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Tuesday, November 18, 2008

Phelps, Lucas, Selten, Stiglitz, and Samuelson

I missed this when it came out last Wednesday, so thanks for the email:

Lucas says pretty much what I said here about the need to regulate the shadow banking sector (though I only gave past regulation credit for 50 years of stability, he says it was 60):

In a financial crisis things happen fast... The responsibility of the Federal Reserve in this situation is to provide more cash reserves, and in that sense they are doing their job. Total reserves were $47 billion on Sept. 10, $180 billion on Oct. 8 and $329 billion on Oct. 22. This is good central banking.

Should we be concerned that people will just hold on to the new reserves and continue to reduce spending? Some of that is surely happening, but more reserves can always be added.

Should we be concerned about inflation? Of course, always.

But right now the recession is the more immediate problem. If inflation resumes, reserves can be taken out as quickly as they were added. This is a classic lender-of-last-resort situation and it is important to maintain focus.

In my view, these are the most important considerations for US policy today. I think if the current Federal Reserve lending policies are continued aggressively our chances of avoiding a recession larger than that of 1982 are very good. At this point, I think this is the best that can be hoped for and it is a lot better than a replay of the 1930s.

The regulatory structure that permitted these events to occur will have to be redesigned, but this is not a job that needs to be done this week nor can it be done well in time to affect the current crisis.

The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or "bank runs." The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.

So money isn't neutral? There's a Phillip's curve after all? Ah.

Samuelson says that if "America turns protectionist, blame past Republican deregulating" as he dismisses both sides of the political divide and declares himself a raging centrist:

Based on my observations of economic history, both short run and long run, I believe that there is no satisfactory alternative to market systems as a way of organizing both economically poor and economically rich populations.

However, using markets is not the same thing as unregulated capitalism so beloved by libertarians. Such systems cannot regulate themselves, either micro-economically or macro-economically. Wherever tried they systematically breed intolerable inequalities. And instead of such inequality being the necessary price to encourage dynamic progress via technological and managerial innovations, it instead breeds dysfunctional shortfalls in what economists call "total factor productivity."

Convincing proof of these points can be found in the deterioration in the US from 2001 to 2008. As CEO pay rose respective to median employee pay -- from a more normal 40 to 1 ratio up to and beyond 400 to 1 -- industrial progress deteriorated rather than accelerated.

In consequence, my view is incurably centrist. ... Libertarians are not just bad emotional cripples. They are also bad advice givers. I refer of course to the views of both Milton Friedman and Friedrich Hayek. The “serfdom” they warn against is not that of Genghis Khan or Lenin-Stalin-Mao or Hitler-Mussolini. Rather, they warn against the centrist states of the modern world. Think only of Switzerland, Britain, the US, the Scandinavian countries, and the Pacific Rim. Why do citizenries there report high indexes of “happiness” and enjoy broad freedoms of speech and belief?

President George W. Bush will figure in the history books as the worst president in the 234 years of US history. One of his inevitable legacies will be, among other things, the danger in 2009-2014 of a US majority that swings leftward far past center. If America turns protectionist, blame past Republican deregulating -- a fine instance of the Law of the Unintended Consequences.

Yes, public policy should regulate (rationally regulate) corporate life and should work to stabilize the macro economy. Yes, future fiscal systems can in a limited degree reduce the more glaring evils of inequality. However, a centrist system can do measurable harm if it acts too strongly to reduce inequality. My goal is the Limited Centrist State.

I am not a centrist because I can’t make up my mind about the Right and the Left. It is because each of those has proved itself to be so non-optimal that rationality and experience move me toward the dynamic moving center.

    Posted by on Tuesday, November 18, 2008 at 01:08 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (42)


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