justice through economic equality) - Comment is free
• Long and Variable Lags - knzn
• Dark art of econometrics -  smh.com.au
• Give A Farewell to Alms credit - Ricardo Hausmann
• a tip of the Mitt - Sisyphus Shrugged
• Mexico’s Plutocracy Thrives on Robber-Baron Concessions - New York Times
• Report: U.S. Less Important to Global Growth Than Thought - WSJ Economics Blog
• The Unfriendly Skies - The New Yorker
• Mining Our Treasures - washingtonpost.com
• Who's Got a Turd in His Briefcase? - Atlantic Free Press
• Is Everything We're Told About Saving the Planet Wrong? - Bradford Plumer
• More Ways for the Fed to Boost Markets - WSJ Economics Blog

Lawrence Summers: This Is Where Fannie and Freddie Step In

Larry Summers looks at three questions arising from the current financial crises, and in response to the third says it's time for Fannie Mae and Freddie Mac to step in and help solve the problems we are having in mortgage markets:

This is where Fannie and Freddie step in, by Lawrence Summers, Commentary, Financial Times (free): ...Financial crises differ in detail but, ... they follow a common arc.

First there is a period of overconfidence... Second, there is a surprise that leads investors to seek greater safety. In the current case it was the discovery of huge problems in the subprime sector and the resulting loss of confidence in the ratings agencies. Third, as investors rush for the exits, ... risk analysis shifts from fundamentals to investor behaviour. As some investors liquidate their assets, prices fall; others are in turn forced to liquidate, further driving prices down. The anticipation of cascading liquidations leads to more liquidations creating price movements that seemed inconceivable only a few weeks before. The reduced availability of credit then has a negative effect on the real economy. Eventually ... there is enough price adjustment that extraordinary fear gives way to ordinary greed and the process of repair begins.

Only time will tell where we are in this cycle. There have been some signs of returning normalcy over the past week, but we cannot judge whether they represent a false spring or the end of a crisis phase. ... The impact on consumer confidence and spending ... remains unknown.

While it is too soon to draw policy lessons, we can highlight questions the crisis points ... out.

First, this crisis has been propelled by a loss of confidence in ratings agencies... There is room for debate over whether the errors ... stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for their ratings and can shop for the highest rating. But there is no room for doubt that ... the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings? ... What, if any, legislative response is appropriate to address the ratings concerns?

Second, how should policymakers address crises centred on non-financial institutions? ... The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question... Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?

Third, what is the role for public authorities in supporting the flow of credit to the housing sector? ... I am among the many with serious doubts about the wisdom of the government quasi-guarantees that supported the government-sponsored entities, Fannie Mae ... and Freddie Mac ... But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up. No doubt, credit standards in the subprime market were too low for too long. Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit.

This crisis could have a silver lining if it leads to the careful reflection on these vital questions.

Does America Need a Recession? Of Course Not...

Does America need a recession? I say no, but The Economist has other ideas:

Does America need a recession?, The Economist: ...When the Fed cut its discount rate on August 17th, it admitted for the first time that the credit crunch could hurt the economy. ... Economists are arguing vigorously about how much damage falling house prices and the subprime mortgage crisis will do. But there is one question that is rarely asked: even if a downturn is in the offing, should the Fed try to prevent it?

Most people think the question smacks of madness. ...

But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows? ...

The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries. ...

Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses ... is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.

This does not mean that the Fed should follow the advice of Andrew Mellon, the treasury secretary, after the 1929 crash: “liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate...It will purge the rottenness out of the system.” America's output fell by 30% as the Fed sat on its hands. As a scholar of the Great Depression, Ben Bernanke, the Fed's chairman, will not make that mistake. Central banks must stop recessions from turning into deep depressions. But it may be wrong to prevent them altogether.

Of course, even if a recession were in America's long-term economic interest, it would be political suicide. A central banker who mentioned the idea might soon be out of a job. But that should not stop undiplomatic economists asking whether a recession once in a while might actually be a good thing.

So let's talk undiplomatically about this:

1. I disagree that we need recessions to have a dynamic economy. Equilibrium means (in simple terms) "no tendency for change" and there is nothing inconsistent with having a constant flow of entering and exiting firms at equilibrium.

When profits are high - as in the traditional price signaling story - there is a rush to enter industries, but the trick is to get there first and take some of the profits before others beat you to it, innovation and technological change are not so important. There are lots of profits to be had by entering with existing technology so, while it does allow the installation of the best and latest technology, there's no strong pressure to innovate. In fact waiting until there is an innovation could be costly.

It's when conditions are tight, i.e. when everyone is making close to zero economic profit, that new cost saving or demand enhancing technological change will pay off. If you have a better product or lower costs than rivals, then you will gain an edge and realize profits. The only way to get ahead is to build a better mousetrap. Sure, conditions will be tight in recessions - that's the traditional creative destruction story - but things are tight in a competitive equilibrium too and the pressure to innovate does not disappear just because the economy is operating at full employment.

So I don't see why a full-employment equilibrium cannot also be a dynamic economy. That is, suppose there is an industry with 1,000 firms in it all doing about the same thing (producing pizza), but every year (at a continuous rate throughout the year), 100 go out of business and are replaced by 100 new firms with a cost advantage or better product (let's put cheese in the crust!). There is no recession here, a firm comes up with a better idea, enters (leading to temporary overemployment), and drives someone else out of business.

I am not an Austrian economist and I don't play one on the internet, so I won't claim to be able to recite what Schumpeter (or anyone else in the Austrian camp) said about this on a particular page of one of his books, so maybe someone who is an adherent to this "we need business cycles" approach can explain why we cannot wipe out the inefficient while remaining at or very near full-employment.

2. Overproducing houses is not like overproducing goods that cannot be stored, i.e. perishables. When too much popcorn is produced relative to demand, it goes to waste. Resources that could be used elsewhere are wasted forever since the excess can't be frozen or stored for the future (or at least assume so for the purposes of illustration, there is that stuff in movie theaters). With houses, there is an intertemporal shift in resource use, but since houses don't spoil in a short period of time, and because people will continue to demand them in the future, overproduction today will result in underproduction tomorrow. The houses were built too soon, and that's an efficiency loss because we gave something up, but when we produce less houses later we can recover (some of) the goods that were lost (too many houses and too few cars in year one, but in year two it's the opposite, too few houses and too many cars relative to the no distortion outcome). In the case of popcorn, since it couldn't be stored, lack of storage means we didn't have the opportunity to produce less later, so there is no way to make up for it, even in part, later on.

That is to say, I hope we don't "creatively destroy" the houses that were (over)built. Sure, some can be creatively transformed into restaurants, business offices, etc., to attenuate the misallocation in the short-run, but there's no need to tear them down and replace them. With time, population and demand will grow, and the houses will be filled. Hula hoop factories needed to be creatively destroyed, they needed to be torn down and replaced - it's unlikely demand will return in the future so having those factories around would be a waste, they would never be re-opened - but houses are not hula hoops. With houses, there is no need to "purge the excesses of the previous boom," just wait for population to catch up (and would it be so bad to have low cost housing available in the interim?).

3. I don't understand the reasoning that says the Fed should not stabilize the economy because it will "create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession."

The reasoning is that if we stabilize the economy, people will then believe recessions are impossible (or underestimate their likelihood) and make bad decisions, so we shouldn't stabilize at all.

People who believe the Fed can prevent all economic fluctuations will be, so to speak, "creatively destructed" the first time there is a recession. But to refuse to stabilize the economy to the best of our ability because we are afraid people might misperceive the degree of stability that is attained seems misguided to me. I would have thought an Austrian response would be to do what's best for the economy and let those who misperceive be weeded out by the market process (or better yet, that they become informed about the true risks - this is a market failure from lack of information and while I'm pleased to see The Economist acknowledge markets can fail, the solution is to provide the information, not to refuse to stabilize).

"The First Permanent President of America"

It's very telling (and a bit scary) when these guys reveal their true objectives. Assuming this isn't satire, and it doesn't appear that it is (it's so far from sane that it's hard to tell), here's a call to, among other things, wipe out the population of Iraq with nuclear weapons, replace them with Americans, and install Bush as our permanent president. From Crooked Timber:

A website run by the neocon thinktank the Center for Security Policy (members include Frank Gaffney, Richard Perle and Doug Feith) has published (then removed) a piece calling for Bush to use his military powers to become “the first permanent president of America” and “ruler of the world”. Along the way he suggests that the population of Iraq should have been wiped out. The website Family Security Matters also runs pieces by Newt Gingrich, Judy Miller and other luminaries.

The full piece is preserved here at Watching the Watchers. I found it via Wikipedia.

As someone would say (though maybe not in this case) “read the whole thing”. It’s impossible to tell if this is satire by someone who has cleverly infiltrated FSM over a lengthy period (quite a few other pieces by the same author, Philip Atkinson were also removed), a sudden outbreak of insanity (unlikely since Atkinson previously published stuff almost as extreme as this, with the endorsement of FSM), or the actual views of CSP/CFM, accidentally revealed and clumsily concealed.

As things stand, there’s a presumption in favor of the last of these views. The piece was published by CSP/FSM and constitutes, at present, their last word on the subject. If they repudiate Atkinson’s views they should say so openly, and live with the embarrassment of having published him and praised his ideas until now.

Here's Atkinson's editorial from the link above:

Conquering the Drawbacks of Democracy, by Philip Atkinson: President George W. Bush is the 43rd President of the United States. He was sworn in for a second term on January 20, 2005 after being chosen by the majority of citizens in America to be president.

Yet in 2007 he is generally despised, with many citizens of Western civilization expressing contempt for his person and his policies, sentiments which now abound on the Internet. This rage at President Bush is an inevitable result of the system of government demanded by the people, which is Democracy.

The inadequacy of Democracy, rule by the majority, is undeniable -- for it demands adopting ideas because they are popular, rather than because they are wise. This means that any man chosen to act as an agent of the people is placed in an invidious position: if he commits folly because it is popular, then he will be held responsible for the inevitable result. If he refuses to commit folly, then he will be detested by most citizens because he is frustrating their demands.

When faced with the possible threat that the Iraqis might be amassing terrible weapons that could be used to slay millions of citizens of Western Civilization, President Bush took the only action prudence demanded and the electorate allowed: he conquered Iraq with an army.

This dangerous and expensive act did destroy the Iraqi regime, but left an American army without any clear purpose in a hostile country and subject to attack. If the Army merely returns to its home, then the threat it ended would simply return.

The wisest course would have been for President Bush to use his nuclear weapons to slaughter Iraqis until they complied with his demands, or until they were all dead. Then there would be little risk or expense and no American army would be left exposed. But if he did this, his cowardly electorate would have instantly ended his term of office, if not his freedom or his life.

The simple truth that modern weapons now mean a nation must practice genocide or commit suicide. Israel provides the perfect example. If the Israelis do not raze Iran, the Iranians will fulfill their boast and wipe Israel off the face of the earth. Yet Israel is not popular, and so is denied permission to defend itself. In the same vein, President Bush cannot do what is necessary for the survival of Americans. He cannot use the nation's powerful weapons. All he can do is try and discover a result that will be popular with Americans.

As there appears to be no sensible result of the invasion of Iraq that will be popular with his countrymen other than retreat, President Bush is reviled; he has become another victim of Democracy.

By elevating popular fancy over truth, Democracy is clearly an enemy of not just truth, but duty and justice, which makes it the worst form of government. President Bush must overcome not just the situation in Iraq, but democratic government.

However, President Bush has a valuable historical example that he could choose to follow.

When the ancient Roman general Julius Caesar was struggling to conquer ancient Gaul, he not only had to defeat the Gauls, but he also had to defeat his political enemies in Rome who would destroy him the moment his tenure as consul (president) ended.

Caesar pacified Gaul by mass slaughter; he then used his successful army to crush all political opposition at home and establish himself as permanent ruler of ancient Rome. This brilliant action not only ended the personal threat to Caesar, but ended the civil chaos that was threatening anarchy in ancient Rome – thus marking the start of the ancient Roman Empire that gave peace and prosperity to the known world.

If President Bush copied Julius Caesar by ordering his army to empty Iraq of Arabs and repopulate the country with Americans, he would achieve immediate results: popularity with his military; enrichment of America by converting an Arabian Iraq into an American Iraq (therefore turning it from a liability to an asset); and boost American prestiege while terrifying American enemies.

He could then follow Caesar's example and use his newfound popularity with the military to wield military power to become the first permanent president of America, and end the civil chaos caused by the continually squabbling Congress and the out-of-control Supreme Court.

President Bush can fail in his duty to himself, his country, and his God, by becoming “ex-president” Bush or he can become "President-for-Life" Bush: the conqueror of Iraq, who brings sense to the Congress and sanity to the Supreme Court. Then who would be able to stop Bush from emulating Augustus Caesar and becoming ruler of the world? For only an America united under one ruler has the power to save humanity from the threat of a new Dark Age wrought by terrorists armed with nuclear weapons.

FamilySecurityMatters.org Contributing Editor Philip Atkinson is the British born founder of ourcivilisation.com and author of A Study of Our Decline. He is a philosopher specializing in issues concerning the preservation of Western civilization. Mr. Atkinson receives mail at rpa@ourcivilisation.com.

Note -- The opinions expressed in this column are those of the author and do not necessarily reflect the opinions, views, and/or philosophy of The Family Security Foundation, Inc.

Just to be sure, I checked the website Family Security Matters for a statement on this, but nothing. As noted above, there's an article by Newt Ginrich and also articles by many others (e.g. Judith Miller), so apparently they have no problem whatsoever publishing in the same venue as Atkinson, but there's nothing explicitly disavowing Atkinson's views.

links for 2007-08-26

• Reviving a Consumer Watchdog - washingtonpost.com
• Inside the Countrywide Lending Spree - New York Times
• Drop Foreseen in Median Price of U.S. Homes - New York Times
• The Fed’s Subprime Solution - New York Times
• Stiff-Arming Children’s Health - New York Times
• In Nature’s Casino - New York Times

Robert Shiller: A Psychology Lesson From the Markets

Robert Shiller says the Fed will have trouble reversing downward psychology in housing markets:

A Psychology Lesson From the Markets, by Robert J. Shiller, Economic View, NY Times: It is no surprise that the Federal Reserve’s discount rate cut has not entirely reassured investors. The Fed can stop a run on the banks, but it cannot control the speculative cycle — a cycle built on psychology and misperceptions that has been sweeping much of the world for the last 10 or 12 years.

I have worked with Karl E. Case ... at Wellesley College ... in conducting ... surveys of recent home buyers. In Los Angeles and San Francisco in 2005, when actual home prices were rising more than 20 percent a year, we found that respondents anticipated big increases far into the future..., the median expected annual climb for the succeeding 10 years was 9 percent.

This expectation would mean that a house valued at an already high level of $650,000 in 2005 would be worth more than $1.5 million in 2015. For most people in 2005, it would also mean that they should buy a house soon, or forever be excluded from owning one — and that it would be better to stretch and buy the most expensive house they could afford...

Now, of course, prices have been falling, and our survey over the last few months shows that in Los Angeles and San Francisco, the median 10-year expected price increase among recent home buyers has come down to 5 percent a year — a number that is likely to decline further if prices continue to drop. As price expectations fall, homeowners lose the incentive to pay off a mortgage on a home they are realizing is beyond their means. They decide to default. We thus have the beginnings of a mortgage crisis.

The problem is fundamental, tied to the imbalance caused by irrationally high home prices and declining optimism that the prices will go higher. Cutting interest rates will not change this basic situation. The problem is fundamental because the speculative cycle afflicts much of the world. ...

Classical economics cannot explain this cycle, because underlying these booms is popular reaction to the price increases themselves. Rising prices encourage investors to expect more price increases, and their optimism feeds back into even more increases, again and again in a vicious circle. As the boom continues, there is less fear of borrowing heavily, or of lending heavily. In this situation, lower lending standards seem perfectly appropriate — and even a fair way to permit everyone to prosper.

Booms cannot go on forever. Downward price feedback sets in. That is when balance sheets become impaired and widening credit problems start to show up.

The puzzle is why this speculative cycle has occurred recently in so much of the world. What do all these countries share that drives them to speculative booms? ...

As we all try to adjust to a rapidly growing and increasingly capitalist world, we have been trying to discover who we are and how we fit into it. This has meant an enormous change in values.

Many people feel that they have discovered their true inner genius as investors and have relished the new self-expression and excitement. Investors across the world have been thinking that they are winners — not recognizing that much of their success is only a result of a boom. Declines in asset prices endanger this very self-esteem.

That is why it is so hard to turn around investor attitudes once a downward psychology sets in. The Fed and other central banks do not have lithium or Prozac in their bag of remedies, and so cannot control it.

I don't have much to say in response to this, maybe you can come up with something, but let me point you to a much more detailed discussion of this topic by Shiller:

Historic Turning Points in Real Estate, by Robert Shiller, Cowles Foundation Discussion Paper No. 1610, June 2007: Abstract This paper looks for markers of ends of real estate booms or busts. The changes in market psychology and related indicators that occurred at real estate market turning points in the United States since the 1980s are compared with changes at turning points in the more distant past. In all these episodes changes in an atmosphere of optimism about the future course of home prices, changes in public interpretation of the boom, as well as evidence of supply response to the high prices of a boom, are noted.

Introduction By some accounts, the greatest challenge for economic forecasters is to predict turning points. It is easy to extrapolate time series. It is less easy to tell when the series will abruptly change trend and enter a different pattern or regime.

Figure 1 shows a chart of US stock price and home price indices since 1987. It shows the Standard & Poor 500 Stock Price Index... It also shows the Standard & Poor/Case-Shiller Composite Home Price Index, a ten-city average which is a measure of the aggregate market for single family homes, and is based on indices that Karl Case and I created in 1988. ... Since the home price index is a threemonth moving average, the S&P 500 is also plotted as a moving three-month moving average so that the two series are comparable.

Doing What You are Expected to Do

Brad DeLong comments on current Fed policy:

Notes on the Federal Reserve's Current Actions, by  Brad DeLong: The Federal Reserve is now focusing on what Larry Meyer calls "liquidity tools" to make sure the market for short-term credit functions despite concerns about counterparty risk and collateral values. The Federal Reserve hopes that it can handle the current situation without having to ease monetary policy--that its liquidity tools will do enough, and that it won't feel forced to rescue market liquidity by cutting interest rates and thus giving what it fears would be an unhealthy boost to spending. (I think the Federal Reserve is wrong here: the fallout from the current liquidity panic means that a year from now we are likely to wish that the Federal Reserve had given a boost to spending today.)

The New York Federal Reserve Bank has not pegged the average funds rate to its 5.25% target, and it now says that it wants to see "trading in the federal funds market at rates close" to 5.25%, not at 5.25%, and the rate has not been at the target for a week. Nevertheless, the target rate has not changed.

My view is that the FOMC is likely to cut the federal funds rate by 25 basis points at its September meeting, but it will do so reluctantly, because markets expect it, not because it believes the situation warrants it.

Of course, if the financial panic-in-embryo starts to affect spending and to slow the real economy, the FOMC will start cutting rates much further and faster.

Brad mentions something I've been wondering and meaning to bring up here. Would/could the Fed set the target rate at a level different from what markets expect? Certainly if there is a split in expectations, say 50% expect the Fed to hold at 5.25% and 50% expect the Fed to cut the target rate to 5.00%, they would have to go one way or the other, but suppose it is 95% for a rate cut, 5% to hold. Does the Fed currently have the courage and credibility to deviate from what it is expected to do by the vast majority of market participants? Brad says no - it will do what the markets expect, even if it thinks the move is not warranted.

That's my sense too and, if that is correct, policy right now is mainly about managing expectations since that determines the rate that will prevail. Maybe I'm wrong - perhaps he Fed would do what it thinks is best whether or not markets expect it - but I think they are largely bound by prevailing market opinion.

Ben Bernanke is still being tested, still establishing his credibility. If he deviates from expectations and turns out to be wrong, then his choice will be questioned - why didn't he listen to the markets? - and the credibility loss could be large (just an academic book guy, not like dear old Alan...). Of course, if he deviates from expectations and is correct he would be hailed, but it is a risky strategy to deviate from expectations at this point.

If the Fed is successful at managing expectations, we'll never know about this since they would always do as expected, and I've assumed the Fed is fairly united itself in what ought to happen (they could be split as well and deliver mixed signals), but I think there is a good chance they will face this choice soon and, if they cannot shift market expectations prior to the meeting, will give in to market opinion. I'm not 100% positive about that, but I do think maintaining credibility going forward - as much as possible - is a substantial constraint on their choices.

The Deceptive Presentation of the FairTax Proposal

Bruce Bartlett says when you read the fine print and uncover the deceptions, the FairTax proposal is far less attractive then its supporters woudl have you believe:

FairTax, Flawed Tax, by Bruce Bartlett, Commentary, WSJ [Update: open link]: Former Arkansas Gov. Mike Huckabee's unexpectedly strong second-place showing in the recent Iowa Republican straw poll is widely attributed to his support for the FairTax.

For those who never heard about it, the FairTax is a national retail sales tax that would replace the entire current federal tax system. ...

Rep. John Linder (R., Ga.) and Sen. Saxby Chambliss (R., Ga.) have introduced legislation ... to implement the FairTax. They assert that a rate of 23% would be sufficient to replace federal individual and corporate income taxes as well as payroll and estate taxes. Mr. Linder's Web site claims that U.S. gross domestic product will rise 10.5% the first year after enactment, exports will grow by 26%, and real investment spending will increase an astonishing 76%.

In reality, the FairTax rate is not 23%. Messrs. Linder and Chambliss get this figure by calculating the tax as if it were already incorporated into the price of goods and services. ...[T]hink of it this way. If a product costs $1 at retail, the FairTax adds 30%, for a total of $1.30. Since the 30-cent tax is 23% of $1.30, FairTax supporters say the rate is 23% rather than 30%.

This is only the beginning of the deceptions in the FairTax. Under the Linder-Chambliss bill, the federal government would have to pay taxes to itself on all of its purchases of goods and services. Thus if the Defense Department buys a tank that now costs $1 million, the manufacturer would have to add the FairTax.... The tank would then cost the federal government $300,000 more than it does today, but its tax collection will also be $300,000 higher.

This legerdemain is done solely to make revenues under the FairTax seem larger than they really are, so that its supporters can claim that it is revenue-neutral. ...

Similarly, state and local governments would have to pay the FairTax on most of their purchases. This means that it is partly financed by higher state and local taxes. ...

State sales taxes have long exempted all but a few services because of the enormous difficulty in taxing intangibles. But the FairTax would apply to 100% of services, including medical care, thus increasing their cost by 30%. No state comes close to taxing services so broadly. Consumers would also find themselves taxed on newly constructed homes. Imagine paying 30% ... on top of the purchase price...

Since sales taxes are regressive ... some provision is needed to prevent a vast increase in taxation on the nonwealthy. The FairTax does this by sending monthly checks to every household based on income. Aside from the incredible complexity and intrusiveness of tracking every American's monthly income ... the FairTax does not include the cost of this rebate in the tax rate. ...

Rejecting all the tricks of FairTax supporters and calculating the tax rate honestly ... professional revenue estimators have always concluded that a national retail sales tax would have to be much, much higher than 23%.

A 2000 estimate by Congress's Joint Committee on Taxation found the ... rate would be 57%. In 2005, the U.S. Treasury Department calculated that a ... rate of 34% would be needed just to replace the income tax, leaving the payroll tax in place. ...

Perhaps the biggest deception in the FairTax, however, is its promise to relieve individuals from having to file income tax returns, keep extensive financial records and potentially suffer audits. Judging by the emphasis FairTax supporters place on the idea of making April 15 just another day, this seems to be a major selling point for their proposal.

Yet all but six states now have state income taxes. So unless one lives in one of those states, this promise is an empty one indeed. In short, the FairTax is too good to be true, and voters should not take seriously any candidate who supports it.

links for 2007-08-25

• Citigroup Gets Fed Help on Using Discount Window - WSJ Economics Blog
• A more detailed view of the Great Quant Meltdown of 2007 - The Curious Capitalist
• Historian: Bush use of quote ‘perverse' - Avi Zenilman - Politico.com
• Politicians are overprotected and isolated - Bruno Frey
• How to get good public services through choice and competition - Julian Le Grand
• Playing the 'Genocide' Card in Iraq - Rick Perlstein
• Central bank impotence and market liquidity - Henry Liu
• Nordic vs American exceptionalism - Worthwhile Canadian Initiative
• New York Fed Accepts Asset-Backed Paper as Collateral - Bloomberg.com
• On Vacation, All by Myself - New York Times
• Who Will Pay for the Next Hurricane? - New York Times
• NASA Believes It Has Found Reason Foam Fell on Shuttle - New York Times
• A new intelligence report paints a bleak picture of Iraq - McClatchy

Not So Subtle

Following up on Paul Krugman's column, from Media Matters via Digby:

Follow Your Instincts, by digby: Sometimes you have to see it to believe it:

LIMBAUGH: Here's [caller] in Lake Orion, Michigan. Thank you for calling. ...

CALLER: Hey, Rush. ... I talked to you once before. ... I know I'm no expert in foreign affairs, but what really confuses me about the liberals is the hypocrisy when they talk about how we have no reason to be in Iraq and helping those people, but yet everybody wants us to go to Darfur. I mean, aren't we going to end up in a quagmire there? I mean, isn't it -- I don't understand. Can you enlighten me on this?

LIMBAUGH: Yeah. This is -- you're not going to believe this, but it's very simple. And the sooner you believe it, and the sooner you let this truth permeate the boundaries you have that tell you this is just simply not possible, the better you will understand Democrats in everything. You are right. They want to get us out of Iraq, but they can't wait to get us into Darfur.

CALLER: Right.

LIMBAUGH: There are two reasons. What color is the skin of the people in Darfur?

CALLER: Uh, yeah.

LIMBAUGH: It's black. And who do the Democrats really need to keep voting for them? If they lose a significant percentage of this voting bloc, they're in trouble.

CALLER: Yes. Yes. The black population.

LIMBAUGH: Right. So you go into Darfur and you go into South Africa, you get rid of the white government there. You put sanctions on them. You stand behind Nelson Mandela -- who was bankrolled by communists for a time, had the support of certain communist leaders. You go to Ethiopia. You do the same thing.

CALLER: It's just -- I can't believe it's really that simple.

[...]

LIMBAUGH: Right. That's exactly right. You've got it. You've got it. Now you just have to believe your own instincts from here on out.

I'm sure I don't have to point out that there are no elected Democrats who "can't wait to get us into Darfur" unless you consider Joe Biden's passionate outbursts about Darfur in the debates to be proof of such a thing. In fact, Darfur is a human tragedy of epic proportions ... and pretty much nobody, certainly not the political class of either party, is much interested in it. So let's just set that aside.

The hideous, racist assumptions in that little "analysis" are so blatant that it's startling, even from the disgusting Limbaugh. The charge that African American voters vote on the basis of African politics is so bizarre I don't even know how to deal with it. And anyway, even if it were true, the fact that the Republicans ... insisted on supporting apartheid until the bitter end would likely have been the motive, especially since those same Republican[s] ... couldn't stop talking about welfare queens and running their political campaigns based on thinly veiled racist attacks. While I'm sure black Americans care about Darfur and South Africa as much as the next decent human being, they know very well that the Republican party is filled with ... haters like Limbaugh who despise them. Voting for the Democrats isn't really that complicated in light of that.

And apparently, the only reason he and his ... listeners can imagine that anyone would oppose apartheid in South Africa or be horrified at the genocide in Darfur is their own craven political interests. I'm afraid that says more about him than it does about Democrats. ...

Look for more of this over the next few months as the Republicans make their case against "the Bitch," "the Black" and "the Breck girl." Limbaugh and Coulter and the boys will do this kind of crude dirty work for them, but there is going to be an awful lot of it that's way more subtle.

Yes, it's really going to be this bad.

"you get rid of the white government there. You put sanctions on them. You stand behind Nelson Mandela -- who was bankrolled by communists"

"U.S. Falters In Bid to Boost Iraqi Business"

I had hopes for this. Very slim hopes, but hopes nonetheless:

U.S. Falters In Bid to Boost Iraqi Business, Few Products Sold To American Firms, by Josh White, Washington Post: More than a year after the Pentagon launched an ambitious effort to reopen Iraqi factories and persuade U.S. firms to purchase their goods, defense officials acknowledge that the initiative has largely failed because American retailers have shown little interest in buying products made in Iraq.

The Pentagon thought U.S. firms would be willing to help revitalize the war-torn Iraqi economy and create jobs for young men who might otherwise join the insurgency. But the effort -- once considered a pillar of the U.S. strategy in Iraq, alongside security operations and political reform -- has suffered from a pervasive lack of security and an absence of reliable electricity and other basic services.

Iraqi officials have recently highlighted pending deals with retailers such as Wal-Mart and J.C. Penney, businesses that they said were considering purchasing Iraqi products from the few local factories that have restarted. But the two companies said last week that they are not in negotiations to buy Iraqi products...

Three officials who have worked with the Pentagon's Task Force to Support Business and Stability Operations in Iraq said in recent interviews that, although some factories have achieved limited success, the larger effort to link Iraqi industries with U.S. retailers has been a "failure." ...

The task force's assumption from the outset -- one shared by top U.S. commanders in Iraq and senior leaders at the Pentagon -- was that jump-starting Iraqi factories would push young men into paying jobs and away from violence.

But, in the past year, only 4,000 jobs have been created... Those results come against the backdrop of a grim overall economic picture...

Suppose Bush had engaged in a no holds barred attempt to get firms to cooperate in this venture, used his bully pulpit at every opportunity to tell firms it's their patriotic duty and used all the usual slime machine tricks against those who don't cooperate. If he had gone all out and asked his business buddies to sacrifice for the cause (for once), told them that if young men can give their lives, can't you help as well, could that have made a difference? Or was it always hopeless? I've always thought we tried this much too late, so we'll never know for sure.

Why did we wait? The idea initially was that the free market would work its magic and somehow provide the jobs that were needed, so there was no need to protect former state-run enterprises -- those needed to be replaced in the name of efficiency. I wonder if adherence to that ideology rather than adopting a top-down planned approach that kept formerly state-run enterprises open and running (and opened more if needed) from the start would have changed the subsequent course of events. Forget efficiency, there was plenty of time ahead to worry about that, just put people to work doing something, anything. There was plenty that needed to be done.

[Update: Dani Rodrik follows up, "Thoma is right of course. And it gives me pleasure to welcome him to the industrial policy sympathizers club..."]

This is expressed better in a quote from a previous post:

[T]he radical restructuring of Iraq's political economy has received ... little critical attention.... It was taken as a given that after knocking off Saddam, we'd rapidly privatize huge swaths of Iraq's national companies, get rid of hundreds of thousands of civil servants, completely restructure the country's tax and finance laws and throw Iraq's economy wide open for foreign multinationals. ...

Paul Krugman: Seeking Willie Horton

Paul Krugman looks at GOP efforts to revive Willie Horton and what that means for the future of the party:

Seeking Willie Horton, by Paul Krugman, Commentary, NY Times: So now Mitt Romney is trying to Willie Hortonize Rudy Giuliani. And thereby hangs a tale — the tale, in fact, of American politics past and future, and the ultimate reason Karl Rove’s vision of a permanent Republican majority was a foolish fantasy.

Willie Horton, for those who don’t remember the 1988 election, ... committed armed robbery and rape after being released from prison on a weekend furlough program. He was made famous by an attack ad ... that played into racial fears. Many believe that the ad played an important role in George H.W. Bush’s victory over Michael Dukakis.

Now some Republicans are trying to make similar use of the recent murder of three college students in Newark, a crime in which two of the suspects are Hispanic illegal immigrants. ...

Mr. Romney, who pretends to be whatever he thinks the G.O.P. base wants him to be, is running a radio ad denouncing New York as a “sanctuary city” for illegal immigrants, an implicit attack on Mr. Giuliani.

Strangely, nobody seems to be trying to make a national political issue out of other horrifying crimes, like the Connecticut home invasion in which two paroled convicts, both white, are accused of killing a mother and her two daughters. ...

To appreciate what’s going on here you need to understand the ... strategy [the G.O.P.] uses to win elections. ... [R]ight-wing economic ideology has never been a vote-winner. Instead, the party’s electoral strategy has depended largely on exploiting racial fear and animosity.

Ronald Reagan didn’t become governor of California by preaching the wonders of free enterprise; he did it by attacking the state’s fair housing law, denouncing welfare cheats and associating liberals with urban riots. Reagan ..[began] his 1980 campaign with a speech ... supporting states’ rights delivered just outside Philadelphia, Miss., where three civil rights workers were murdered in 1964.

And if you look at the political successes of the G.O.P. since it was taken over by movement conservatives, they had very little to do with public opposition to taxes, moral values, perceived strength on national security, or any of the other explanations usually offered. To an almost embarrassing extent, they all come down to just five words: southern whites starting voting Republican. ...

But Republicans have a problem: ... America is becoming less white, mainly because of immigration. Hispanic and Asian voters were only 4 percent of the electorate in 1980, but they were 11 percent of voters in 2004 — and that number will keep rising...

Those numbers are the reason Karl Rove was so eager to reach out to Hispanic voters. But the whites the G.O.P. has counted on to vote their color, not their economic interests, are having none of it. From their point of view, it’s us versus them — and everyone who looks different is one of them.

So now we have the spectacle of Republicans competing over who can be most convincingly anti-Hispanic. I know, officially they’re not hostile to Hispanics in general, only to illegal immigrants, but that’s a distinction neither the G.O.P. base nor Hispanic voters takes seriously.

Today’s G.O.P., in short, is trapped by its history of cynicism. For decades it has exploited racial animosity to win over white voters — and now, when Republican politicians need to reach out to an increasingly diverse country, the base won’t let them.

_________________________
Previous (8/20) column: Paul Krugman: It's a Miserable Life
Next (8/27) column: Paul Krugman: A Socialist Plot

On Rescuing Housing: "Get with it, Mr. President"

William Gross explains why we need to rescue housing, and that fiscal, not monetary policy is the solution for struggling homeowners:

Why We Need a Housing Rescue, by William H. Gross, Commentary, Washington Post: During times of market turmoil, it helps to get down to basics. ... Financial institutions lend trillions ... among each other. The Fed lends to banks, which lend to prime brokers such as Goldman Sachs and Morgan Stanley, which lend to hedge funds, and so on. The food chain is not one of predator feasting on prey but a symbiotic credit extension, always for profit but never without trust that the money will be repaid... When the trust breaks down, money is figuratively stuffed into Wall Street and London mattresses as opposed to extended to the increasingly desperate hedge funds and other financial conduits. These structures in turn are experiencing runs from depositors and lenders exposed to asset price declines of unexpected proportions. In such an environment, markets become incredibly volatile...

The past few weeks have exposed a giant crack in modern financial architecture... While the newborn derivatives may hedge individual, institutional and sector risk, they cannot hedge liquidity risk. ... Only the central banks can solve this, with their own liquidity infusions and perhaps a series of rate cuts.

Should markets be stabilized, policymakers must then decide what to do about the housing market. Seventy percent of American households are homeowners. Granted, a dose of market discipline in the form of lower prices might be healthy, but forecasters are projecting more than 2 million defaults... The resulting impact on housing prices is likely to be close to a 10 percent decline. Such an asset deflation has not been seen in the United States since the Great Depression.

Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 2 to 3 percentage points by the Fed would not avert an increase in interest rates of adjustable-rate mortgages; nor would they guarantee that the private mortgage market -- flush with fears of depreciating collateral -- would follow along in terms of 30-year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits. Such a move would also more than likely weaken the dollar -- even produce a run...

The ultimate solution must not emanate from the Fed but from the White House. Fiscal, not monetary, policy should be the preferred remedy. In the early 1990s the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers yet 2 million homeowners must be thrown to the wolves today? If we can bail out Chrysler, why can't we support American homeowners?

Critics warn of a "moral hazard." If we bail out homeowners this time, they claim, it will just encourage another round of speculation in the future. But there's never been a problem in terms of national housing price bubbles until recently. Home prices have been the most consistent, least bubbly asset aside from Treasury bills for the past 50 years. Only in the past few years, when regulation has broken down, when the Fed has failed to exercise appropriate supervision, have we seen "no-doc" and "liar" loans and "100 percent plus" loans. If you enforce regulation, you'll have no problem with moral hazard.

This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hardworking Americans. ...

Get with it, Mr. President. This is your moment to one-up Barney Frank and the Democrats. Create a Reconstruction Mortgage Corporation. Or, at the least, modify the existing FHA program, long discarded as ineffective. Bail 'em out -- and prevent a destructive housing deflation that Ben Bernanke cannot avert. After all, you're the Decider, aren't you?

Michael Woodford: Globalization and Monetary Control

Another paper from Michael Woodford. In this one, he asks if globalization means that the Fed will lose the ability to influence inflation:

Globalization and Monetary Control, by Michael Woodford, NBER WP 13329, August 2007: Abstract It has recently become popular to argue that globalization has had or will soon have dramatic consequences for the nature of the monetary transmission mechanism, and it is sometimes suggested that this could threaten the ability of national central banks to control inflation within their borders, at least in the absence of coordination of policy with other central banks. In this paper, I consider three possible mechanisms through which it might be feared that globalization can undermine the ability of monetary policy to control inflation... These three fears relate to potential changes in the form of the three structural equations of a basic model of the monetary transmission mechanism: the LM equation, the IS equation, and the AS equation respectively.

What are the three factors that potentially change the IS, LM, and AS curves?

On the one hand, it might be thought that in a globalized world, it is "global liquidity" that should determine world interest rates rather than the supply of liquidity by a single central bank (especially a small one); thus one might fear that a small central bank will no longer have any instrument with which to shift the LM curve. Alternatively, it might be thought that changes in the balance between investment and saving in one country should matter little for the common world level of real interest rates, so that the "IS curve" should become perfectly horizontal even if the LM curve could be shifted. It might then be feared that loss of control over domestic real interest rates would eliminate any leverage of domestic monetary policy over domestic spending or inflation. Or as still another possibility, it might be thought that inflation should cease to depend on economic slack in one country alone (especially a small one), but rather upon "global slack"; in this case the AS curve would become horizontal, implying that even if domestic monetary policy can be effectively used to control domestic aggregate demand, this might not allow any control over domestic inflation.

And he finds that:

I take up each of these possibilities, by discussing the effects of openness (of goods markets, of factor markets, and of financial markets) on each of these three parts of a "new Keynesian" model of the monetary transmission mechanism. I first consider each argument in the context of a canonical open-economy monetary model..., and show that openness need not have any of the kinds of effects that I have just proposed. In each case, I also consider possible variants of the standard model in which the effects of globalization might be more extreme. These cases are not always intended to be regarded as especially realistic, but are taken up in an effort to determine if there are conditions under which the fear of globalization would be justified. Yet I find it difficult to construct scenarios under which globalization would interfere in any substantial way with the ability of domestic monetary policy to maintain control over the dynamics of domestic inflation.

It is true that, in a globalized economy, foreign developments will be among the sources of economic disturbances to which it will be appropriate for a central bank to respond, in order for it to achieve its stabilization goals. But there is little reason to fear that the capacity of national central banks to stabilize domestic inflation, without having to rely upon coordinated action with other central banks, will be weakened by increasing openness of national economies.

links for 2007-08-24

• Two Major Airlines Admit to Price Fixing - washingtonpost.com
• Commercial Paper Has Biggest Weekly Drop Since 2000 - Bloomberg.com
• Scientists propose explanation for out-of-body experiences - EurekAlert
• Emphasis on conifer forests places multiple species at risk - EurekAlert
• CBO Sees No Significant Improvement in Budget Outlook - CBPP
• Meet some people who aren't getting paid this year. - By Daniel Gross
• University of Minnesota astronomers find gaping hole in the Universe - EurekAlert
• Sound Policy or Liquidity Addicts? - Macro and Other Market Musings
• Report Raises Strong Doubt About Iraqi Government - New York Times
• U.S. Falters In Bid to Boost Iraqi Business - washingtonpost.com

Countrywide Trolls for Customers

I thought the problem right now was supply, not demand, but this email spam that just arrived suggests otherwise:

Introducing the Combo Loan from Countrywide

Ads that make it appear Countrywide is desperate for more "homeowners with less than perfect credit" won't inspire much confidence.

Update: The Washington Post also notices:

What Credit Crunch? To Judge by Lenders' Teasers, It's Still Subprime Time, by Nancy Trejos, Washington Post: On AOL.com this week, the Internet-based loan company LendingTree offered "Bad credit options" and a $425,000 loan for only $1,376 a month. And Countrywide Financial, the nation's largest mortgage lender, declared, "Bad Credit? Call Today. Refinance or Tap into Your Home's Equity" in an online ad from its Full Spectrum Lending Division...

Why Did Ratings Agencies Fail to Properly Assess Risk?

Charles Calomiris and Joseph Mason discuss the assessment of risk by ratings agencies, who is to blame for their failure, and possible improvements to the rating system:

We need a better way to judge risk, by Charles Calomiris and Joseph Mason, Commentary, Financial Times: Recent downgrades on residential mortgage-backed securities (RMBS) and collateralised debt obligations, and subsequent hedge fund failures and market turmoil, have led many to blame ratings agencies for the mortgage mess. ...

The agencies reply that accurately accounting for risk is not their job and that they are protected by the right of free speech. They point to disclaimers ... that make it clear that they are paid by the companies they rate and that ratings are statements of opinion, not recommendations. ...

[S]uch admonitions ring hollow. Ratings agencies do more than opine; they play an active role in structuring RMBS and CDOs. They also serve as important sources of information about securitisation performance and often enumerate measures that issuers must take to maintain ratings in troubled securitisations.

More importantly, unlike typical market actors, ratings agencies are more likely to be insulated from the standard market penalty for being wrong, namely the loss of business. Issuers must have ratings, even if investors do not find them very accurate. ... Portfolio regulations for banks, insurance companies and pension funds set minimum ratings on debts these intermediaries are permitted to purchase. Thus, government has transferred substantial regulatory power to ratings agencies, since they now effectively decide which securities are safe enough for regulated intermediaries to hold.

Giving ratings agencies more power actually reduces the value of their ratings by creating a strong incentive for grade inflation and making the meaning of ratings harder to discern. Regulated investors encourage ratings agencies to understate risk so that the menu of high-yielding securities available to them is larger. The regulatory use of ratings thus has changed the constituency demanding a rating from free-market investors interested in a conservative opinion to regulated investors looking for an inflated one.

Grade inflation has been concentrated particularly in securitised products, where the demand is especially driven by regulated intermediaries. In 1994, economists Richard Cantor and Frank Packer ... pointed out that grade inflation was ... driven by the least reputable ratings agencies: “...Most ‘third’ agencies ... assign significantly higher ratings on average than Moody’s and Standard & Poor’s.” ...

Although there is evidence that Moody’s and S&P remain relatively conservative..., it is clear that even Moody’s has allowed its ratings scale for securitised products to become inflated. Bloomberg Markets reported in July that: “Corporate bonds rated Baa, the lowest Moody’s investment grade rating, had an average 2.2 per cent default rate over five-year periods from 1983 to 2005... From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 per cent, Moody’s found.” In other words, long before the current crisis, Moody’s was aware that its Baa CDO securities were 10 times as risky as its Baa corporate bonds.

Given the different and shifting meanings of Baa and other ratings as measures of risk and given the high rate of financial innovation and the lack of transparency inherent in multi-layered structured finance deals, it is not surprising that investors underestimated risks so badly leading up to the recent crisis.

It is no use blaming the ratings agencies, which are simply responding to the incentives inherent in the regulatory use of ratings. The solution is for regulators to reclaim the power that has been transferred to ratings agencies...

How can regulatory power be reclaimed? ...[One] solution is to reform existing regulations to avoid the use of letter grades in setting standards for permissible investments by regulated institutions. In the absence of letter grades, banks and their regulators would look at the underlying risks of investments, not ratings. Indeed, ratings agencies sell tools to investors that permit exactly this sort of analysis. Full disclosure by regulated institutions of these new measures of portfolio risks and a greater reliance on market discipline to discourage excessive risk-taking would further improve the regulatory process.

Another solution I saw elsewhere is to assign the companies to the rating agencies randomly so that today's rating does not affect the probability of getting business from that firm in the future. But I'm not sure how to impose market discipline on the firms that issue poor ratings if the assignments are random. If I know I will get a certain percentage of business (by random draw) no matter what, then there is no penalty for being wrong. I like the idea of randomization because it breaks the link between inflated ratings and getting more business, but the percentage of business a firm is assigned should be connected to their success at rating companies, and there would need to be a mechanism for entry and exit. Thus, over time firms who do best would increase their share, and firms who do worse would lose out and eventually be dropped opening up a spot (by bid?) for a new firm to enter.

I'm interested in hearing other proposals to create incentives for ratings agencies to issue accurate assessments.

Update: In comments, two stories have emerged:

Were the signals bad? Even the article says that the tools are available to do more detailed analysis, so why didn't they if so much was at stake? Still, one has the sense risks weren't fully understood for some reason and bad signals are one possibility.

Or were the signals fine, but ignored due to some market failure or incentive incompatibility where, for example, those making decisions do not have a full stake in the losses and hence do not fully account for risk? I think this has merit, or at least warrants thinking harder about.

Or some of both?

Does Immigration Cause Lower Prices?

According to this paper that is forthcoming in the Journal of Political Economy, "a one percentage point increase in the ratio of immigrants to natives in a city decreases prices by 0.5 percentage points on average":

Study: Immigration can lower prices of consumer products, EurakAlert: An important new study examines how immigration influences the prices of consumer goods. The study, forthcoming in the Journal of Political Economy, challenges the predictions of the perfectly competitive model – that an increase in demand leads to higher prices. Instead, the study finds that immigration can lower the prices of food, clothing, furniture, and appliances and have a significant moderating effect on inflation.

Immigration to Israel from the Former Soviet Union (FSU) increased dramatically in 1990, growing from about 1,500 immigrants a month in October 1989 to about 35,000 a month in December 1990.

Using the large variation in the number of new immigrants across Israeli cities (e.g., some Arab towns reported no new immigrants from the FSU), Saul Lach (Hebrew University of Jerusalem and the Centre for Economic Policy Research), compared the relative size of the FSU immigrant population with monthly, store-level prices for 915 products. These products were sold in more than 1,800 retail stores in 52 Israeli cities during 1990.

Controlling not only for native population size and overall city size, as larger cities may have more competitive markets, but also for the effects of religious holidays on prices during a certain month, Lach finds that a one percentage point increase in the ratio of immigrants to natives in a city decreases prices by 0.5 percentage points on average.

In other words, prices in a city with an average proportion of new immigrants were 2.6 percent lower in December 1990 than in cities where no immigrants settled.

While the effect was consistent for almost all product categories, Lach found that the immigration effect was significantly stronger for products for which FSU immigrants constituted a larger share of the market, such as pork and vodka.

As Lach argues, newly arrived immigrants may be more price sensitive because of lower income and lack of brand loyalty. Immigrants, who may initially be unemployed, may also have more time to compare prices, and stores will tend to lower their prices to attract these new customers. [Saul Lach. “Immigration and Prices,” Journal of Political Economy, 115:4.]

"Thanks Alan!"

Tito Boeri and Luigi Guiso discuss Alan Greenspan's role in the housing bubble [more on this topic in the post below this one]:

Subprime crisis: Greenspan’s Legacy, by Tito Boeri and Luigi Guiso, Vox EU: It’s difficult to predict how long the crisis in the world’s financial markets will last. Its dynamics recalls that of previous crises, such as that of 1998 (the Russian default and the collapse of LTCM), which have by now been forgotten by many. An excess of liquidity (i.e. an abundance of loans at low cost) has suddenly been transformed into a dearth of liquidity; many dealers find it hard to sell the assets in their portfolios. ...

Back to the present

It’s useful to disentangle the causes of the crisis. Three factors contribute to the current crisis that was triggered by the expectation of defaults on subprime mortgages in the US.

• The low financial literacy of US households;
• The financial innovation that has resulted in the massive securitisation of illiquid assets, and;
• The low interest rate policy followed by Alan Greenspan’s Fed from 2001 to 2004.

The third cause is by far the most important. Without Greenspan’s policy, the present crisis probably would have never occurred.

Low Financial Literacy

The first ingredient of the crisis is a blend of bad information, financial inexperience and myopia of consumers/investors. They fell for the prospect of getting a mortgage at rates never seen before and then extrapolating these rates out for thirty years. This myopia was encouraged and indeed exploited by banks and other lenders eager to attract and retain clients. This is surprisingly similar to what has been seen in the past when banks and intermediaries have advised their clients to invest in financial assets ill-suited to their ability to bear risk. In both cases, a biased advisor is the reflection of a clear conflict of interest in the financial industry. Financial literacy is low not only in financially backward countries (as one would expect), but also in the US. Only two out of three Americans are familiar with the law of compound interest; less than half know how to measure the effects of inflation on the costs of indebtedness. Financial literacy is particularly low among those who have taken out subprime mortgages. The intermediaries exploited this financial illiteracy.

Securitisation

The second ingredient is the pace of financial innovation during the last ten years and the securitisation that it produced. Today it is easy to “liquidify” a portfolio of illiquid credits (typically a combination of bank loans or mortgages) so they can be packaged into investor portfolios. Any bank with distressed loans has used this technique to securitise its own credits. Like all financial innovations, this too has pros and cons. The advantage is that by making an illiquid credit liquid, one can achieve important efficiency gains; investors can take longer-term positions and so earn a higher return. It also spreads the risk of insolvency across a much wider group, reducing the level of risk exposure of any individual agent. But securitizations also have their disadvantages. They weaken the incentives of financial intermediaries to monitor the behavior of the original borrower. In addition, since a credit that has become risky can be liquidated more easily, banks have less incentive to screen borrowers carefully. This opens the credit-markets doors to poor quality borrowers.

Low interest rates

The first two factors aren’t new. Without the third factor – the legacy of the “central banker of the century” – the crisis probably would have never occurred.

Warning, Bursting Bubble Ahead!

The post above this one on Greenspan and the subprime crisis reminded me of this. There seems to be this idea that nobody was warning about the dangers of the housing bubble before it burst. But some people were. This was Paul Krugman just under two years ago writing about Greenspan and the bubble:

Greenspan And The Bubble, by Paul Krugman, Commentary, NY Times,  August 29, 2005: Most of what Alan Greenspan said at last week's conference in his honor made very good sense. But his words of wisdom come too late. He's like a man who suggests leaving the barn door ajar, and then -- after the horse is gone -- delivers a lecture on the importance of keeping your animals properly locked up.

Regular readers know that I have never forgiven the Federal Reserve chairman for his role in creating today's budget deficit. In 2001 Mr. Greenspan, a stern fiscal taskmaster during the Clinton years, gave decisive support to the Bush administration's irresponsible tax cuts, urging Congress to reduce the federal government's revenue so that it wouldn't pay off its debt too quickly.

Since then, federal debt has soared. But as far as I can tell, Mr. Greenspan has never admitted that he gave Congress bad advice. He has, however, gone back to lecturing us about the evils of deficits.

Now, it seems, he's playing a similar game with regard to the housing bubble.

At the conference, Mr. Greenspan didn't say in plain English that house prices are way out of line. But he never says things in plain English.

What he did say, after emphasizing the recent economic importance of rising house prices, was that ''this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent.'' And he warned that ''history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.'' I believe that translates as ''Beware the bursting bubble.''

But as recently as last October Mr. Greenspan dismissed talk of a housing bubble: ''While local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely.''

Wait, it gets worse. These days Mr. Greenspan expresses concern about the financial risks created by ''the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages.'' But last year he encouraged families to take on those very risks, touting the advantages of adjustable-rate mortgages and declaring that ''American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.''

If Mr. Greenspan had said two years ago what he's saying now, people might have borrowed less and bought more wisely. But he didn't, and now it's too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath.

How bad will that aftermath be? The U.S. economy is currently suffering from twin imbalances. On one side, domestic spending is swollen by the housing bubble, which has led both to a huge surge in construction and to high consumer spending, as people extract equity from their homes. On the other side, we have a huge trade deficit, which we cover by selling bonds to foreigners. As I like to say, these days Americans make a living by selling each other houses, paid for with money borrowed from China.

One way or another, the economy will eventually eliminate both imbalances. But if the process doesn't go smoothly -- if, in particular, the housing bubble bursts before the trade deficit shrinks -- we're going to have an economic slowdown, and possibly a recession. ...

So there's a rough ride ahead for the U.S. economy. And it's partly Mr. Greenspan's fault.