Economist's View

How Should We Respond to Uncertainty about Climate Change?

Paul Klemperer asks, what if the climate change skeptics are right that there are more uncertainties about the potential for problems than we have been led to believe?:

If climate sceptics are right, it is time to worry, by Paul Klemperer, Vox EU: Al Gore says the science on global warming is clear and there is a major problem. Vaclav Klaus, Czech president, contends that climate change forecasts are speculative and unreliable. Whose claims are scarier?

Of course, Mr Klaus exaggerates (he is a politician) but if he is partly right, we should be more concerned, not less. Consider an analogy. If, like many of my neighbours in Oxford, you fear that new building is exacerbating flooding, how would you feel if models that predicted bad news were discredited?

It depends. If the original models were biased, your best guess of the height of future floods is now lower. But if the models merely underestimated the uncertainty, the range of plausible outcomes is now greater, so flood defences would need to be higher for us to feel safe.

Likewise, if our understanding of climate systems is flawed, our best guess about the dangers we face may be less pessimistic, but extreme outcomes are more likely.

Why Did Risk Models Fail?

I've been meaning to write about this, but haven't had the chance to think it through thoroughly. The topic is why risk models failed to inform regulators, and failed to protect investors during the recent crisis. Many of these strategies rely upon mining data for correlations that can be used to construct portfolios that (supposedly) have low variance returns.

I've wondered if the problems these models encountered can be explained using standard criticisms concerning the use of reduced form approaches to look for correlations in the data, correlations that can breakdown when there is any change in the underlying structure of the model, or a change in how policy reacts to macroeconomic variables (i.e. a standard Lucas-type critique of relying on reduced form estimates rather than deeper structural parameters and shocks). There's a difference between mining data for correlations and understanding why those correlations occur. The former can be accomplished through a variety of approaches, some borrowed from other disciplines. The goal isn't to understand how things work, the models generally make no attempt to explain why particular correlations are in the data, they simply look for the existence of correlations and attempt to exploit them. That may work fine as a money-making strategy in the short-run when the structure of the economy is fairly constant, but for understanding why things work the way they do, and to understand how things might suddenly change, theoretical models are necessary. There may also be a problem with the difference in responses to systemic and more localized shocks, particular since large economy-wide shocks are relatively rare and hence hard to evaluate using data-based methods.

But as I said, I haven't given this enough thought, so here are some views on why risk models failed just when they were most needed from people who have spent more time thinking about this than I have. Let's start with Alan Greenspan since the explanation that comes after this references this article:

How did we go so wrong?

The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple... A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn ... from ... periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

The contraction phase of credit and business cycles, driven by fear, have historically been far shorter and far more abrupt than the expansion phase... Over the past half-century, the American economy was in contraction only one-seventh of the time. But it is the onset of that one-seventh for which risk management must be most prepared. Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification. ...

Paul Krugman: The Dilbert Strategy

The administration has a plan for financial market reform - a new "org chart":

The Dilbert Strategy, by Paul Krugman, Commentary, NY Times: Anyone who has worked in a large organization — or, for that matter, reads the comic strip “Dilbert” — is familiar with the “org chart” strategy. To hide their lack of any actual ideas about what to do, managers sometimes make a big show of rearranging the boxes and lines that say who reports to whom.

You now understand the principle behind the Bush administration’s new proposal for financial reform...: it’s all about creating the appearance of responding to the current crisis, without actually doing anything substantive.

The financial events of the last seven months, and especially the past few weeks, have convinced all but a few diehards that the U.S. financial system needs major reform. Otherwise, we’ll lurch from crisis to crisis — and the crises will get bigger and bigger. ...

The Bush administration, however, has spent the last seven years trying to do away with government oversight of the financial industry. In fact, the new plan was originally conceived of as “promoting a competitive financial services sector leading the world and supporting continued economic innovation.” That’s banker-speak for getting rid of regulations that annoy big financial operators.

To reverse course now, and seek expanded regulation, the administration would have to back down on its free-market ideology — and it would also have to face up to the fact that it was wrong. And this administration never, ever, admits that it made a mistake.

Thus, in a draft of a speech to be delivered on Monday, Henry Paulson, the Treasury secretary, declares, “I do not believe it is fair or accurate to blame our regulatory structure for the current turmoil.”

And sure enough, according to the executive summary of the new administration plan, regulation will be limited to institutions that receive explicit federal guarantees — that is, institutions that are already regulated, and have not been the source of today’s problems. As for the rest, it blithely declares that “market discipline is the most effective tool to limit systemic risk.”

The administration, then, has learned nothing from the current crisis. Yet it needs, as a political matter, to pretend to be doing something.

So the Treasury has, with great fanfare, announced — you know what’s coming — its support for a rearrangement of the boxes on the org chart. OCC, OTS, and CFTC are out; PFRA and CBRA are in. Whatever.

Will rearranging these boxes make any difference? I’ve been disappointed to see some news outlets report as fact the administration’s cover story — the claim that lack of coordination among regulatory agencies was an important factor in our current problems.

The truth is that that’s not at all what happened. The various regulators actually did quite well at acting in a coordinated fashion. Unfortunately, they coordinated in the wrong direction.

For example, there was a 2003 photo-op in which officials from multiple agencies used pruning shears and chainsaws to chop up stacks of banking regulations. The occasion symbolized the shared determination of Bush appointees to suspend adult supervision just as the financial industry was starting to run wild.

Oh, and the Bush administration actively blocked state governments when they tried to protect families against predatory lending.

So, will the administration’s plan succeed? I’m not asking whether it will succeed in preventing future financial crises — that’s not its purpose. The question, instead, is whether it will succeed in confusing the issue sufficiently to stand in the way of real reform.

Let’s hope not. ... If we don’t reform the system this time, the next crisis could well be even bigger. And I, for one, really don’t want to live through a replay of the 1930s.

"Bagehot, Central Banking, and the Financial Crisis"

I have argued that the degree to which we can intervene into financial markets depends, in part, on the degree to which the intervention will cause moral hazard problems in the future. My argument has been that we should intervene now, and then use regulation to prevent moral hazard problems from arising in the future. Thus, this brings up two considerations that should guide policy interventions. First, how much moral hazard will there be in the future if we intervene today (using an intervention strategy that attempts to construct incentives that limit this problem)? If the answer is that very little moral hazard is created, then intervening now is not very costly, at least not from a moral hazard perspective. If the answer is a lot, then the second consideration comes into play.

The second consideration is how much moral hazard can be reduced through changes in regulation. Even if intervening potentially creates a big moral hazard problem, if there are ways to change the regulations or the rules about how problems will be addressed in the future (with commitment) that substantially reduce moral hazard worries, then intervening now is also less costly.

The article below has more on the moral hazard problem based on a discussion of how the 125-year-old Bagehot's doctrine can be applied to today's financial crisis. One conclusion is that "The important extent of asymmetric information in this market points to a severe [moral hazard] problem."

The severe moral hazard problem is induced by a severe asymmetric information problem. Does the asymmetric information problem also limit the ability of regulators to reduce worries about moral hazard in the future? It can, and if regulators cannot help with the moral hazard problem in the future, then our ability to intervene today to solve problems is more limited. For example, this is from "Recent Developments in the Theory of Regulation," by Mark Armstrong and David Sappington, The Handbook of Industrial Organization, 2005:

This chapter has reviewed recent theoretical studies of the design of regulatory policy, focusing on studies in which the regulated firm has better information about its environment than does the regulator. The regulator’s task in such settings often is to try to induce the firm to employ its superior information in the broader social interest. One central message of this chapter is that this regulatory task can be a difficult and subtle one. The regulator’s ability to induce the firm to use its privileged information to pursue social goals depends upon a variety of factors, including the nature of the firm’s private information, the environment in which the firm operates, the regulator’s policy instruments, and his commitment powers. ... However, ... a regulator with strong commitment powers typically can ensure that consumers and the firm both gain... But when a regulator cannot make long-term commitments about how he will employ privileged information revealed by the firm, the regulator may be unable to induce the firm to employ its superior information to achieve Pareto gains. Thus, the nature of the firm’s superior knowledge, the firm’s operating technology, the regulator’s policy instruments, and his commitment powers are all of substantial importance in the design of regulatory policy. ... Another central message of this chapter is that options constitute important policy instruments for the regulator. It is through the careful structuring of options that the regulator can induce the regulated firm to employ its privileged information to further social goals. As noted above, the options generally must be designed to cede rent to the regulated firm when it reveals that it has the superior ability required to deliver greater benefits to consumers. Consequently, it is seldom costless for the regulator to induce the regulated firm to employ its privileged information in the social interest. However, the benefits of providing discretion to the regulated firm via carefully-structured options generally outweigh the associated costs, and so such discretion typically is a component of optimal regulatory policy in the presence of asymmetric information.

Here's the discussion of how the 125-year-old Bagehot's doctrine can be applied to today's financial crisis, and how it relates to the moral hazard problem:

Bagehot, central banking, and the financial crisis, by Xavier Vives, Vox EU: The present financial crisis poses two main questions: whether it is similar to past crises and how central banks should intervene to preserve the stability of the system.

The current financial turmoil seems extraordinary because it has unexpectedly affected the heart of the functioning of our sophisticated money markets. Despite the Northern Rock episode, the main contours of the current crisis seem very distant from scenes of crises past where newspapers were covered with photos of depositors queuing to withdraw their money during a panic. Yet this crisis is just a modern-market form of a traditional banking crisis.

links for 2008-03-31

• The Fed's Regulatory Future - WSJ Economics Blog
• Stigma’s Declining Half-Life? - Lane Kenworthy
• Why the Paulson Plan is DOA - Economics Unbound
• Race and the Social Contract - New York Times
• Ben Stein Watch: March 30, 2008 - Felix Salmon
• Going for Broke - James Surowiecki
• Al Gore defies the laws of probability - Marshall Jevons
• The Dis-Integration of the News - Economic Principals
• Piercing This Bubble For Good - Roger C. Altman
• Don't regulate, rationalize - Interfluidity

Resolving the Financial Market Crisis

In thinking about how to resolve the financial market crisis, I've said that we should do two things, pursue some version of a mortgage repurchase plan, and pursue some means of removing risky assets from financial markets:

[T]he Fed [can] remove risk from the market by purchasing risky mortgage backed securities... I think purchasing mortgages would [also] help to stabilize the mortgage market, so I ... favor ... the mortgage purchase plan, particularly since it helps homeowners directly. I am just not sure that it will be enough by itself to get credit flowing again. ... Because of the uncertainty about whether purchasing mortgages will be enough to stabilize markets, I would advocate doing a combination of both policies, purchase troubled mortgages and purchase troubled financial assets at the same time... (and other measures, e.g. regulatory change, could also be put into place so his is not all that can be done).

In a follow-up, I added that:

I believe a combination of both plans - the Treasury intervening to purchase mortgages and reissue them on more attractive terms, and the Fed intervening to purchase mortgage backed securities (MBS) - is the safest bet. Even if one of the measures isn't enough on its own, hopefully the combination will prove sufficient.

The analytics of proposals such as this are starting to come together. Brad DeLong has done us a favor and provided the latest step in the analytical process. Here's a fragment of a much longer post he has provided. Notice that he has also added recapitalization to the list of policies, an important innovation since this is one of the keys helping financial markets to move forward:

What do we do now? That is the subject of Larry Summers's column. We do two things. First, we have the Federal government reduce the supply of risky financial assets by having the government buy or guarantee (thus making the assets no longer risky, you see) or support the purchase of mortgages (and other things) and so push the private financial-sector supply of financial assets to the left. Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the supply up and to the right, like so:

And so pushing up the prices and reducing the interest rates charged on financial assets, making the good equilibrium reappear, and keeping us out of depression, like so:

That, in a nutshell with simple graphs, is what Larry is saying, with the addition that he thinks that we now have in motion enough policy moves to resolve the crisis and save the world economy from depression. But there are four additional points that don't fit easily on the graphs. We need to make sure that we also:

• do smart things to try to keep this from happening again
• assign blame and try as hard as we can--without causing a depression--to make sure that those who bear responsibility don't make out like bandits by looting the Treasury as this is accomplished.
• make sure that others--even if they are still largely innocent bystanders at the moment--do not earn unjustified windfall fortunes in the process.
• make sure that the upward-and-to-the-right orange-arrow movement of the supply curve does in fact take place: make sure that financial intermediaries that survive and profit because of government intervention become not just part of the problem but part of the solution: that because "much is being given to financial institution shareholders and management, [it is only fair that much] action to help the economy and protect the taxpayer... be expected in return."

Now there are three objections to this analysis and this plan of action, roughly: (1) it's immoral, (2) it's unfair, and (3) it can't work in the long run. To expand a bit ... [...Brad's post...]

Adverse Selection, Loan Defaults, and Credit Rationing

What is the source of foreclosures, interest rate resets or falling prices? In this post, I said:

It's easy to explain how interest rate resets could increase foreclosure rates since the monthly housing payment will change as a result of the reset, but why do falling prices cause increased foreclosures? Falling prices don't change monthly payments, so why do more people default?

The post then explains how falling prices can increase defaults and Richard Green provides academic work supporting the mechanism.

But falling prices and interest rate resets are not mutually exclusive explanations for rising foreclosure rates, both could be at work, and Brad DeLong presents a model that explains how, through adverse selection, rising interest rates can cause increases in defaults.

The purpose of this post is to further illuminate Brad's discussion and to explain how the adverse selection mechanism operates.

To do so, rather than try to impress all of you by building my own model, I'll avoid reinventing the wheel and will instead base this discussion on a version of the Stiglitz and Weiss (1981) model presented in Carl Walsh's Monetary Theory and Policy text (so full credit should be given to those authors). The presentation is mathematical, but along the way I will try to provide the intuitive underpinnings, so hopefully the points will be clear even if the mathematics is not.

The basic point of the model is to illustrate two things. First, how an increase in the interest rate can increase defaults. This is the main point. Second, how equilibrium credit rationing can occur, i.e. how financial markets can settle on an equilibrium where there are buyers willing to take out loans at the going interest rate, but nobody willing to lend them money at that rate, and the excess demand for loans is not resolved through rising interest rates.

I should add that there are other mechanisms that can be used to explain these results, moral hazard and monitoring cost models for example (e.g., as interest rates increase, borrowers are induced to take on more risk in moral hazard models, and the increased risk taken on by borrowers increases defaults) so this should not be considered exhaustive.

Summers: Steps To Safeguard America’s Economy

Larry Summers, who is becoming a bit more optimistic about economic conditions, says monetary and fiscal policy measures enacted or likely to be enacted have helped to reduce the chances of severe problems, but there are still dangers to worry about and the next step for policymakers is to increase the amount of capital held by financial firms:

Steps that can safeguard America’s economy, by Lawrence Summers, Commentary, Financial Times: Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers...

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac ... to purchase more than an additional $300bn in mortgage-backed securities. ...

Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

The confidence engendered by all of this has led to some normalisation in credit markets. ... It is sometimes darkest before the dawn. For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission. ...

While spreads have come in somewhat, markets continue to price in significant probabilities of default for even the most apparently strong financial institution, reflecting in part concerns about their solvency. At the same time it needs to be recognised that the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system.

All of this implies that a priority for financial policy has to be increases in the level of capital held by financial institutions. Capital infusions to date fall far short of prospective losses. Without new capital, the financial sector will operate with too much risk and leverage or will put the economy at risk by restricting the flow of credit. ...

The policy approach should start with the GSEs. These institutions’ viability ... depends on the implicit federal guarantee of their several trillion dollars of liabilities. ...

It is not appropriate that their shareholders’ “heads I win, tails you lose” bet with the taxpayer be expanded for this purpose. Given their past and prospective losses, their regulator – supported by the Treasury, the Fed and, if necessary, Congress – should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending. ...

Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.

As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital. Consideration should be given to collective actions designed to destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return.

Is Poverty Caused by Irrational Behavior?

Is the poverty trap caused by a fundamental change in behavior once the number of problems an individual faces crosses some critical threshold?:

The sting of poverty, by Drake Bennett, Boston Globe: ...In the community of people dedicated to analyzing poverty, one of the sharpest debates is over why some poor people act in ways that ensure their continued indigence. Compared with the middle class or the wealthy, the poor are disproportionately likely to drop out of school, to have children while in their teens, to abuse drugs, to commit crimes, to not save when extra money comes their way, to not work.

To an economist, this is irrational behavior. It might make sense for a wealthy person to quit his job, or to eschew education or develop a costly drug habit. But a poor person ... would seem to have the strongest incentive to subscribe to the Puritan work ethic, since each dollar earned would be worth more ... than to someone higher on the income scale. Social conservatives have tended to argue that poor people lack the smarts or willpower to make the right choices. Social liberals have countered by blaming racial prejudice and the crippling conditions of the ghetto... Neoconservatives have argued that antipoverty programs themselves are to blame for essentially bribing people to stay poor.

[Charles] Karelis, a professor at George Washington University, has a simpler but far more radical argument to make: traditional economics just doesn't apply to the poor.

"Obama and the Class Question"

Richard Florida takes a look at how support for Democratic presidential candidates varies across the creative and working classes, and the how the variation "raises an  interesting dilemma for campaign strategists":

Obama and the class question, by Richard Florida: ...Pundits on all sides have framed this election - and especially the Democratic primary - as turning on the traditional fault lines of race, gender and generation.

The talk shows go on and on about how Mr. Obama is attracting black and young voters and how Ms. Clinton finds her voice among women and baby boomers.

But what is seldom discussed and yet most interesting... At bottom, both the Democratic primary and the upcoming general election turn on an even deeper economic and social force: class.

In 2002, I defined a new creative class of inventors, entrepreneurs, engineers, artists, musicians, designers and professionals in idea-driven industries.

Today, nearly 40 million American workers fit into that group, 35 per cent of the total working population and a good deal more than the 23 per cent who make up the working class. ...

Up to this point, creative-class people have predominantly cast themselves as politically independent or "post-partisan," and their political sympathies have been up for grabs.

The traditional Republican platform of individualism, economic opportunity and fiscal responsibility appeals to them; but so, too, do the Democratic values of social liberalism, environmentalism and a progressive track record on gay and women's rights.

Democratic candidates such as Bill Bradley and Howard Dean attracted the creative class in the 2000 and 2004 elections. But no one has caught fire with this class like Barack Obama. ...

To get a better sense of how this deep this support runs, I asked opinion pollster John Zogby to look into how creative-class people were voting in this primary season.

Comment Policy

Everyone seems to be posting their comment policies lately. Here's mine:

links for 2008-03-30

• Bleakonomics - New York Times
• Fed May Rethink Hands-Off Approach Towards Bubbles - Bloomberg
• The Next President Is Causing This Crisis? - Washington Post
• Obama Calls Treasury Plan ‘Inadequate’ - WSJ Washington Wire
• Why LBJ bowed out - LA Times
• Carnegie Mellon Economist Says Oil Prices Aren't High Enough - prnewswire

"The Smart Way Out of a Foolish War"

The war. When will it end?:

The Smart Way Out of a Foolish War, by Zbigniew Brzezinski, Commentary, Washington Post: Both Democratic presidential candidates agree that the United States should end its combat mission in Iraq within 12 to 16 months of their possible inauguration. The Republican candidate has spoken of continuing the war, even for a hundred years, until "victory." The core issue of this campaign is thus a basic disagreement over the merits of the war and the benefits and costs of continuing it. ...

Alan Blinder: How to Cast a Mortgage Lifeline?

Alan Blinder gives details on how to structure a modern version of the depression-era HOLC program. The program is an attempt to reduce the number of foreclosures and stabilize financial markets:

How to Cast a Mortgage Lifeline?, by Alan S. Blinder, NY Times: The financial markets are downright scary. And it seems unlikely that we can extricate ourselves from the current series of rolling financial crises without improving the situation in three related markets: those for houses, mortgages and securities based on mortgages.

In a previous column for Sunday Business, I advocated one possible approach: creating a modern version of the Home Owners’ Loan Corporation, or HOLC, the Depression-era entity that bought up old mortgages and issued new, more affordable ones in their stead. ...

But this is one of those cases where the devil truly is in the details. How would it work in practice? Let’s concentrate on six major design issues:

U.S. Recession Probabilities

My colleague Jeremy Piger's recession probability index has been updated (previous) with the latest data - through January 2008:

As you can see, historically, the index has been accurate. Currently, it's still headed upward, but it's not yet to the level where a recession is indicated:

Historically, three consecutive months of recession probabilities exceeding 0.8 has been a good indicator that an expansion phase has ended and a new recession phase has begun, while three consecutive months of recession probabilities below 0.2 has been a good indicator that a recession phase has ended and a new expansion phase has begun.

Let Them Eat Their Losses

Daniel Gross, like most everyone else, is unimpressed with John McCain's economic policies:

Staying on Bush's Course Here's some straight talk: McCain's fiscal program is either a joke or a fantasy, by Daniel Gross, Slate: In the last week, the three remaining presidential candidates made big-picture economic speeches.... Barack Obama ...[and] Hillary Clinton ... have remarkably detailed (and remarkably similar) platforms on how to attack the various economic woes facing America. ...

Unfortunately, the brains behind [John McCain's] economic operation seems to be former Sen. Phil Gramm, the Texas A&M economist-turned-senator... And the sections on McCain's Web site about domestic policy reveal, as Matt Yglesias noted, "a nearly astounding level of vacuity."

Reading McCain's economic agenda and listening to his speech, it appears that the problem with the last eight years is that we haven't seen enough tax breaks for the wealthy, that economic royalism hasn't been pursued with sufficient vigor, and that the middle and working classes haven't been stiffed sufficiently.

McCain wants to extend the Bush tax cuts, which he once opposed as a needless sop to the rich in a time of war. (I await David Brooks' inevitable explanation of how opposing taxes in a time of war in 2001 and 2003, when deficits were low, but supporting them in 2011, in a time of war and high deficits, is deeply moral and admirable.) But McCain wants to see Bush's tax relief and raise it some. ... "In all, his tax-cutting proposals could cost about $400 billion a year, according to estimates ... by CBO and the McCain campaign," the Wall Street Journal reported. And how to make up for the lost revenues? Hmmm. McCain promises to cut earmarks; to eliminate waste, fraud, and abuse; and to reduce the projected growth of Medicare; but he won't provide many numbers. ... Essentially, McCain wants to cut revenues by about 15 percent from current levels, with nothing close to that in spending reductions... Here's some straight talk: McCain's fiscal program is either a joke or a fantasy.

McCain's housing speech ... provided a good description of the problem. But his solution to an era in which financial deregulation set the stage for federal bailouts, rampant speculation, and reckless lending is ... less regulation. ...

For McCain, ... [p]oor decisions should not be rewarded—unless those poor decisions are made by really rich people who run investment banks and hedge funds. While "those who act irresponsibly" shouldn't be bailed out as a matter of principle, it's OK to take extraordinary measures to help banks prevent "systemic risk that would endanger the entire financial system and the economy." Obama and Clinton—and the Bush administration...—have argued that it might be possible to spare further systemic risk if something were done to buck up the fortunes of homeowners. Bollocks, says McCain. People should just put up more money for down payments and work harder to keep current with their mortgage payments. ...

At a time of rampant economic insecurity and low consumer confidence, at the end of a business cycle in which median incomes didn't rise and the percentage of working people with health insurance fell, McCain won't succumb to the easy temptation of saying that government policy can help improve the situation. But smart politics? I wonder. What's left of the Republican Party is becoming increasingly downscale, and many swing states have been ravaged by the housing crisis (Nevada, Florida) and globalization (Ohio, Michigan). Besides, he's already got the let-them-eat-cake vote sewed up.

Update: From Paul Krugman:

The Gramm connection, by Paul Krugman: Aha: the Politico notices that Phil Gramm, McCain’s economic guru, can also be viewed as the father of the financial crisis.

The general co-chairman of John McCain’s presidential campaign, former Sen. Phil Gramm (R-Texas), led the charge in 1999 to repeal a Depression-era banking regulation law that Democrat Barack Obama claimed on Thursday contributed significantly to today’s economic turmoil. ...

According to federal lobbying disclosure records, Gramm lobbied Congress, the Federal Reserve and Treasury Department about banking and mortgage issues in 2005 and 2006.

During those years, the mortgage industry pressed Congress to roll back strong state rules that sought to stem the rise of predatory tactics used by   lenders and brokers to place homeowners in high-cost mortgages

Where have I seen that before? Ah:

His chief economic adviser is former Senator Phil Gramm, a fervent advocate of financial deregulation. In fact, I’d argue that aside from Alan Greenspan, nobody did as much as Mr. Gramm to make this crisis possible.

Seriously, the Gramm connection tells you all you need to know about where a McCain administration would stand on financial issues: squarely against any significant reform.

links for 2008-03-29

• Runaway health care costs were #1! - Paul Krugman
• A memo to the next president - Jeff Sachs - Scientific American
• NYT omits GOP's supply-side claims - Brendan Nyhan
• Can We Correct Our Own Biases? - Zubin Jelveh
• Why Recessions are Good...for Your Health - Macro and Other Market Musings
• McCain Forecloses Early - Gail Collins
• Treasury Dept. Plan Would Give Fed Wide New Power - New York Times
• Jim Repetti's work on wealth, taxes, and Democracy - ataxingmatter
• Treasury Dept. Plan Would Give Fed Wide New Power - NY Times

Trust in the Fund

This is worth echoing:

About the Social Security trust fund, by Paul Krugman: I see from comments on an earlier post, plus some of the incoming links, that the whole “there is no trust fund, so the system will be in crisis in 2017″ thing is still out there. So I’m just going to reprint what I wrote about this three years ago:

Social Security is a government program supported by a dedicated tax, like highway maintenance. Now you can say that assigning a particular tax to a particular program is merely a fiction, but in fact such assignments have both legal and political force. If Ronald Reagan had said, back in the 1980s, “Let’s increase a regressive tax that falls mainly on the working class, while cutting taxes that fall mainly on much richer people,” he would have faced a political firestorm. But because the increase in the regressive payroll tax was recommended by the Greenspan Commission to support Social Security, it was politically in a different box - you might even call it a lockbox - from Reagan’s tax cuts.

The purpose of that tax increase was to maintain the dedicated tax system into the future, by having Social Security’s assigned tax take in more money than the system paid out while the baby boomers were still working, then use the trust fund built up by those surpluses to pay future bills. Viewed in its own terms, that strategy was highly successful.

The date at which the trust fund will run out, according to Social Security Administration projections, has receded steadily into the future: 10 years ago it was 2029, now it’s 2042. As Kevin Drum, Brad DeLong, and others have pointed out, the SSA estimates are very conservative, and quite moderate projections of economic growth push the exhaustion date into the indefinite future.

But the privatizers won’t take yes for an answer when it comes to the sustainability of Social Security. Their answer to the pretty good numbers is to say that the trust fund is meaningless, because it’s invested in U.S. government bonds. They aren’t really saying that government bonds are worthless; their point is that the whole notion of a separate budget for Social Security is a fiction. And if that’s true, the idea that one part of the government can have a positive trust fund while the government as a whole is in debt does become strange.

But there are two problems with their position.

Interest Rate Resets, Falling Prices, and Foreclosures

I didn't post John Berry's most recent article, Fed Actions Defuse Subprime ARM Rate Reset Bomb, because I wasn't sure if interest rate resets are the major source of the foreclosure problem. There's evidence that falling prices are the main source of the foreclosure problem, not interest rate resets, and I didn't want to push the "don't worry so much" point, or focus attention on resets, if that is not the right thing to look at. First, here's Brad DeLong's summary of John Berry's article:

John Berry Notes that the ARM Reset Bomb Has Been Somewhat Diffused..., by Brad DeLong: He writes, for Bloomberg:

Bloomberg: Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners' monthly payments jumped when interest rates reset to a higher level. Not only is that unlikely to happen, this year's resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007. The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level. The Federal Reserve's cuts in its target for the overnight lending rate -- the last to 2.25 percent on March 18 -- from 5.25 percent in mid-September, plus actions to increase liquidity in the inter-bank lending market, have caused the Libor to fall.

Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven't been due to resets so far. Many borrowers simply bought a house or condo they couldn't afford unless bailed out by rising prices, and lower rates alone won't help them much. Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been.

Much of the discussion about the danger of resets has focused on the initial interest rate, or ``teaser rate,'' that ARMs carried. That left the impression it was a very low rate that would adjust up a lot. Most of the initial rates were 8.5 percent or above, and now many are set to adjust hardly at all...

Here's why I wonder if this is missing the main factor behind foreclosures. This is Richard Green (original post with graph):

Is Everything we Know About Subprime Wrong?, by Richard Green: Yesterday I saw a great talk by Paul Willen of the Boston Fed. An earlier version of the paper he gave is here.

I don't think I am caricaturing what he said to say when I describe the following takeaways from his talk:

(1) Falling house prices lead to defaults more than defaults lead to falling house prices. ...

(2) Interest rate resets have little of anything to do with the large number of defaults we are observing. For the vast majority of subprime loans, defaults or refinances happen before resets take place. It is moreover the case that the size of the resets is smaller than most of us think, because the initial teaser rates are pretty high.

(3) While ARMs have higher default rates than FRMs, putting ARM borrowers into FRMs will not necessarily reduce defaults. ...

Beyond this last point, a working paper I have with Cutts and Ramogopal shows that ARM borrower are fundamentally more likely to be risk-takers than FRM borrowers, so the difference in loan performance between the two products may say more about the distributions of the different borrowers, rather than the products themselves.

In any case, all of this means that many of the policies being pushed at the moment (such as interest rate freezes) may not be particularly helpful in resolving the crisis.

I decided to post on this after all because a debate has broken out about whether Berry's conclusion about resets is correct. But if resets aren't the big problem we should worry about, whether he's right or wrong isn't as important and we should shift our focus away from resets and toward policies that prevent or attenuate falling prices.

With respect to the debate over resets, here's Andrew Leonard with a summary of Yves Smith's criticism of Berry's conclusions:

Whatever happened to the great ARM reset crisis?, by Andrew Leonard: Remember all the concerns expressed about the great ARM reset bulge of 2008, when the introductory, low-rate periods of millions of adjustable-rate mortgages were supposed to expire and send countless more American homeowners into foreclosure?

On Thursday, Bloomberg News columnist John Berry suggested that the reset crisis wouldn't be as bad as once predicted. He gave two reasons: First, the interest rate cuts orchestrated by the Fed are having the desired trickle down effect of putting downward pressure on the interest rates that various ARMs will reset at, and second, contrary to popular belief, most borrowers don't actually have mortgages with absurdly low initial interest rates, so they won't suffer too much damage. ...

Berry based his conclusions on data presented in a recent report from two New York Federal Reserve Bank economists...

I read Berry's column on Thursday and considered noting it here. How the World Works savors contrarian takes. But in my judgment, over the past two years that I've been following his coverage of the Federal Reserve and the economy, Berry has consistently understated the potential harm that might be wreaked by the housing bust and credit crunch. ... So I decided not to call attention to yesterday's Berry column, figuring it just wasn't that interesting that someone who has a track record of optimism about the economy was ladling out some more good cheer.

With this background, readers might therefore understand why I was intrigued to read Naked Capitalism's Yves Smith analyze Berry's column this morning and call it "extraordinarily misleading."

Emphasizing that the data Berry based his conclusions on came from just one month of mortgage-backed securities issued by just one mortgage lender, Smith took the time to look at a database containing information on 38 million mortgages issued between 2004 and 2006. That database shows that out of 8.4 million ARMS originating during that time period, only 9.1 percent had initial interest rates of 8.5 percent or higher. A whopping 1.1 million were 2 percent or lower. (Contrast that to Berry's assertion that "most of the initial rates were 8.5 percent or more.") ...

Again, though, we shouldn't get too wrapped up in this debate if it is not the source of the problem. If it's prices and not resets, then policy prescriptions need to deal with price effects, e.g. setting a price floor, rather than wasting a lot of time constructing proposals to insulate homeowners from interest resets.

On price floors and mortgage bailouts to prevent foreclosures, it's nice to see people coming around to the idea. Ryan Avent of The Bellows discusses how we determine irresponsible actions, if we even can, and what this means for policy:

More on Mortgage Bailouts, The Bellows: It should be clear that I’m coming around on the idea of providing assistance to struggling homeowners, for a number of different reasons. A big one is that the case for concern about moral hazard grows weaker by the day. In looking at McCain’s mortgage assistance plan (which is, basically, there will be none), you see that he doesn’t want to reward those who got themselves into this position by acting irresponsibly. But is it the case that most of the people harmed by the housing collapse are those who acted irresponsibly? ...

The ... fate of an individual homeowner depends on the state of the market. McCain says he doesn’t want to reward folks who bought a house knowing they could only afford it if prices continued to rise. Fine. How does he feel about folks who bought a house knowing they could afford it so long as prices didn’t decline by 20 percent? Or so long as half the surrounding homes didn’t enter foreclosure?

Why is this important? Let me quote OFHEO:

The causal relationship between home prices and foreclosures is two-directional: high foreclosure activity can both cause and be caused by home price declines. Home price declines can cause foreclosures by decreasing the equity homeowners have in their properties. Mortgagors are much more likely to default on their loans if the current value of their property falls below the outstanding loan balance... Declines in home prices will increase the frequency with which homeowners ... “walk away” from the property and the mortgage.

Home foreclosures contribute to weakening prices by introducing additional supply to the inventory of unsold homes. Compounding this influence is the fact that the sellers of foreclosed homes, frequently creditors, may be strongly averse to holding onto the property for an extended period of time. As a result, they may be willing to sell for lower prices than resident homeowners.

So, we had some borrowers who were going to default if prices quit skyrocketing. When prices quit skyrocketing, they went belly up, and prices stopped rising entirely. Then the borrowers who needed prices to rise at least a little went belly up, pushing prices downward. Then the borrowers who needed prices to at least stay level went belly up, pushing prices downward. You see where this is going.

At the same time, troubles in credit markets due to defaults have pushed up key interest rates and made it difficult for potential buyers to get loans, heaping still more downward pressure on housing markets. The end result is that a lot of people who weren’t speculating, and who weren’t really being too reckless, have found themselves in a great deal of trouble.

At some point the best way to handle this issue is not to make sure that wrongdoers are punished, because the damage has simply spread too far and included too many people who weren’t trying to game the system. At that point, you bail out the system to keep it from sinking, and you fix the rules that allowed this situation to arise in the first place. We’re at that point, and the failure to recognize that fact will mean that this cataract just sucks in a steadily widening field of homeowners, who are steadily less responsible for the problems we face.

That's the argument I've been making, "you bail out the system to keep it from sinking, and you fix the rules that allowed this situation to arise in the first place."

Update: I have a question, and it's come up in comments as well. It's easy to explain how interest rate resets could increased foreclosure rates since the monthly housing payment will change as a result of the reset, but why do falling prices cause increased foreclosures? Falling prices don't change monthly payments, so why do more people default?

I can think of one reason. Every month, a certain number of people will become unemployed and the unemployment event itself could cause foreclosures if they cannot meet monthly payments. But the problem is worse when prices are falling below loan values since if the person needs to move to take a new job, the only option they may have is to move and default on the loan, or stay where they are and default on the loan (and there's no longer any equity in the house that can be used to tide them over until they get another job). Thus, as housing prices fall and this happens more and more often, we see foreclosure rates increasing (the fall in housing prices may be associated with rising unemployment rates making it worse). Similarly, many housing sales are driven by divorce. When this happens and neither person can make the payments alone, it's often necessary to sell the house. If prices are falling, default is more likely since they may not be able to make up the difference between the loan value and the value of the house. Neither of these explanations have much to do with people making bad decisions about the housing purchase per se, if they had stayed employed or stayed married they could have made the payments, but that's not what happened. When housing prices are falling below loan values, the problems people experience in life are amplified.

How else could falling prices increase foreclosures?

Update: Richard Green gives an answer:

Worth rereading: Deng, Quigley and Van Order from 13 years ago, by Richard Green: Mark Thoma tries to unravel the mystery of why house prices matter more than rate resets. The paper by D, Q and VO is Mortgage Default and Low Downpayment Loans: The Costs of Public Subsidy, and I think it helps answer the question. The abstract:

This paper presents a unified model of the default and prepayment behavior of homeowners in a proportional hazard framework. The model uses the option-based approach to analyze default... The results indicate the sensitivity of default to the initial loan-to-value ratio of the loan and the course of housing equity. The latter is a measure of the extent to which the default option is in the money. The results also indicate the importance of trigger events, namely unemployment and divorce, in affecting ... default behavior. The empirical results ... indicate that if zero-downpayment loans were priced as if they were mortgages with ten percent downpayments, then the additional program costs would be two to four percent of funds made available -- when housing prices increase steadily. If housing prices remained constant, the costs of the program would be much larger indeed. Our estimates suggest that additional program costs could be between $74,000 and $87,000 per million dollars of lending. If the expected losses from such a program were not priced at all, the losses from default alone could exceed ten percent of the funds made available for loans.

When households have equity in their house, they don't default. This is why the unprecedented drop in nominal house prices nationally is so calamitous. At the same time, households don't usually default unless they face a trigger event, such as unemployment, divorce and illness. A large rate reset may also constitute such a trigger event, but as three Boston Fed economists show, these are not all that common. Trigger events, moroever, are not sufficient conditions for default, and negative equity is a necessary condition for default.

Paul Krugman: Loans and Leadership

What do the presidential candidate's responses to the mortgage crisis tell us about the kind of president each is likely to be?:

Loans and Leadership, by Paul Krugman, Commentary, NY Times:

When George W. Bush first ran for the White House, political reporters assured us that he came across as a reasonable, moderate guy.

Yet those of us who looked at his policy proposals — big tax cuts for the rich and Social Security privatization — had a very different impression. And we were right.

The moral is that it’s important to take a hard look at what candidates say about policy. ...[P]olicy proposals offer a window into candidates’ political souls... Which brings me to the latest big debate: how should we respond to the mortgage crisis?...

Mr. McCain is often referred to as a “maverick” and a “moderate”... But his speech on the economy was that of an orthodox, hard-line right-winger. It... was more about what Mr. McCain wouldn’t do than about what he would. His main action proposal, as far as I can tell, was a call for a national summit of accountants...

Mr. McCain more or less came out against aid for troubled homeowners: government assistance “should be based solely on preventing systemic risk,” which means that big investment banks qualify but ordinary citizens don’t.

But I was even more struck by Mr. McCain’s declaration that “our financial market approach should include ... removing regulatory, accounting and tax impediments to raising capital.” ... Mr. McCain is selling the same old snake oil, claiming that deregulation and tax cuts cure all ills.

Hillary Clinton’s speech could not have been more different.

True, Mrs. Clinton ...[has] echoes of the excessively comfortable relationship her husband’s administration developed with the investment industry. But the substance of her policy proposals..., like that of her health care plan, suggests a strong progressive sensibility.

Maybe the most notable contrast between Mr. McCain and Mrs. Clinton involves ... restructuring mortgages. Mr. McCain called for voluntary action on the part of lenders — that is, he proposed doing nothing. Mrs. Clinton wants a modern version of the Home Owners’ Loan Corporation, the New Deal institution that acquired ... mortgages..., then reduced payments to a level ... homeowners could afford.

Finally, Barack Obama’s speech ... followed the cautious pattern of his earlier statements on economic issues.

I was pleased that Mr. Obama came out strongly for broader financial regulation... But his proposals for aid..., though significant, are less sweeping than Mrs. Clinton’s: he wants to nudge private lenders into restructuring mortgages rather than having the government simply step in and get the job done.

Mr. Obama also continues to make permanent tax cuts ... a centerpiece of his economic plan. It’s not clear how he would pay both for these tax cuts and for initiatives like health care reform, so his tax-cut promises raise questions about how determined he really is to pursue a strongly progressive agenda.

All in all, the candidates’ positions on the mortgage crisis tell the same tale as their positions on health care: a tale that is seriously at odds with the way they’re often portrayed.

Mr. McCain, we’re told, is a straight-talking maverick. But on domestic policy, he offers neither straight talk nor originality; instead, he panders shamelessly to right-wing ideologues.

Mrs. Clinton, we’re assured by sources right and left, tortures puppies and eats babies. But her policy proposals continue to be surprisingly bold and progressive.

Finally, Mr. Obama is widely portrayed, not least by himself, as a transformational figure who will usher in a new era. But his actual policy proposals, though liberal, tend to be cautious and relatively orthodox.

Do these policy comparisons really tell us what each candidate would be like as president? Not necessarily — but they’re the best guide we have.

links for 2008-03-28

• Gloomy About Globalization (Review of Stiglitz) - NY Review of Books
• Fed Leaders Ponder an Expanded Mission - washingtonpost.com
• Fedspeak: Rosengren on Bank Supervision - WSJ Economics Blog
• Recession, Shmecession? Ask Mishkin - WSJ Economics Blog
• Regulatory Rethink - WSJ.com
• The mortgage crisis and the government's safety net - Daniel Gross
• Will Iceland Erupt? - - Alpha.Sources
• Jeffrey Sachs on The Daily Show - Comedy Central
• Emergency Bank Debt Insurance: The Silver bullet solution? - Vox EU
• Obama's plan to change the economy - Andrew Leonard
• Obama's plan for Regulating Financial Institutions - Richard Green
• Fedspeak: Stern on Bailouts and Bubbles - WSJ Economics Blog
• Bernanke's Research Prepares Him for Current Crisis - WSJ Economics Blog
• Sachs appeal - Economist.com
• Current Economic Outlook, and Recent Actions - Lockhart - FRB Atlanta
• Neocon Regrets (cartoon) - Tom Tomorrow
• Income Concentration Rose Again in 2006 - CBPP
• Does McCain Subscribe to the Laffer Hypothesis? - Jeff Frankel

Feldstein on the Falling Dollar

Martin Feldstein says we're fortunate, the decline in the dollar is coming at a good time:

The dollar is falling at the right time, by Martin Feldstein, Commentary, Financial Times: The dollar’s recent decline ... triggered numerous calls for exchange rate intervention. ... But intervention proposals misunderstand the significance of ... the recent dollar declines, ... and the potential adverse effects of intervention. ...

The value of the dollar, like other asset prices, fluctuates substantially from year to year. But over long periods of time the dollar’s real value has changed very little. The real, inflation-adjusted value of the dollar against a broad basket of currencies, has declined only 7 per cent over the past 20 years...

The recent decline of the dollar has led many people to talk about the current “weakness” of the dollar, encouraging intervention to stop the dollar’s further decline. This confuses recent declines with fundamental weakness. The very large US trade deficit shows that the value of the dollar is ... actually very strong. Because of the dollar’s strength, prices of US goods in global markets make them inadequately competitive.

The dollar’s decline over the past five years stimulated exports and helped to shrink the trade deficit. ... But the trade deficit last year was still more than $700bn or 5.1 per cent of gross domestic product. Since US imports are still nearly twice as large as US exports, it takes a very large fall of the dollar to shrink the net deficit.

Despite the recent dollar decline, America’s trading partners still have large trade surpluses. ... So the more competitive dollar is not causing fundamental trade problems for America’s trading partners.

The falling dollar reflects an unwillingness of private and public portfolio investors around the world to hold the current amounts of dollar securities at the existing interest rate and exchange rate. To induce them to do so, and to increase their holdings by the roughly $700bn needed to fund this year’s US current account deficit, requires either a lower value of the dollar ... or a higher rate of interest... A lower dollar has the favourable effect of stimulating US net exports and therefore of raising the US growth rate at a time of general economic weakness. In contrast, higher interest rates would reduce aggregate investment and other aspects of aggregate demand. The US has therefore been fortunate that the adjustment to the fall in world demand for US securities has taken the form of a lower dollar rather than of a rise in the level of US interest rates.

Exchange rate intervention to strengthen the dollar would be ... counterproductive. If it succeeded, it would cause the dollar to rise when the US economy needs a more competitive dollar. ... Investors and policy officials should recognise that the dollar’s current decline is part of a natural process for reducing the US trade deficit. Because of the potential weakness of the US economy in the coming months, the dollar decline and the resulting reduction in the trade deficit have actually come at a good time.

A "53-Trillion Dollar Asteroid"?

This argues we should leave Social Security benefits alone:

Time to honour America’s debt to the retired, by John Shilling, Commentary, Financial Times: The first American baby boomers have now become eligible to retire and start drawing on Social Security... Many politicians are telling us that the resulting rise in Social Security “entitlement” payments will break the budget, so we have to cut benefits to retired people. But the politicians do not want to mention that the Social Security system has been compiling a huge surplus. Why? Because they have been using that surplus for years to hide the real size of the current federal budget deficit, allowing them to spend more and justify tax cuts for the wealthy. ...

Social Security was initially a pay-as-you-go system – annual payroll taxes of workers covered that year’s payments to retired people. By the early 1980s, however, it was clear that this system was not sustainable. Payments were increasing faster than revenues, and when the baby boomers started retiring and collecting pensions, there would be huge shortfalls. President Ronald Reagan had the prudence to address this problem early enough to make Social Security sustainable. ... Social Security payroll taxes were raised, creating a surplus in the trust fund that would fully cover the future costs of baby-boomer retirement. ...

Baby boomers, and all others who have worked since 1983, paid in more than needed for Social Security retirement payments. They saved and created the trust fund surplus, which now amounts to more than $2,000bn and must be invested in US Treasury bonds. It is projected to reach nearly $3,000bn in 10 years. Then Social Security will stop generating a surplus to subsidise the rest of the budget and will begin redeeming its bonds to help make payments.

Current projections show that the trust fund bonds may be exhausted by about 2041. The trust fund’s full sustainability for at least the next 75 years could be restored easily with minor adjustments...

Politicians understand that, with the Social Security Trust Fund surplus declining, they will no longer be able to borrow from them under the table while announcing fictitiously smaller deficits to justify continued expenditures and tax cuts. And they will have to generate funds from other sources of revenue to redeem the bonds after 2017. Rather than admit too much was borrowed recently, and must now be repaid, they want to reduce Social Security benefits. This puts much of the burden on the middle class, who created most of the surplus that has been used to hide the real size of the deficits.

Fundamentally, the Social Security issue is not one of “entitlements” but of the obligation of our government to honour its debt and not reduce Social Security benefits.

There has been lots written and discussed in the media on Social Security, but not nearly as much on the real problem, rising health care costs.

Maybe one reason people are so confused about about the Social Security funding issue and the degree to which it is a problem is due to imagery like this from supposedly trusted news sources:

The broadcast itself did mention health costs and Medicare, but it would have been difficult to tell from the broadcast, or from Wolf Blitzer's questions and presentation, that the rising cost of health care rather than Social Security is the source of the problems. And the interview with Glenn Beck didn't help at all.

Update: See pgl at Angry Bear who also noticed Beck's claim.

Did Too Much Regulation Cause Our Economic Problems?

Ed Glaeser says John Kenneth Galbraith's "'The Affluent Society' seems relevant once more":

The Age of Abundance, by Edwatd Glaeser, Commentary, NY Sun: Fifty years ago, John Kenneth Galbraith's "The Affluent Society" soared to the top of the best-seller list. ... Much of "The Affluent Society" is rooted in the 1950s, but the book's central question remains central today: Should a rich society embrace free-market capitalism and private wealth, or should that society use its wealth for more public purposes like fighting poverty and improving infrastructure?

"The Affluent Society" reflects both the economy and the culture of 1958. The book's main observation was that America has become unbelievably prosperous. ... Galbraith beautifully captured that moment in the late 1950s when rising prosperity freed the median American from having real fears about basic necessities. ...

But while "The Affluent Society" reflects American society in the 1950s, it was quite detached from postwar trends in economics, which is why Galbraith has rarely been embraced by economists. In the 1940s, cutting-edge economists turned to mathematical models and statistics. Galbraith did not. ...

"The Affluent Society" is better seen as eloquent moral suasion rather than expert economic analysis. Galbraith sees two possible paths for an affluent America, and he strongly favors one of them. "The Affluent Society" argues that America can put its faith in free enterprise, which might create more and more stuff, or it can follow the more morally uplifting path of trying to reduce poverty and improve the quality of life with the help of a more robust public sector. .. Galbraith attacks the relentless pursuit of output, which, as he sees it, only satisfies unnecessary desires ginned up by clever advertisers.

Galbraith's advocacy of public spending aimed at reducing inequality and improving infrastructure helped usher in the 1960s. Lyndon Johnson's war on poverty was decidedly Galbraithian. While the New Deal social programs were born of economic desperation, Johnson's social spending reflected the confidence of prosperity, just as Galbraith had foreseen. But after 1969, the American public gradually turned against Galbraithian social policy. By 1980, Galbraith's arch-nemesis, Milton Friedman, had found an intellectual home in the White House. In the 1990s, even Democrats embraced private wealth over public spending. But in 2008, "The Affluent Society" seems relevant once more. As the political pendulum swings left, candidates once again call for a more vibrant state to right social wrongs. The excesses of the 1960s are forgotten and once again, the government is seen as society's savior. For people of all political stripes, it is worthwhile returning to "The Affluent Society," and pondering what Galbraith got right and what he got wrong.

While I am a staunch supporter of free markets, I agree with Galbraith that there is much the public sector needs to do. Private firms do not automatically provide safe streets, good roads, and clean water. Even more important, Galbraith was dead right in arguing that we need more effective schools. Human capital is our best tool against poverty and economic stagnation.

Galbraith's great failure was that he never really understood how much society is strengthened by a free and competitive private sector. "The Affluent Society" argues that a lack of regulation made American homes inferior to those in European social democracies. That view was wrong in 1958 and is completely untenable today. American housing is the best in the world, and the weaknesses of the housing market reflect too much, not too little, regulation, especially those rules that stymie construction and make housing unaffordable. While Galbraith was right that some social problems do need a stronger public sector, his analysis would read better today if he had also appreciated the tremendous vitality that comes with economic freedom.

Obviously, I disagree that the problems we are seeing in the housing market were caused by too much rather than too little regulation. Glaeser's not the only one making this claim:

Regulatory Overkill, by Allan Meltzer, Commentary, WSJ: The claim that deregulation went too far is coming from many sides. We need more regulation, the argument goes, and even a single regulator to bring stability. ...

Their diagnosis is wrong. Mistaken regulation contributed greatly to the current problems in financial markets. Take the 1970s Basel agreement between developed country governments, which followed bank failures in Germany and the U.S. The idea was to have equivalent risk standards in all the principal lending countries. The agreement required banks to increase their capital if they increased mortgage loans and other risky assets.

The banks responded, however, by developing instruments that avoided higher reserves by moving risky loans off their balance sheets. Risk moved to all corners of the global marketplace. We find out who holds the risky assets when they announce they are about to fail.

The response to the Basel regulation is not unique. The first principle of regulation is: Lawyers and politicians write rules; and markets develop ways to circumvent these rules without violating them. ...

The perennial argument of regulators is: "If only I had more power. . ." Not so. Regulators did not see the chicanery at Enron. Nor did they prevent the dot-com bubble or the Latin American debt problems in the 1980s. A main reason is "capture" -- when the interests of the regulated dominate the interests of the public.

Capture is not the only reason regulation often fails. Regulators and most politicians are good at developing rules and restrictions, but poor at thinking about the incentives that the market will face. If the incentives are strong, the market circumvents the regulation. The Basel regulation encouraged a system that is far less transparent than the system it replaced. ...

Mr. Frank and Senate Banking Committee Chairman Christopher Dodd are planning more schemes to move the risk to the taxpayers from those who made bad decisions, such as buying mortgages that are now in default. As a result, ordinary citizens will ask themselves: Why should I pay my mortgage if my neighbors can get theirs reduced? These proposals have stark long-term consequences. The financial system cannot survive if the bankers make the profits and the taxpayers take the losses.

The government has a responsibility to prevent systemic crises and financial collapse. Long ago that job was given to the Federal Reserve. It serves as lender of last resort to the market. Today, the Fed should not rescue individual firms, but it must keep the payments system from failing. To carry out that responsibility, the Fed has auctioned reserves and exchanged marketable Treasury bills for illiquid mortgages, and it has succeeded so far. Now, it must stop responding to calls for lower interest rates.

If the government underwrites all the risks, call it socialism. If it underwrites only the failures, call it foolishness.

Other than citing Basel as a general example, and I'd argue that even though Basel was not perfect it was much better than having no regulation at all, Meltzer doesn't actually say how too much regulation brought about this particular crisis. His arguments are about the problems he sees with regulation more generally, but there are no specific details about how over regulation may have caused our current difficulties. If the regulations under Basel caused banks to move assets off the books, then without regulation they wouldn't have needed to move them, but the assets still could have been used in the same way, financial institutions could have taken the same risks and would have had the same or more incentive to do so without regulatory oversight, and they could have caused the same troubles. I don't see how the regulations themselves caused the risk taking. Regulation caused evasion of regulation, and Basel II is trying to deal with that problem, but the regulations did not cause the risk-taking itself. I think Meltzer would likely argue that the regulations caused complicated financial instruments to be created that had risk properties that were difficult to assess - without regulation money would have stayed in the regulated sector where the risks would have been more transparent. But that seems to me to be an argument for regulation that forces transparency (as in the regulated sector), not an argument against regulation.  Glaeser's argument that our economic troubles are due to regulations that interfere with housing construction doesn't seem to me to be able to explain what is happening either, and he doesn't explain the connection in any detail, so basically we have two people asserting our current troubles were caused by too much regulation, but no concrete story about how that occurred. If they had one, I'm sure they'd tell it.

Update: Here's a bit more on Basel from Mishkin's monetary theory and policy text (this was written before the current crisis hit, note that regulators were already worried about banks' off-balance-sheet activities and Basel was an attempt to reduce risk their exposure):

Bank capital requirements take two forms. The first type is based on the leverage ratio, the amount of capital divided by the bank's total assets. To be classified as well capitalized, a bank's leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. Through most of the 1980s, minimum bank capital in the United States was set solely by specifying a minimum leverage ratio.

"Ten Days That Changed Capitalism"

I'm sort of surprised at the number of people coming to the conclusion that "something big just happened" that will change how capitalism operates. For example, Martin Wolf and David Wessel both conclude that recent financial instability overturns the idea that markets always function best when government involvement is minimized or absent altogether. They are talking about slightly different topics, Martin Wolf discusses how the regulatory environment must be changed so that financial markets will function better, whereas David Wessel is talking about active and direct government intervention to stabilize prices and markets. The first is about the end of "The Great Deregulation" and the second about the end of the belief that markets always quickly self-correct on their own, but in both cases the conclusion is the same, some markets must be managed using regulatory and/or stabilization tools in order to avoid problems that can negatively affect the entire economy:

Ten Days That Changed Capitalism, by David Wessel, Capital, WSJ (FREE): The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse. ...[T]he government's recent actions don't (yet) register at FDR levels. ... But something big just happened. It happened without an explicit vote by Congress. And... billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess. ...

Was this necessary? It's messy, uncomfortable and undoubtedly flawed in many details. Like firefighters rushing to a five-alarm fire, policy makers are making mistakes that will be apparent only in retrospect.

But, regardless of how we got here, the clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed. Federal Reserve Chairman Ben Bernanke spent an academic career learning how to avoid repeating those mistakes.

Is it working? It is helping. One key measure is the gap between interest rates on mortgages and safe Treasury securities. A wide gap means high mortgage rates, which hurt an already sickly housing market. ...

The gap remains enormous by historical standards, but has narrowed. On March 6, according to FTN Financial, 30-year fixed-rate mortgages were trading at 2.92 percentage points above the relevant Treasury rates; Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points. Money markets are still under stress, as banks and others hoard cash and super-safe short-term Treasurys.

Is it enough? Probably not. Although it's hard to know, the downward tug on the overall economy from falling house prices persists. The next step, if one proves necessary, is almost sure to require the explicit use of taxpayer money.

The case for doing more is twofold. One is to cushion the blow to families and communities, even if some are culpable. The other is to disrupt a dangerous downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further, and so on.

In ordinary times, a capitalist economy lets prices -- such as those of homes, mortgage-backed securities and stocks -- fall to the point where the big-bucks crowd rushes in, hoping to make a killing. But if the big money remains on the sidelines, unpersuaded that a bottom is near, the wait for bargain hunters to take the plunge could be very long and very painful.

So the next step, no matter how it is dressed up, is likely to involve the government's moving in ways that put a floor under prices, hoping that will limit the downside risks enough so more Americans are willing to buy homes and deeper-pocketed investors are willing, in effect, to lend them the money to do so.

Robert Reich: Taxpayers Deserve a Share if Bear Stearns Makes a Profit

Scroll for:

• Bear Stearns "bailout" for taxpayers [4:38 -9:42]
• The prospect of a depression [10:26-14:38]

The idea is that if taxpayers are going to cover the downside, then they ought to have a share of any profits on the upside.

links for 2008-03-27

• Types of Taxes - Ezra Klein
• Fixing the Housing Crunch - washingtonpost.com
• When a System is not a System - Musings of a Distractible Mind
• The Intelligence Revolutionary - tnr
• Does Anyone Really Believe This? - Tom Bozzo
• Confidence men - Free exchange
• Speedy puzzle-solving parrot (video) - Scientific American

Keynes: The End of Laissez-Faire

As a follow up to the discussion of Liberalisation’s Limit in the post below this one, this is a discussion of laissez-faire from Keynes. It's a bit longer than usual, but not by a lot and it's well worth the effort:

The End of Laissez-Faire, by John Maynard Keynes (1926): I The disposition towards public affairs, which we conveniently sum up as individualism and laissez-faire, drew its sustenance from many different rivulets of thought and springs of feeling. For more than a hundred years our philosophers ruled us because, by a miracle, they nearly all agreed or seem to agree on this one thing. We do not dance even yet to a new tune. But a change is in the air. We hear but indistinctly what were once the clearest and most distinguishable voices which have ever instructed political mankind. The orchestra of diverse instruments, the chorus of articulate sound, is receding at last into the distance.

At the end of the seventeenth century the divine right of monarchs gave place to natural liberty and to the compact, and the divine right of the church to the principle of toleration, and to the view that a church is 'a voluntary society of men’, coming together, in a way which is 'absolutely free and spontaneous' (Locke, A Letter Concerning Toleration). Fifty years later the divine origin and absolute voice of duty gave place to the calculations of utility. In the hands of Locke and Hume these doctrines founded Individualism. The compact presumed rights in the individual; the new ethics, being no more than a scientific study of the consequences of rational self-love, placed the individual at the centre. ‘The sole trouble Virtue demands', said Hume, 'is that of just Calculation, and a steady preference of the greater Happiness.' (An Enquiry Concerning the Principles of Morals, section LX).

These ideas accorded with the practical notions of conservatives and of lawyers. They furnished a satisfactory intellectual foundation to the rights of property and to the liberty of the individual in possession to do what he liked with himself and with his own. This was one of the contributions of the eighteenth century to the air we still breathe.

The purpose of promoting the individual was to depose the monarch and the church; the effect - through the new ethical significance attributed to contract - was to buttress property and prescriptions. But it was not long before the claims of society raised themselves anew against the individual. Paley and Bentham accepted utilitarian hedonism from the hands of Hume and his predecessors, but enlarged it into social utility (‘I omit’ says Archdeacon Paley, 'much usual declamation upon the dignity and capacity of our nature, the superiority of the soul to the body, of the rational to the animal part of our constitution; upon the worthiness, refinement, and delicacy of some satisfactions, and the meanness, grossness, and sensuality of others: because I hold that pleasures differ in nothing but in continuance and intensity' - Principles of Moral and Political Philosophy, Book 1, chap. 6). Rousseau took the Social Contract from Locke and drew out of it the General Will. In each case the transition was made by virtue of the new emphasis laid on equality. 'Locke applies his Social Contract to modify the natural equality of mankind, so far as that phrase implies equality of property or even of privilege, in consideration of general security. In Rousseau's version equality is not only the starting-point but the goal.' (Leslie Stephen, English Thought in the Eighteenth Century, II, 192).

"Liberalisation’s Limit"

Martin Wolf says he's been under a "delusion" about the ability of securitization to carry risks outside of the traditional banking system and reduce the need for regulation:

The rescue of Bear Stearns marks liberalisation’s limit, by Martin Wolf, Commentary, Financial Times: Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve ... declared this era over. ... Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns... I do not know whether the risks justified the decisions... Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices... This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions.

Greater regulation must be on the way. The lobbies of Wall Street will ... resist.... But, intellectually, their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice... It is also a matter of efficiency. ...

I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion. ...

Yet the extension of the Fed’s safety net to investment banks is not the only reason this crisis must mark a turning-point in attitudes to financial liberalisation. So, too, is the mess in the US ... housing markets. ... Again, this must not happen again... The ... aftermath will surely be much more regulation than today’s. ...

One note: Free markets is not the point. Producing well-functioning, competitive markets is the goal, that's when our models say the outcome is optimal. If removing restrictions gets you in the vicinity of the competitive outcome, and most often it does, then that is the right thing to do. But if making markets as free as we can doesn't produce a competitive outcome, then another approach is needed (and the extent to which an intervention that overcomes a market failure and produces a more competitive market reduces freedom is a debate for another day, but I don't see why it necessarily does).

Martin Wolf says regulation is coming, but "lobbies of Wall Street will ... resist" any change. That's what happened when financial markets were subjected to new regulations during the New Deal, but bankers are lucky - we're all lucky - their objections didn't stop the changes from being enacted. Daniel Gross notes the ways in which those changes are still helping us today:

The New New Deal, by Daniel Gross: In the 1930s, Franklin Delano Roosevelt saved American capitalism from its own self-inflicted wounds by erecting a new financial infrastructure—often over the vociferous opposition of the bankers and investors whose poor judgment had helped precipitate the Great Depression. During the New Deal, the government reacted to a disastrous systemic failure by creating the sort of backstops, insurance, and risk-spreading mechanisms the market had failed to develop on its own, such as deposit insurance, federal securities registration, and federally sponsored entities that would insure mortgages.

Despite sustained efforts to tear down the New Deal ... the 1930s-vintage infrastructure has proved remarkably durable. ... Although the Tennessee Valley Authority has yet to pitch in, four 70-year-old agencies are helping to cushion the blow of the housing bust. Let's count them.

1. The Federal Home Loan Bank system. Last year, the model of originating and securitizing mortgages began to break down... Mortgage companies that relied on the capital markets (rather than deposits) to raise the money for mortgages suddenly found themselves starved for cash. Many of them turned to the FHLB, which was created in 1932 (so let's give that one to Herbert Hoover) and provides capital to lenders. Indeed, had it not been for the FHLB, it's possible that the nation's largest mortgage lender, Countrywide Financial Corp., might have gone under. ... On Monday, the FHLB pitched in again ... to ... double the number of mortgage-backed securities issued by Fannie Mae and Freddie Mac...

2. The Federal Housing Authority. The FHA, which was created in 1934, insures mortgages made ... to borrowers who are creditworthy but not particularly affluent. As the mortgage market grew ... and subprime lenders peddled credit to underserved markets, the FHA may have seemed outdated. But in the wake of the subprime debacle, the FHA has suddenly become an important part of the effort to stanch the rising tide of foreclosures. ...

3. The Federal National Mortgage Association (Fannie Mae), which was created in 1938. Fannie Mae purchases ... mortgages under a certain size ... and packages them into securities, which it effectively insures. ... Fannie Mae and its brother government-sponsored enterprise, Freddie Mac, are playing a central role in the federal response to the housing crisis. ...

4. The Federal Deposit Insurance Corp. The FDIC, which was founded in 1933 and insures bank deposits, is playing more of a passive role. Many of the financial institutions that have failed or suffered near-death experiences in the current crisis—subprime lenders, jumbo lenders...—essentially fell victim to runs on the bank. ... But one sector has been largely immune from runs on the bank—banks themselves. Even as banking companies have racked up significant losses..., and even as some tiny banks have failed, Americans haven't rushed to yank their cash out of their checking and savings accounts. ...

Quoting Martin Wolf once more, he says "times of crisis are when new functions emerge." This article is something I came across in a search - it's an "interview" of Carter Glass by the Minneapolis Fed - that discusses how crises cause change (you'll see why interview is in quotes).

Two additional topics are discussed in the "interview" that have come up here recently, the erosion of the "walls between commercial and investment banks" that occurred in the late 1990s (that's when this interview was conducted), and the erosion of regulatory authority as banks found ways to evade regulations, i.e. "national banks had created affiliates as a way of doing precisely those things that the National Bank Act prohibited them from doing." Thus, in that respect, the motivation for the regulatory change that produced the Glass-Steagall act is the same as the motivation for more regulatory control today - the existence of a shadow banking system outside of regulatory authority that has the ability undermine faith in the financial system, or to produce feedback effects that can cause banks under the Fed's authority to fail:

A Conversation with Carter Glass, The Region, December 1997: Since Carter Glass has been dead for over 50 years, we were naturally surprised that he agreed to be interviewed by The Region. ... Woodrow Wilson claimed that Glass, as a member of the House of Representatives, had "snarled the Federal Reserve Act through Congress out of one side of his mouth" and speculated that Glass might have accomplished even more using his whole mouth. ... Out of deference to his extreme advanced age of 139 and perhaps worried about his reputation for being easily provoked, we eased into the following conversation as gently and graciously as we knew how.

REGION: Senator, thank you very much for coming. It's a wonderful privilege to meet the man who invented the Federal Reserve System.

links for 2008-03-26

• Building the ivory tower: Network effects in academia - Vox EU
• Homeowners Who Won’t Cut the Price - New York Times
• St. Louis Fed Taps Successor for Poole (Good choice) - WSJ Economics Blog
• Lessons learnt from Great Depression - Times Online
• What a Rodent Can Do With a Rake in Its Paw - New York Times
• Bear: Did the Fed and Treasury Push Too Hard? - naked capitalism
• John McCain's plan to ignore the economy - Andrew Leonard
• McCain-onomics: A tax cut in every corporate pot - Andrew Leonard
• Evolving the Wow! Factor - Olivia Judson
• 3 Theories That Might Blow Up the Big bang - Discover

"Immigration and Social Security"

From Kevin Drum:

Immigration and Social Security, by Kevin Drum: Paul Krugman points out that in the 2008 report of the Social Security Trustees released today the "actuarial balance" of the system is better than it's been since 1993. ... But how much better? ... [L]ast year the trustees estimated that Social Security had an overall 75-year deficit of 1.95% of taxable payroll. ...This year it's 1.70%. That's a pretty substantial improvement. What caused it? ...

[I]mmigrants. To be specific, better estimates of the taxes and benefits received by illegal immigrants — or, as the trustees refer to them, "other-immigrants":

In previous reports, the other-immigrant population was projected using assumed ... numbers... For this year's report, the ... numbers ... are projected by explicitly modeling other immigrants and other emigrants...

Translation: instead of just pulling a net number out of a hat, the trustees built a model... And guess what?

• Illegal immigrants tend to skew young. This benefits the system.
• Young people have more children than older people. This benefits the system.
• Some illegal immigrants pay taxes for a few years and then leave. This benefits the system.

Bottom line: "This year's report results in [...] a substantial increase in the number of working-age individuals contributing payroll taxes, but a relatively smaller increase in the number of retirement-age individuals receiving benefits in the latter half of the long-range period." Give or take a bit, it turns out that this shores up the Social Security system to the tune of around $13 billion per year. Thanks, illegal immigrants!

Shiller: Has Financial Innovation Been Discredited?

Robert Shiller says we shouldn't try to limit financial market innovation, we might need it to prevent another crisis:

Has Financial Innovation Been Discredited?, by Robert J. Shiller, Project Syndicate: Skeptics of financial liberalization and innovation have been emboldened by the crisis in the world’s credit markets... Are these skeptics right? Should we halt financial liberalization and innovation in order to prevent crises like the sub-prime disaster from recurring? ...

FRBSF: The Economic Outlook

Mary Daly of the San Francisco Fed gives the outlook for the US economy ("Over the whole of 2008, we expect output to rise by about 1 percent"):

FedViews, by Mary C. Daly, Federal Reserve Bank of San Francisco: Recent data on the real economy have been disappointing, adding to pressures created by ongoing disruptions in financial markets.   

Should We Mimic Denmark's Energy Policy?

Is it possible to reduce greenhouse gas emissions, but still have a "remarkably strong economic record and without relying on nuclear power"?:

On Carbon, Tax and Don’t Spend, by Monica Prasad, Commentary, NY Times: Everyone seems to be talking about a carbon tax. ... The idea is that polluters should pay for the environmental damage they cause. Slap a tax on carbon, the theory goes, and you will get fewer carbon emissions, more revenue for government and energy independence, all at the same time. No wonder people from both sides of the political divide have come out in support of it.

But a carbon tax isn’t a new idea. Denmark, Finland, Norway and Sweden have had carbon taxes in place since the 1990s, but the tax has not led to large declines in emissions in most of these countries — in the case of Norway, emissions have actually increased by 43 percent per capita. ...

The one country in which carbon taxes have led to a large decrease in emissions is Denmark, whose per capita carbon dioxide emissions were nearly 15 percent lower in 2005 than in 1990. And Denmark accomplished this while posting a remarkably strong economic record and without relying on nuclear power.

What did Denmark do right? There are many elements to its success, but taken together, the insight they provide is that if reducing emissions is the goal, then a carbon tax is a tax you want to impose but never collect.

This is a hard lesson to learn. The very thought of new tax revenue has a way of changing the priorities of the most hard-headed politicians... But if we want lower emissions, the goal of a carbon tax is to prompt producers to change their behavior, not to allow them to continue polluting while handing over cash to the government.

How do you get them to change? First, you prevent policy makers from turning the tax into a cash cow. Carbon tax discussions always seem to devolve into gleeful suggestions for ways to spend the revenue. ...

Denmark avoids the temptation to maximize the tax revenue by giving the proceeds back to industry, earmarking much of it to subsidize environmental innovation. Danish firms are pushed away from carbon and pulled into environmental innovation, and the country’s economy isn’t put at a competitive disadvantage. So this is lesson No. 1 from Denmark.

The second lesson is that the carbon tax worked ... because it was easy for Danish firms to switch to cleaner fuels. Danish policy makers made huge investments in renewable energy and subsidized environmental innovation. ...[T]he tax gave companies a reason to leave coal and the investments in renewable energy gave them an easy way to do so... The key was providing easy substitutes. ...

[A] carbon tax has been promoted almost as a panacea — just pop in the economic incentives and watch them work their magic. But unless steps are taken to lock the tax revenue away from policymakers and invest in substitutes, a carbon tax could lead to more revenue rather than to less pollution.

An increase in gasoline taxes ... would likewise be the wrong policy for the United States. Higher gas taxes would raise revenue but do little to curb pollution.

Instead, if we want to reduce carbon emissions, then we should follow Denmark’s example: tax the industrial emission of carbon and return the revenue to industry through subsidies for research and investment in alternative energy sources, cleaner-burning fuel, carbon-capture technologies and other environmental innovations.

I thought cap and trade - which is economically equivalent to a carbon tax if implemented correctly - was what "Everyone seems to be talking about," but I'll go with the premise. Also, I don't know much about how energy usage statistics have changed over time for these countries, or why, so I'll have to take the information given on faith (anybody disagree?).

Here's a graph I constructed awhile back to show the effects of a proposal to impose a carbon tax, then return every dime to the public. The economic consequences of these revenue neutral proposals are covered in most microeconomics principles classes, and people such as Robert Frank have made somewhat more formal proposals along these lines (and Marty Feldstein has a scheme he says "actually raises the income of a majority of households" and prevents policy makers from turning the tax into a cash cow, one of the concerns above). So the lesson that "a carbon tax is a tax you want to impose but never collect," is not such a "hard lesson to learn," it's a fairly common exercise (though economists would use different terminology to describe it).

There is no doubt that we should find out where and why under-investment in energy saving technology is occurring and fix the problem as soon as possible, and that can be accomplished in a variety of ways, a dedicated carbon tax is not the only possibility. But if we do impose a carbon tax, a priority for me would be to make sure that the households most vulnerable economically to an increase in energy prices are given the help they need, and it's fairly easy to construct proposals that they have this characteristic. If anything is left over after lower income households are compensated it can be earmarked for other purposes, one possibility is to support policies that help to get the proposal through the political process and do some good at the same time, but the main thing is to get the tax (or the equivalent cap and trade policy, or something that is effective) in place so we can begin to make headway on the global warming problem.

"An Absence of Oversight"

Robert Waldmann has more on bank regulation, and whether an erosion of the wall between banks and Wall Street helped to bring about the financial market crisis:

Paul Krugman Doesn't Need My Help, by Robert Waldmann: Paul Krugman doesn't need my help, but I think that Jonathan Taplin is being unfair here and is also unfamiliar with the evidence on banking regulation and banking crises.

He tells a tale of how after the Great Depression, Democrats worked to protect the banking system from runs, by enacting a split of Investment Banks and Commercial Banks.

[snip]

But never once in the whole article does he point out who yielded to the enticements of Wall Street--who was responsible for destroying the Glass-Steagall separation of Banks and Investment Banks--Bill Clinton.

Krugman didn't mention the Glass-Steagall act in his column. ...

The ... problem is not, say, that commercial banks which were allowed to own common stock gambled and lost. The way in which the Glass-Steagal act would have been relevant is if the investment banks had taken deposits. They didn't. The crisis is based on commercial banks being irrelevant, not on their being allowed to do things they couldn't do before. ...

[This also rebuts the update at the end of the post A Coordinated Effort to Destroy Effective Regulation.]

From comments:

There is reason to believe, I am again told with authority, that the problem in the financial markets has not been an absence of regulatory capability, but an absence of oversight and regulation that is part of the anti-regulatory philosophy that has steadily grown for 25 years but reached culmination with this Administration. ...

I think there's something to this. There is quite a bit of discretionary authority in the hands of regulators. As the philosophy of both parties has drifted toward a hands off approach over time, and as appointment after appointment to this or that agency has reflected that changing philosophy, the accompanying regulatory oversight has changed along with it. The changes have been more dramatic under Republican administrations, and the current administration strongly prefers a hands off approach on all matters involving economic policy (with the exception of tax cuts for the wealthy), so it's no surprise that the same philosophy has, over the last several years, filtered into the offices charged with regulatory oversight more so than in the past (and appointments based upon how much someone contributed and the strength of their ideology rather than their competence hasn't helped). To change all of this and reign in the excesses, it will take more than just changing the rules, it will also be necessary to change the people interpreting and enforcing the rules, and that won't happen without a change in party in control of the executive branch.

Robert's point is that we need to address the correct problems, and pointing fingers at the change in the Glass-Steagall act misses the mark, but once we understand where the problems are we also need the will to address them and it's hard to imagine that will existing under the continuation of this administration's economic philosophy that we would get with McCain. It's not that clear that the Democratic candidates have the will either, that was Paul Krugman's point, but at least there's some hope.

links for 2008-03-25

• Reforming to attract foreign investors - Vox EU
• The Price of Dithering - TierneyLab
• McCain adviser abandons misguided tax plan - Think Progress
• Debut of South Park Online - Andrew Sullivan
• Exit, pursued by Bear Stearns - Dean Baker
• McCain versus McCain - The Democratic Party
• Why we should fear a McCain presidency - FT
• Death Toll for Iraq War Reaches 4,000 - New York Times
• Counterparty of last resort? - Interfluidity
• The Fed and Crony Capitalism - Thomas Palley
• Too much information? Study shows how ignorance can be influential - EurekAlert
• An Explanation for Soaring Commodity Prices - Jeff Frankel

"We Are Not There Yet"

Richard Green takes issue with his "fellow white guys":

Micky Kaus and Bill Kristol want us all to shut-up about race, by Richard Green: Kristol, in fact, "cringes" that Obama brought up the subject. But while my fellow white guys Kaus and Kristol (perhaps we need to find a third K?) think it is time to get over race, the problem is that many white people have yet to do so. Consequently, the best empirical evidence shows that while there is far less discrimination now than there was in the past, discrimination remains substantial, and arises from prejudice.

Here in an abstract from Zao, Ondrich and Yinger (2006):

This study examines racial and ethnic discrimination in discrete choices by real estate brokers using national audit data from the 2000 Housing Discrimination Study. It uses a fixed-effects logit model to estimate the probability that discrimination occurs and to study the causes of discrimination. The data make it possible to control for auditors’ actual demographic and socioeconomic characteristics and characteristics assigned for the purposes of the audit. The study finds that discrimination remains strong but has declined in both the scope and incidence since 1989. The estimations also identify both brokers’ prejudice and white customers’ prejudice as causes of discrimination.

Before any of us white folks who have never suffered meaningful discrimination or prejudice, or who have never even suffered the little indignities of being stopped by the police for no reason, or been followed by a security guard in a store, or been looked at suspiciously or altogether avoided on the street, tell the world that we don't need to talk about or think about race anymore, perhaps we need to try to walk in the shoes of someone who has suffered all these things.

Things are getting better. All I have to do is see how kids behave at my daughters' high school to know so; who knows, by the time my generation is dead, race may no longer be a problem. But we are not there yet. We are not even close. I think Obama's speech nailed where we are with remarkable precision.

Kristol has some pretty strange arguments. His lead argument against a conversation on race is that:

In 1997 President Bill Clinton announced, with great fanfare, that he intended “to lead the American people in a great and unprecedented [if he did say so himself] conversation about race.” That conversation quickly went nowhere. And just as well.

So are we to infer from this argument that anything Bill Clinton couldn't get done isn't worth doing? It's no secret that Clinton was a better president than Bush, but Kristol's statement probably gives Clinton more credit than he deserves - there may be some worthwhile things left to do that, even though he tried, Clinton was unable to accomplish.

Kristol has other arguments too:

In 1969, Pat Moynihan, then serving on Richard Nixon’s White House staff, wrote Nixon a memo explaining that “the issue of race could benefit from a period of ‘benign neglect.’ The subject has been too much talked about. ... We may need a period in which Negro progress continues and racial rhetoric fades.” Moynihan, ... was right then, and his argument is right now.

So, let me get this straight. Clinton tried to talk about race, but failed, so we aren't talking about it. But according to Moynihan, who is right, we are talking about race too much. Huh? No talk is too much? Certainly some talk is too much:

A new national conversation about race isn’t necessary...

Anyway, I shouldn't waste a lot of time on Kristol. Even if he was worth reading regularly, I'd wait for him to string together several columns in a row that don't have a correction appended to the end about some key part of a previous column before paying much attention. He's probably not used to having to actually own up to inaccuracies in his writing and correct them, and it appears to be taking him a bit of time to adjust.

Paul Krugman: Taming the Beast

Are any of the candidates serious about financial reform?

Taming the Beast, by Paul Krugman, Commentary, NY Times: We’re now in the midst of an epic financial crisis, which ought to be at the center of the election debate. But it isn’t.

Now, I don’t expect presidential campaigns to have all the answers to our current crisis — even financial experts are scrambling to keep up with events. But I do think we’re entitled to more answers, and in particular a clearer commitment to financial reform, than we’re getting so far.

In truth, I don’t expect much from John McCain, who has both admitted not knowing much about economics and denied having ever said that. Anyway, lately he’s been busy demonstrating that he doesn’t know much about the Middle East, either.

Yet the McCain campaign’s silence on the financial crisis has disappointed even my low expectations.

And when Mr. McCain’s economic advisers do speak up about the economy’s problems, they don’t inspire confidence. For example, last week one McCain economic adviser — Kevin Hassett, the co-author of “Dow 36,000” — insisted that everything would have been fine if state and local governments hadn’t tried to limit urban sprawl. Honest.

On the Democratic side, ... Hillary Clinton... like Mr. Obama, has been disappointingly quiet about the key issue: the need to reform our out-of-control financial system.

Let me explain. America came out of the Great Depression with a pretty effective financial safety net, based on a fundamental quid pro quo: the government stood ready to rescue banks if they got in trouble, but only on the condition that those banks accept regulation of the risks they were allowed to take.

Over time, however, many of the roles traditionally filled by regulated banks were taken over by unregulated institutions — the “shadow banking system,” which relied on complex financial arrangements to bypass those safety regulations.

Now, the shadow banking system is facing the 21st-century equivalent of the wave of bank runs... And the government is rushing in to help, with hundreds of billions...

Given the risks to the economy if the financial system melts down, this rescue mission is justified. But you don’t have to be an economic radical ... to see that what’s happening now is the quid without the quo.

Last week Robert Rubin, the former Treasury secretary, ... put it clearly: If Wall Street companies can count on being rescued like banks, then they need to be regulated like banks.

But will that logic prevail politically?

Not if Mr. McCain makes it to the White House. His chief economic adviser is former Senator Phil Gramm, a fervent advocate of financial deregulation. In fact, I’d argue that aside from Alan Greenspan, nobody did as much as Mr. Gramm to make this crisis possible.

Both Democrats, by contrast, are running more or less populist campaigns. But at least so far, neither Democrat has made a clear commitment to financial reform.

Is that simply an omission? Or is it an ominous omen? Recent history offers reason to worry.

In retrospect, it’s clear that the Clinton administration went along too easily with moves to deregulate the financial industry. And it’s hard to avoid the suspicion that big contributions from Wall Street helped grease the rails.

Last year, there was no question at all about the way Wall Street’s financial contributions to the new Democratic majority in Congress helped preserve, at least for now, the tax loophole that lets hedge fund managers pay a lower tax rate than their secretaries.

Now, the securities and investment industry is pouring money into both Mr. Obama’s and Mrs. Clinton’s coffers. And these donors surely believe that they’re buying something in return.

Let’s hope they’re wrong.

Bruce Bartlett: Stop Those Checks

Bruce Bartlett says we should cancel the rebate checks and use the money in other ways:

Stop Those Checks, by Bruce Bartlett, Commentary, NY Times: With unusual speed and cooperation last month, George W. Bush and Democrats in Congress agreed to a tax rebate set to be paid out beginning in May. Families will get checks for $300 to $1200 or more, and it is assumed that they will all rush out to spend this money immediately, giving retailers a boost that will raise economic growth.

Despite the bipartisan support for the rebate, few economists have supported the idea. They note that we have tried rebates in the past — most recently in 2001 — and there is no evidence that they have meaningfully stimulated either consumption or growth. By and large, people saved the money they received or paid bills...; very few used their rebates to increase spending.

The true reason why the current rebate has been so popular in Washington is that giving away free money in an election year is good for politicians of both parties. Superficially, it looks as if Washington is responding to a real problem with decisive action. ...

But in the almost six weeks since the rebate legislation was signed into law, the economic situation has changed. The meltdown in financial markets is much more serious than it looked in February. ...

The solution, therefore, is not to drop $100 bills from helicopters — which is essentially what the rebate would do. Rather, what we need is a mortgage Superfund that can clean up the toxic waste. If we can cleanse the financial system of at least some of the bad debts, it will do far more to restore the economy to health than anything that could be accomplished by the rebate...

We all know that the government is eventually going to get stuck with a lot of the bad debts... At the same time, there are increasing demands for targeted relief for homeowners facing foreclosure. It looks to many people as if Washington cares more about fat-cat bankers than working families in hard times. At some point, Congress is going to respond with additional aid for people caught in the mortgage mess, and this relief will come on top of the $117 billion cost of the rebate.

We need to stop and ask whether we can afford to spend $117 billion that the Treasury Department does not have on a program of dubious effectiveness. It simply makes no sense to send out checks to people who have no need for it as some kind of election-year bribe to vote for incumbents of both parties. That money would go a long way toward cleaning up the mortgages that are poisoning the financial sector.

Congress should immediately repeal the rebate and redirect the money that has been budgeted into a package of measures that would help the housing sector and those people who actually need assistance. The Treasury might use some of the money, for example, to enable Fannie Mae and Freddie Mac ... to buy up some of the bad mortgages, get them off bank balance sheets and help homeowners refinance them.

My gut tells me that the vast majority of Americans would happily give up their rebate if they knew that the money would be used instead to help families in need and start the process of cleaning up the bad debts in the housing sector. Everyone knows that we will have to spend the money eventually...

This is a proposal that both Republicans and Democrats should embrace. It involves no increase in the deficit. We would simply redirect already appropriated money...

The checks haven’t gone out yet so no one has to give anything back. Congress could pass a repeal bill in a day if it wanted to. At a minimum, hearings should be held on this proposal in light of the country’s deteriorating financial situation.

Some people may have already purchased goods on credit and are planning to pay it back with the rebate, so the fact that the checks haven't gone out yet does not imply the rebates have not yet altered people's plans. Breaking promises now is a bad idea.

However, if we were to do this, instead of repealing everyone's rebate, how about leaving the rebates in place for households with incomes under a certain amount, households that are likely to spend the money rather than save it, and repeal it for households with higher incomes? I don't object to any of the spending because it increases the deficit, that's how the economy is stimulated (and you pay for the rebates when times are better helping to deflate or prevent bubbles), but there's no reason for the rebates to go to households who are unlikely to use the money to stimulate the economy, particularly when we might use the money more productively in other ways, e.g. on programs to prevent foreclosures.

But we can wish all we want, the rebates are in place, the machinery is rolling forward, and nothing will stop them now (and since they have already been promised, nothing should stop them). The rebates are water under the bridge. We could have structured the fiscal policy response in a much more productive way, but we didn't. Now we need to devote our attention to preventing further troubles rather than wasting effort trying to change what has already been done. If enabling "Fannie Mae and Freddie Mac ... to buy up some of the bad mortgages, get them off bank balance sheets and help homeowners refinance them" is the best policy to pursue - and a policy along those lines would help if we could do it quickly enough - then what are we waiting for? Whether we have rebates or not doesn't matter, we should do what is needed to get the mortgage repurchase program into place as soon as we can.

But the politics make me doubt that we will be able to craft an effective fiscal policy response to deal with the foreclosure problem. I hope politicians prove me wrong, that they will move as fast to help struggling homeowners as they would if tax cuts were on the table, but that seems unlikely. For that reason, the burden may remain largely with the Fed, and they will need to consider the full array of both conventional and unconventional policy responses if conditions continue to deteriorate. And if the Fed does succeed in bailing us out of this mess, it will be in spite of rather than in conjunction with fiscal policy. The rebates might help a little, but the rebates are not enough. Politicians will tout their responsiveness in time of need by citing the rebates voters received, but the truth is that the response has been inadequate, and voters ought to ask what politicians have done to help stem foreclosures, and what additional measures they have taken or plan to take in response to the crisis, for example on the regulatory front. Let's hope the Fed can pull this off.

links for 2008-03-24

• Bar Tabs and Tax Cuts - Lane Kenworthy
• The ... Soul of the Monetary Economist: A Platonic Dialogue - Brad DeLong
• You Tube Tip - Unfogged
• The War Endures, but Where’s the Media? - New York Times
• Last year's Easter post: Horton Hatches the Easter Eggs
• Austin Kelly: Zero Down Mortgages perform really badly - Richard green
• Too Dumb To Fail - James Surowiecki
• US can learn from Japan’s crisis - FT
• Salon shows how to read WSJ for free - Boing Boing
• Kicking the Can down the Road - Econbrowser

"A Coordinated Effort to Destroy Effective Regulation"

Fred Block, an economic sociologist at UC Davis, explains the political changes that led to the financial crisis:

Mortgage Meltdown for Dummies: Defining the Changes We Need, by Fred Block, Dissent: ...[T]he escalating crises of the housing and financial sectors have the potential to concentrate our minds on the specific reforms that our nation urgently needs. This requires understanding how our current problems are a direct result of the policies pushed by Republican Presidents from Ronald Reagan to George W. Bush.

The story begins with systematic efforts by Ronald Reagan to dramatically reduce the regulation of financial markets and facilitate a huge transfer of income and wealth to the highest income households. These policies were embraced and expanded by later Republican presidents and “succeeded” in producing a new era of income inequality and out-of-control financial activity. ...

Starting in 1981, Ronald Reagan set out to deliver on two major changes that he had promised his business supporters. He significantly rolled back government regulation of the financial sector... At the same time, Reagan cut taxes for the very rich, a policy initiative that was replicated by George W. Bush. Taken together, these steps facilitated a dramatic shift of income...

As the rich grew wealthier, they invested growing amounts in hedge funds that pursued risky strategies to earn annual returns that were far higher than those available for ordinary investments... The government never regulated these funds because they were closed to most people; one had to exceed a certain wealth threshold to play. The theory was that these already rich investors could cope if these highly speculative investments turned bad. ...

As hedge funds grew increasingly successful, they produced rate of return envy among established financial institutions. Pension funds, for example, wanted a piece of the higher return action and started putting some of their money into these unregulated funds. The big investment banks, similarly ... started imitating the strategies pioneered by the hedge funds. Many of them, like Bear Stearns, were even allowed to create their own hedge funds. ...

This is where the subprime mortgages come in. Starting in the 1990s, some independent mortgage brokers and mortgage firms figured out how to make money by lending to poor people who could not qualify for standard mortgages. The firms acted just like the local pawn shop, appealing to relatively desperate people who would be willing to pay substantially higher interest rates if only they could own a home. ...

Since housing prices, even in low income neighborhoods, were rising steadily, the lenders thought they faced little risk. Even if the borrower defaulted, the lender could always foreclose and sell the house for an even higher price... [B]ankers were eager to package large bundles of these mortgages and resell them to hedge funds and other investors. ... Hedge funds bought huge quantities..., usually using borrowed money..

This whole house of cards rested on the assumption that housing prices would continue the rise... But as subprime lending expanded, so too, inevitably did foreclosures, and as more foreclosed properties hit the market, prices started heading downward. ... By February 2008, almost nine million homeowners ... owed more on their mortgages than the house is worth, and that number is bound to rise...

[A] task for a new administration is to reverse the mistaken policies that created this mess. The right-wing experiment with free market orthodoxy has been a complete and total failure. It is time to repair the damage by driving the top 1 percent share of household’s income back down... We also need to restore effective regulation to all corners of the financial sector, especially hedge funds. ...

About that regulation:

Hiding behind the invisible hand, by Paul Krugman: Pretty good story on the coming fight over financial regulation. But it lets the Bushies off way too lightly, by suggesting that lack of coordination between agencies led to the awesome failure of regulators to take action against the bubble:

Except for the Federal Reserve, all of the federal bank agencies receive funding from fees paid by member institutions, and some specialists have long argued that the agencies competed with each other to woo institutions with lighter regulation.

“There was no federal coordinated oversight, and as a result there was a competition to reach the bottom, both in federal and state organizations,” said Brian C. McCormally, a former enforcement chief at the Office of the Comptroller of the Currency.

Actually, there was plenty of coordination — a coordinated effort to destroy effective regulation:

Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.

The lack of oversight, in short, was no oversight: it was part of the plan.

Here's some of the "Pretty good story":

In Washington, a Split Over Regulation of Wall Street, NY Times: As Congress and the Bush administration struggle to contain the housing and credit crises ... a split is forming over how to strengthen oversight of financial institutions after decades of deregulation.

The administration and Democratic lawmakers in Congress agree that the meltdown in credit markets exposed weaknesses in the nation’s tangled web of federal and state regulators...

But the two sides strongly disagree about whether, after decades of a freewheeling encouragement of exotic new services and new players like hedge funds, the pendulum should swing back to tighter control. ...

Given the philosophical differences about the value of government regulations, some experts were skeptical that Congress and the Bush administration would agree on more than cosmetic changes.

“There is a political will, but I’m not certain that it can overcome longstanding philosophic objections to dealing with free markets in a crisis environment,” said Arthur Levitt Jr., the chairman of the Securities and Exchange Commission under President Bill Clinton. ...

Regulations can make markets work better, so it's not clear to me why those who believe in the power of markets have such a knee jerk reaction against any kind of regulatory oversight.

One way regulation can help markets function efficiently is to require that full and truthful information be made available to all market participants. We see regulations like this so much that we take many of them for granted, e.g. weights and measures regulations, truth in advertising and labeling, full disclosure rules in housing markets, and so on. Without government to enforce these rules, markets can break down or lose efficiency.

One aspect of the problems in financial markets is exactly like this, information is incomplete or asymmetric, and these problems are pervasive. For example, complicated financial instruments are difficult to evaluate because they lack transparency. Currently, with all the financial turmoil, nobody is sure what they are worth, market participants don't have the information they need to make that determination, and many markets have broken down entirely. Similarly, there are also information problems in real estate markets, with real estate agents and mortgage brokers much better informed about the variety, eligibility, and terms of loan products than their customers. This made it easy for real estate agents and mortgage brokers to steer customers into loans that were profitable, but not always in the best interest of their customers. On the other side, customers don't always reveal truthful information about their situations, e.g. their income, debts, etc., and this can also lead to inefficiencies (and sometimes both sides work together to fool the next person in the chain).

There are many other regulations that are needed besides those intended to increase available information, one example is increasing capital requirements, and different regulations address different market failures. Not only do we have information problems in these markets, we also have moral hazard issues of the type that occur when people do not have enough of their own money at stake when taking on risky investments using other people's money (borrowed or deposited). Capital requirements will likely encounter more resistance than measures to increase transparency, but it is a means of reducing excessive risk taking and the options need to be fully explored.

There's a lot more to do, redefining what a bank is, and then bringing all banks under a consistent and central regulatory authority, rethinking the discount window (we are likely headed to a channel/corridor system anyway, so it's a good time to rethink the whole operation, what assets can be traded, with whom, etc.), but to emphasize the information aspect more, here's Tyler Cowen:

It’s Hard to Thaw a Frozen Market, by Tyler Cowen, Economic Scene, NY Times: Real estate bubbles have burst before, without bringing such trouble to the financial system. What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values. ... The results have been a form of financial gridlock.

If you think that traders have been well informed of late, take another look at the wild path of Bear Stearns shares: A year ago, the stock was selling for $170 a share. At the close on March 14, just before the deal by which Bear Stearns was to be bought by JPMorgan Chase, Bear had a book value of $80 a share — and a share price of $30. The JPMorgan transaction, arranged two days later, valued the company at about $2 a share. Since then, the shares have been trading above $2, which in part reflects the possibility of the deal breaking up.

Every step of the way, the pricing of the stock has surprised the market — and yet Bear Stearns is a firm with a lengthy history, not an Internet start-up or a biotech whose value is based on a new but untried wonder drug.

To understand the depths of the current crisis, let’s go back to an apparently unrelated episode in economic thought: the socialist calculation debate. Starting in the 1920s, Ludwig von Mises, the leader of the so-called Austrian School of Economics, charged that socialism was unable to engage in rational economic calculation. Without market prices, he reasoned, no one knows how much economic resources are worth.

The subsequent poor performance of planned economies bore out his point. ... The irony is that the supercharged capital markets of the American economy are now — at least temporarily — in a somewhat comparable position. ...

Market prices have been drained of their informational value and thus don’t much reflect the “wisdom of crowds,” as they would under normal circumstances. Investors are instead flocking to the safest of assets, like Treasury bills.

The absence of trading is a big problem. Financial institutions have been stuck holding illiquid assets, whose value cannot be easily determined. Who wants to lend to the institutions holding them? No wonder there is a credit crisis and a general attitude of wait and see. ...

So what now? Regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions. This will limit dangerous leverage, contain contagion effects and make the system less dependent on the steady flow of good information. ...

Update: More on the need for regulation, and on the need to consolidate regulation under a single authority:

U.S. Financial Regulation 2008, by John Tepper Marlin: In late 1999, the bulwark bank regulation of 1933, the Glass-Steagall Act - the wall between investment banks and commercial banks - was torn down. This was a great victory for creative bankers, who had found the wall irksome and restrictive.

The teardown opened the way for the Bankers Panic of 2008.

Ophelimity vs. Wantability

In 1918, Irving Fisher wrote an AER article trying to replace the term utility with something he found more suitable:

Is "Utility" the Most Suitable Term for the Concept It is Used to Denote?, by Irving Fisher, American Economic Review, volume 8 (1918), pp. 335-7: In all sciences, and particularly in one like economics, which appeals to the general public and which uses concepts and terms already at least partially familiar, it is a matter of some practical importance to select a suitable terminology.

The concept called "final degree of utility" by Jevon's, "effective utility", "specific utility", and "marginal efficiency" by J. B. Clark, "marginal utility" and "marginal desirability" by Marshall, Gide and others, "Grenznutzen" by the Austrians, "Werth der letzten Atome" by Gossen, "rareté" by Walras, and "ophélimité" by Pareto, seem still in need of really satisfactory terms by which to express it.

links for 2008-03-23

• Rubin: 'A Lot Of Trouble Could Lie Ahead' - WSJ Economics Blog
• Gap in Life Expectancy Widens for the Nation - New York Times
• In Washington, a Split Over Regulation of Wall Street - New York Times
• Mortgage Meltdown for Dummies: Defining the Changes We Need - Fred Block
• Op-Classic, 1994: Arthur C. Clarke on Killer Comets - New York Times
• Iraq, $5,000 Per Second? - Kristof - New York Times
• Do we want Fed governors to stick around for 14 years? - Justin Fox
• Mark Thoma on the Mortgage-Backed Security Problem - ataxingmatter
• Will central banks buy real estate? Adopting Belarus standard.- Rybinski.eu
• A New-Keynesian Model with Unemployment - NBER - Blanchard and Gali

The Nation: Toward a New Deal

• Bill McKibben: A Green Corps
• Michael J. Copps: Not Your Father's FCC
• Andrea Batista Schlesinger: A Chaos of Experimentation
• Eric Schlosser: The Bare Minimum
• Frances Moore Lappé: The Only Fitting Tribute
• Adolph Reed Jr.: Race and the New Deal Coalition
• The Rev. Jesse Jackson: For the 'FDR'
• Andy Stern: Labor's New Deal
• Anna Deavere Smith: Potent Publics
• Sherle R. Schwenninger: Democratizing Capital
• Stephen Duncombe: FDR's Democratic Propaganda
• Howard Zinn: Beyond the New Deal

Death with Dignity

I voted in favor of this both times it was on the ballot:

A decade of data Death With Dignity Act working as intended, Editorial, Register Guard: It was an unremarkable anniversary in all but one respect: After 10 years, the simple fact that Oregon’s unique Death With Dignity Act has survived is, in itself, quite remarkable.

The nation’s only law allowing terminally ill patients who meet strict guidelines to receive a prescription for a lethal dose of medication has been under attack since the early days of the Bush administration.

Jacob Hacker: "Socialized Medicine"

Jacob Hacker says its time to adopt a national health plan:

Let's Try a Dose. We're Bound to Feel Better., by Jacob S. Hacker, Commentary, Washington Post: "Socialized medicine" is the bogeyman that just won't die. The epithet has been hurled at every national health plan since the New Deal -- even Medicare, which critics warned would strip Americans of their freedom.

And now it's back. Republicans from President Bush on down have invoked the specter of socialism in denouncing Democrats' attempts to expand publicly funded health insurance... Never mind that nobody is proposing to turn doctors into public employees and hospitals into government institutions -- the literal meaning of socialized medicine. ...

But the critics have it backward.

Are Central Banks Planning to Make Coordinated Purchases of Mortgage Backed Securities?

I've proposed that central banks purchase mortgage backed securities to remove risk from financial markets a couple of times as one part of a package of measures to free up credit markets, but it's received a cold reception each time (the second link has the most details - I used the term "Risk Absorber of Last Resort" to describe this type of policy, and I could have stressed the last resort aspect more than I did). It's not hard to understand why these proposals find little support since they are viewed as bailing out the very people who created the problems we are experiencing, thereby creating a moral hazard problem going forward and the perception that rich people get help while the typical household is left to fend for itself against the wave of foreclosures sweeping across housing markets. It is also viewed as putting taxpayer money at excessive risk. Even so, central banks appear to be considering such proposals, though it's not clear to what degree and which banks are involved. I'm glad that central banks are at least thinking along these lines even if it is only a last resort option - it's an indication they are doing their best to explore the full range of policy options, which is one of the reasons I initially pushed in this direction:

Central banks float rescue ideas, by Chris Giles and Krishna Guha, Financial Times: Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.

Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.

The conversations, part of a broader exchange as to possible future steps in battling financial turmoil, are at an early stage. However, the fact that such a move is being discussed at all indicates the depth of concern that exists over the health of the banking system. ...

The Bank of England appears most enthusiastic to explore the idea. The Federal Reserve is open in principle to the possibility that intervention in the MBS market might be justified in certain scenarios, but only as a last resort. The European Central Bank appears least enthusiastic.

Any move to buy mortgage-backed securities would require government involvement because taxpayers would be assuming credit risk. There is no indication as yet that the US administration would favour such moves. In the eurozone it would require agreement from 15 separate governments. ...

[A] strongly held view at one European central bank is that it is not “mark-to-market” accounting that is to blame for severe weaknesses in banks’ balance sheets but that prices of MBS securities have fallen to levels that imply unrealistically high rates of default.

If public authorities were to buy and hold sufficient mortgage-backed securities – rather than simply lend against them as they have until now – at prices well below face value but above current prices, they would set a floor in the MBS market.

The Fed does not believe that the point has yet been reached when such drastic action is necessary and considers the discussions it has had with its counterparts to represent “blue-sky thinking” rather than the formulation of a definitive policy proposal. ...

Analysts say the US government also has plenty of scope to boost support for the markets indirectly through the Federal Housing Administration or Fannie Mae and Freddie Mac.

The UK lacks these institutions, which could be one reason why the Bank of England is keenest to explore outright intervention. ...

I think the difference in institutions is one of the reasons for the different responses in the US and UK. In the US, using existing institutions such as the FHA to help homeowners by purchasing mortgages, and then reissuing them on better terms has much broader, but by no means universal, support - much more than intervening to purchase non-government securities. But as noted in the article, that option is not available in the UK.

But on the plans to purchase mortgage backed securities, there's this from the WSJ's economics blog:

Fed Says Not Discussing Coordinated MBS Buying, by Greg IP: The U.S. Federal Reserve, responding to press reports, said it is not discussing coordinated purchases of mortgage-backed securities with other central banks.

“The Federal Reserve is not involved in discussions with foreign central banks for coordinated buying of MBS,” a senior Fed official said. ...

[Krzysztof Rybinski, former deputy governor of the National Bank of Poland - citing an article in The Economist for support - seems to like the MBS purchase idea.]

It's probably a good time to remember this:

Matthew Yglesias (March 16, 2008) - Sunday Financial Meltdown Blogging: ...I don't, in general, have any opinions about the problems in the financial markets that go beyond the utterly obvious -- bad things seem to be afoot and I'm worried....

But ... I don't necessarily have a problem with the government intervening to bail a bunch of rich guys out when their own bad decisions blow up in their faces if that's what's needed for the health of the overall economy, but this sort of thing is one of several reasons why I think the very rich should pay high tax rates and we shouldn't be happy about the prospect of ever-growing inequality. At a certain level, the game is rigged and you're not really bearing any risk...

This is part of a more general point. One of many justifications for a progressive tax is to reduce inequities that arise because the economy departs from our ideal, textbook model. These departures from ideal conditions, and things like moral hazard and regulatory capture are certainly departures, allow income to be earned that is hard to justify. Using taxes to reduce the inequities that arise because some groups are unfairly advantaged by an imperfect system is a reasonable response to this problem.

One final note. I think there are two places to attack the financial market problems, cause (bad loans and foreclosures) and effect (falling asset values due to bad loans and foreclosures). On the cause side there are the mortgage purchase proposals (the plans from Alan Blinder and Barney Frank for example), and on the effect side there are the proposals to purchase the assets directly (or intervene in some other way, e.g. provide insurance or temporary shelter through lending facilities) in order to remove the risk from the market.

Dealing with the cause is best, but there is the question of timeliness - can we get it done in time? - and effectivieness - will it work - and my point all along has been that if we cannot solve the foreclosure problem using a Blinder/Frank type approach, we had better have other options waiting in the wings. Direct purchases of mortgage backed securities is one such option.

links for 2008-03-22

• Man in the News: Timothy Geithner - FT
• Budgeting for war - Project Syndicate
• 2 Senators Want HUD Official Out - New York Times
• What hospital patients want - Vox EU
• Keys to Climate Protection - Jeff Sachs
• Getting Duped: How the Media Messes with Your Mind - SciAm
  

Mass Layoffs

Mass Layoff data (defined as 50 or more layoffs from a single firm) were released today. Here's a graph showing the number of mass layoff events along with claims for unemployment insurance since March, 2004 (when this data series begins). Recent data are not encouraging:

Mass Layoffs

The spike is Katrina. This is where the recent layoffs came from:

 

Did Greenspan Cause the Crisis?

Jeff Sachs says Greenspan and the Fed are to blame for our current troubles. Greenspan disagrees:

The roots of crisis, by Jeffrey Sachs, Project Syndicate: The US federal reserve's desperate attempts to keep America's economy from sinking ... do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening.

To a large extent, the US crisis was actually made by the Fed... One main culprit was none other than Alan Greenspan, who left the current Fed chairman, Ben Bernanke, with a terrible situation. But Bernanke was a Fed governor in the Greenspan years, and he, too, failed to diagnose correctly the growing problems with its policies.

Paul Krugman: Partying Like It’s 1929

We're relearning the lesson that "unregulated, unsupervised financial markets can all too easily suffer catastrophic failure":

Partying Like It’s 1929, by Paul Krugman, CVommentary, NY Times: If Ben Bernanke manages to save the financial system from collapse he will — rightly — be praised for his heroic efforts.

But what we should be asking is: How did we get here? Why does the financial system need salvation? Why do mild-mannered economists have to become superheroes?

The answer, at a fundamental level, is that ... having refused to learn from history, we’re repeating it.

Contrary to popular belief, the stock market crash of 1929 wasn’t the defining moment of the Great Depression. What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.

This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure. As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way. ...

Banks ... sometimes — often based on nothing more than a rumor —... face runs... And a bank that faces a run by depositors ... may go bust even if the rumor was false.

Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction. And there can be wider economic effects...

That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.

And we all lived happily for a while — but not for ever after.

Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that ... bypass[ed] regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players ... seemed to offer better deals... Meanwhile, those who worried ... that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

In fact, however, we were partying like it was 1929 — and now it’s 1930.

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

Mr. Bernanke and his colleagues at the Fed are doing all they can to end that vicious circle. We can only hope that they succeed. Otherwise, the next few years will be very unpleasant — not another Great Depression, hopefully, but surely the worst slump we’ve seen in decades.

Even if Mr. Bernanke pulls it off, however, this is no way to run an economy. It’s time to relearn the lessons of the 1930s, and get the financial system back under control.