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Wednesday, December 31, 2008

"Should We Fear a Trade Backlash?"

More and more I have been asked why we should allow immigration when there is so much domestic unemployment. It's a hard question to answer, more so when you are talking to someone who is looking for a job and having a hard time finding one. Similarly, people ask why we should allow imports on the belief that restricting them would help with the domestic employment situation.

But one problem with protectionist measures is that they are like standing up to see better at a basketball game. If everyone is sitting down and you stand up, you will, of course, see better. You will be better off, so there will be a tendency to want to stand up, particularly during crucial parts of the game. But if everyone else stands up too, the result is different. Nobody can see any better than they could sitting down (on average), and they are less comfortable standing than they were sitting. All that happens as each person tries to stand up and improve their situation is that everyone is made, collectively, worse off. (I realize some people do prefer to stand - especially during the exciting periods of the game - but for the purposes of the example I'm assuming the the highest utility outcome is where everyone is sitting. If you don't like this example, think of a crowded freeway and someone leaving for work early to beat the traffic. If that person is the only one to leave early, or one of the few, it works, but if everyone tries to leave early, you get the same old freeway problems but everyone had to get up earlier - so they are worse off.). Same with protectionism. If one country imposes protectionist measures by itself, the measures can be helpful and hence there is a tendency to do this, but when all countries follow suit and retaliate with their own set of trade restrictions, it makes everyone worse off.

Will governments repeat the "Smoot-Hawley-like backlash against trade" that occurred during the Great Depression? Barry Eichengreen says that could happen, but fortunately we've learned a thing or two since then. e.g. the value of fiscal policy, and hopefully that will keep the crowd under control:

Should we fear a trade backlash?, by Barry Eichengreen, Commentary, Project Syndicate: With more than a whiff of depression in the air, is a Smoot-Hawley-like backlash against trade about to follow? ... The danger exists. ... Other economic aspects of the 1930s that many of us thought we would never see in our lifetimes have reared their ugly heads. ...

Some of these fears relate to the protectionist rhetoric of Barack Obama... Then there are the bailouts for General Motors and Chrysler. A subsidy for domestic auto producers is functionally equivalent to a tax on the US sales of foreign producers. Finally there is the fear that the US fiscal stimulus package ... will be rendered less effective if the increased demand is allowed to leak out in the form of increased imports. US politicians will be quick to react with protectionist measures if they see that today's spending programmes, which create a debt burden for future generations, fail to stimulate the American economy and only benefit other countries.

Fortunately there are reasons for thinking that this danger is overstated. First, the growth of multinational production and global supply chains has altered the political economy. Protecting US auto producers no longer automatically benefits US parts suppliers when the Big Three source many of their parts from Canada. Foreign companies with an interest in the maintenance of free and open trade are better represented in the political process than they were in the 1930s. ...

Second, in 1930 Congress resorted to Smoot-Hawley out of desperation over its lack of alternatives. It was not that the Congress ... resorted to a tariff to maximise the employment-creating impact from expansionary fiscal policies. Rather the tariff was imposed instead of expansionary fiscal policies, there as yet being no understanding of the case for fiscal stimulus. The danger of a tariff as a convoluted employment-creating policy is now less, precisely because we understand that there are direct ways for the government to stimulate demand, namely by cutting taxes and raising public spending.

Finally, if fiscal stimulus and the Fed's zero interest rate policy mainly suck in imports, then the dollar will decline in response to the widening current account deficit. This will shift demand back toward domestic goods, venting the pressure for a protectionist response. This is no mere hypothetical: we have already seen the dollar falling in anticipation of just these developments. This is fundamentally different from 1930, when the US and other countries were on the gold standard and there was no scope for the exchange rate to adjust. ...

Today, in contrast to the 1930s, our politicians have no shortage of policy levers. They just need to pull the right ones.

    Posted by on Wednesday, December 31, 2008 at 10:44 AM in Economics, International Trade | Permalink  TrackBack (0)  Comments (106) 

    "When Handed a Lehman..."

    Harold Meyerson:

    The Big Bailout Lessons, by Harold Meyerson, Commentary, Washington Post: Two things we learned about our ... economy in 2008: Lesson One: If it's big and you don't regulate it, you end up nationalizing it. ...[U]nregulated and underregulated capitalism ends up confronting democratic governments with a subprime choice: Either let a major institution go down and watch as chaos follows (the Lehman option) or funnel gobs of the public's money into such institutions to avoid such Lehman-like chaos. ...

    When the American financial industry came tumbling down this year, the laissez-faire ideologues of this most ideological administration indulged their ideology just once, allowing Lehman to go under. Thereafter, as one giant institution after another tottered under the weight of dubious deals, the administration tossed ideology out the window and funneled money to the banks.

    Laissez faire be damned, the ideologues concluded: When handed a Lehman, make Lehman aid.

    The lesson for 2009 couldn't be clearer: To avoid nationalization, you need regulation. Or, the lesson's ideological corollary: To avoid socialism (to whatever extent throwing public money at banks is socialism), you need ... the willingness to restrain capitalism from its periodic self-destruction...

    Lesson Two: In matters economic, the Civil War isn't really over. ...Abraham Lincoln ... might detect in the congressional war over the automaker bailouts a strong echo of the war that defined his presidency. Now as then, the conflict centered on the rival labor systems of North and South. Now as then, the Southerners championed a low-wage, low-benefits system while the North favored a more generous one. And now as then, what sparked the conflict was the North's fear of the Southern system becoming the national norm. ...

    Over the past century, of course, the conflict between North and South has been between union and non-union labor. The states of the industrial Midwest and the South ... developed two distinct economies. Residents of the unionized north enjoyed higher ... paychecks and ... higher public outlays on health and education, than did their counterparts in the union-resistant South.

    But, just as Lincoln predicted, the United States was bound to have one labor system prevail, and the debate over the General Motors and Chrysler bailout was really a debate over which system -- the United Auto Workers' or the foreign transplant factories' -- that would be. ...

      Posted by on Wednesday, December 31, 2008 at 12:24 AM in Economics | Permalink  TrackBack (0)  Comments (85) 

      links for 2008-12-31

        Posted by on Wednesday, December 31, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (19) 

        Tuesday, December 30, 2008

        "How to Prevent the Great Depression of 2009"

        Roger Farmer says the Fed needs to target an asset price index "to prevent bubbles and crashes":

        How to prevent the Great Depression of 2009, by Roger E.A Farmer, Financial Times: ...Since world war two, economic policy in most western democracies has been based on Keynesian economics. But although policy makers still rely on Keynes' ideas, academics gave up on his theories 40 years ago and went back to classical economics... The result has been 40 years of disconnect in which policy makers are tinkering with the engine without a manual. ...

        We have seen economies stagnate for a decade or more in the past - the UK in the 1920s, the US in the 1930s and Japan in the 1990s - and it would be presumptuous to think that this cannot happen again when the existing dominant paradigm says that it could not happen in the first place.

        Classical economists argue that falling wages will restore equilibrium; but this is based on the belief that the labour market works like an auction in which employment is determined by demand and supply.

        It ignores the very real frictions involved in searching for a job by both households and firms that can lead to many possible equilibrium employment levels just as Keynes argued in the General Theory. ...

        So where do we go from here? The only actor large enough to restore confidence in the US market is the US government. The current policy of quantitative easing by the Fed is a move in the right direction but it does not, as yet, go nearly far enough.

        It is time for a greatly increased role for monetary policy through direct intervention of central banks in world stock markets to prevent bubbles and crashes. Central banks control interest rates by buying and selling securities on the open market.

        A logical extension of this idea is to pick an indexed basket of securities: one candidate in the US might be the S&P 500, and to control its price by buying and selling blocks of shares on the open market.

        Even the credible announcement that a policy of this kind was being considered should be enough to boost the markets and restore consumer and investor confidence in the real economy.

        Critics will argue that this policy is dangerous socialist meddling. But I am not arguing that the government should pick winners and losers: only that it should stabilise a broad basket of stocks.

        This policy would still allow poorly run firms to fail but it would not allow all firms to fail at the same time. Although the free market is very good at deciding how many left and right shoes to produce, it cannot prevent systemic risk that arises from the psychology of herd behaviour. This is a job for Uncle Sam.

        As I've noted many times, most recently here, I am also warming up to the idea of having the Fed target an asset price index in addition to inflation and unemployment. But there are lots of questions to be answered first. What growth rate in the stock price index should we target? Should it be 8%? Lower? Higher? What is the correct time frame? Day to day fluctuations are quite volatile, we wouldn't want to react to every movement in the index, so how do we come up with a core measure that gives us an indication of the long-run trend in stock prices? Does value weighting, as in the S&P 500, give the optimal index, or would some other weighting scheme do better? Do we only include financial assets, or should other asset prices such an housing price index also be targeted? If so, how would we do that? When targets are in conflict, how much weight should deviations of the asset price index from its target value be given relative to deviations of inflation and output from their target values? Will it still be true that it is optimal for the Fed to react by raising the federal funds rate more than one to one in response to changes in inflation? How will adding another source of variation to the federal funds rate affect its smoothness? We don't fully understand why interest rate smoothing is an important component of the Taylor rule, but it does seem to be an important, so how will this change will affect smoothness (it depends upon how the coefficients in the Taylor rule are adjusted after the new piece is added)?

        And that's just a few of the questions, I'm sure I've overlooked many more (and please feel free to fill in the missing pieces in comments). Thus, while I certainly think this is a fruitful area to investigate, particularly in light of recent experience with the housing and stock price bubbles, we have more thinking to do and more regressions to run before we are ready to implement this kind of policy.

        Finally, even with theoretical and empirical support, I'd be wary that asset price targeting alone will be enough to prevent problems in asset markets from developing in the future. Asset price targeting is a complement to other measures such as regulatory and enforcement changes, not a substitute, and I think it would be a mistake to believe simply twiddling with the policy rule will be enough to avoid another financial market meltdown that threatens the wider economy.

        Update: Barkley Rosser, in comments, with an opposing view:

        I spoke on the matter of "battling bubbles" at the Galbraith conference in New York.  In November.  I specifically suggested not doing something like this, or more generally not trying to use broad interest rate policy to influence speculative markets.  However, I did support more targeted interventions in specific markets where there was good evidence of a serious speculative bubbles.  I argued for using more specific regulatory tools along the lines suggested by Robert Feinman, such as changing margin requirements, or for housing tightening rules on mortgages, or for commodities, using buffer stocks (Strategic Petroleum Reserve, etc.) for interventions.

        The real downside of using broad monetary policy to tamp down general stock market bubbles has been seen.  It was called the Great Depression. 

        Also, keep in mind that we have not had a stock market bubble in recent years.  We have had bubbles in housing and in oil and in some other commodities, but the P/E ratios have been pretty reasonable.  The recent plunges of the stock market are not crashes of bubbles (the 2000 decline was, especially for dotcom stocks).  Rather these are fundamental declines based on rationally expected declines in future profits and dividends.

        Oh, and I do not see setting any sort of rule for this sort of thing as making any sense.  It will have to be discretionary and case by case, keeping in mind that any such interventions will always be strongly opposed by those who are in the middle of making money from the bubble.

        Update: Tyler Cowen adds to the dissenting voices.

        Update: Given the recent discussion about whether the current recession is due to a reduced willingness to work, I debated leaving this line about "contagious laziness" in, but didn't. Angus at Kids Prefer Cheese fills the void:

        Wow, speaking of Laziness.....: Roger Farmer writing December 30th 2008 in the FT:

        "In classical economics, the prices of stocks are determined by fundamentals and the fundamentals of the economy are sound. The US had the same stock of factories and machines in August that it had in July and the US workforce has not been afflicted by a sudden attack of contagious laziness."

        Franco Modigliani writing in the AER, March 1977:

        "Sargent (1976) has attempted to remedy this fatal flaw by hypothesizing that the persistent and large fluctuations in unemployment reflect merely corresponding swings in the natural rate itself. In other words, what happened to the United States in the 1930's was a severe attack of contagious laziness!"

        Ouch! Can't one of the all-time greats of Macro get any love in this day and age???

        Update: Discussion continues here.

          Posted by on Tuesday, December 30, 2008 at 11:34 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (1)  Comments (113) 

          "Disagreeing With Martin Feldstein On Defense Spending"

          Stan Collender rebuts Martin Feldstein's call to use increased defense spending as a stimulus measure:

          Disagreeing With Martin Feldstein On Defense Spending, by Stan Collender [Creative Commons]: As I said about a month ago, its not always smart to disagree publicly with an economic icon, especially when he's Martin Feldstein. Nevertheless, a Feldstein article published on Christmas Eve in the Wall Street Journal is so wrong that it and he deserve to be called out.

          The title of the article -- "Defense Spending Would Be A Great Stimulus" -- says it all. It's Feldstein's contention that additional military spending should be part of whatever economic stimulus package Congress and the Obama administration adopt in a few weeks.

          Here are my objections almost paragraph by paragraph.

          Continue reading ""Disagreeing With Martin Feldstein On Defense Spending"" »

            Posted by on Tuesday, December 30, 2008 at 12:15 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (76) 

            links for 2008-12-30

              Posted by on Tuesday, December 30, 2008 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (35) 

              Monday, December 29, 2008

              "Correspondence, Abstraction, and Realism"

              Philosopher of social science Daniel Little on "realists" versus "instrumentalists":

              Correspondence, abstraction, and realism: Science is generally concerned with two central semantic features of theories: truth of theoretical hypotheses and reliability of observational predictions. ... Truth involves a correspondence between hypothesis and the world; while predictions involve statements about the observable future behavior of a real system. Science is also concerned with epistemic values: warrant and justification. The warrant of a hypothesis is a measure of the degree to which available evidence permits us to conclude that the hypothesis is approximately true. A hypothesis may be true but unwarranted (that is, we may not have adequate evidence available to permit confidence in the truth of the hypothesis). Likewise, however, a hypothesis may be false but warranted (that is, available evidence may make the hypothesis highly credible, while it is in fact false). And every science possesses a set of standards of hypothesis evaluation on the basis of which practitioners assess the credibility of their theories--for example, testability, success in prediction, inter-theoretical support, simplicity, and the like. ...

              Whatever position we arrive at concerning the possible truth or falsity of a given economic hypothesis, it is plain that this cannot be understood as literal descriptive truth. Economic hypotheses are not offered as full and detailed representations of the underlying economic reality. For a hypothesis unavoidably involves abstraction, in at least two ways.

              Continue reading ""Correspondence, Abstraction, and Realism"" »

                Posted by on Monday, December 29, 2008 at 03:42 PM in Economics, Methodology | Permalink  TrackBack (0)  Comments (19) 

                Is the Recession Driven by "A Reduced Willingness to Work"?

                David Beckworth responds to the claim that this recession is due to "a reduced willingness to work," and that "Labor demand shifts explain no more than 10 percent of what has happened in this recession":

                What Happened to the 1,911,000 Lost Jobs?, by David Beckworth: Mark Thoma directs us to a stunning claim made by Casey Mulligan in the New York Times:

                [T]he decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).

                If true, this claim means most of the 1,911,000 jobs lost since December 2007 are the result of voluntary choices made by employees. This interpretation probably strikes most observers as ridiculous, but before we dismiss it out of hand let's take a look at the employment data. The place for data on this question is the BLS's Job Opportunity and Labor Turnover Survey (JOLTS). This survey provides data on job openings, hires, and separations, and goes back to December 2000.

                Continue reading "Is the Recession Driven by "A Reduced Willingness to Work"?" »

                  Posted by on Monday, December 29, 2008 at 10:44 AM in Economics, Unemployment | Permalink  TrackBack (0)  Comments (56) 

                  Paul Krugman: Fifty Herbert Hoovers

                  Because of the crisis, state and local governments are facing falling tax revenues, increased demand for social services, and high credit costs. These factors, along with balanced budget rules, are forcing cutbacks at the state and local level at a time when just the opposite is needed:

                  Fifty Herbert Hoovers, by Paul Krugman, Commentary, NY Times: ...[A]s Washington tries to rescue the economy, the nation will be reeling from the actions of 50 Herbert Hoovers — state governors who are slashing spending in a time of recession, often at the expense both of their most vulnerable constituents and of the nation’s economic future. ...

                  Now, state governors aren’t stupid (not all of them, anyway). They’re cutting back because they have to... But ... contemplate just how crazy it is ... to be cutting public services and public investment right now.

                  Think about it: is America — not state governments, but the nation as a whole — less able to afford help to troubled teens, medical care for families, or repairs to decaying roads and bridges than it was one or two years ago? Of course not. Our capacity hasn’t been diminished; our workers haven’t lost their skills; our technological know-how is intact. Why can’t we keep doing good things?

                  It’s true that the economy is currently shrinking. But that’s the result of a slump in private spending. It makes no sense to add to the problem by cutting public spending, too.

                  In fact, the true cost of government programs, especially public investment, is much lower now than in more prosperous times. When the economy is booming, public investment competes with the private sector for scarce resources — for skilled construction workers, for capital. But right now many of the workers employed on infrastructure projects would otherwise be unemployed, and the money borrowed to pay for these projects would otherwise sit idle.

                  And shredding the social safety net at a moment when many more Americans need help isn’t just cruel. It adds to the sense of insecurity that is one important factor driving the economy down.

                  So why are we doing this to ourselves?

                  The answer, of course, is that state and local government revenues are plunging along with the economy — and ... lower-level governments can’t borrow their way through the crisis. Partly that’s because these governments ... are subject to balanced-budget rules. But even if they weren’t, running temporary deficits would be difficult. Investors, driven by fear, are refusing to buy anything except federal debt...

                  Are governors responsible for their own predicament? To some extent. Arnold Schwarzenegger, in particular, deserves some jeers. ... But even the best-run states are in deep trouble. Anyway, we shouldn’t punish our fellow citizens and our economy to spite a few local politicians.

                  What can be done? Ted Strickland, the governor of Ohio, is pushing for federal aid ... on three fronts: help for the neediest, in the form of funding for food stamps and Medicaid; federal funding of state- and local-level infrastructure projects; and federal aid to education. That sounds right...

                  And once the crisis is behind us, we should rethink the way we pay for key public services.

                  As a nation, we don’t believe that our fellow citizens should go without essential health care. Why, then, does a large share of funding for Medicaid come from state governments, which are forced to cut the program precisely when it’s needed most?

                  An educated population is a national resource. Why, then, is basic education mainly paid for by local governments, which are forced to neglect the next generation every time the economy hits a rough patch?

                  And why should investments in infrastructure, which will serve the nation for decades, be at the mercy of short-run fluctuations in local budgets?

                  That’s for later. The priority right now is to fight off the attack of the 50 Herbert Hoovers, and make sure that the fiscal problems of the states don’t make the economic crisis even worse.

                    Posted by on Monday, December 29, 2008 at 12:33 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (61) 

                    links for 2008-12-29

                      Posted by on Monday, December 29, 2008 at 12:15 AM in Links | Permalink  TrackBack (0)  Comments (13) 

                      Sunday, December 28, 2008

                      Was Risk Misperceived, Misrepresented, or Misallocated?

                      We know that excessive risk taking was a factor in the financial crisis, but why people were willing to take on excessive risk?

                      There are several explanations for this. In one class of models, misperception of risk generates excessive demand for risky assets, housing and financial assets in particular. There are a variety of stories about why risk is misperceived, ratings agencies failed to do their jobs, risk assessment models turned out to be wrong, people believed that housing prices would continue to go up, and so on. The key is that in this class of models the misperception of risk gives people a false sense of security, and induces them to take on more risk than they can handle.

                      In another class of models, risk is misrepresented. Here, there is out and out fraud or other practices where, essentially, people know that the house is made of cards, but advertise it as being made of bricks anyway, and assure people that it is perfectly safe. Fraud could cause the victim to misperceive risk, so this is related to the first class of models, but I am trying to separate excessive risk taking brought about by intentional misrepresentation from excessive risk taking brought about by errors in judgment (or, perhaps more accurately in some cases, from negligence).

                      In a third class of models risk is misallocated, and there are two strands of risk misallocation models. In one, the mechanism that causes people to take excessive risk is knowledge that the government will step in and cover any potential catastrophic losses (risk is reallocated from the private to the public sector). This is the moral hazard problem, and the claim that government intervention led to excessive risk taking has been leveled pretty much wherever government has played a role in housing and financial markets, even when the role has not been very large.

                      In the second strand of risk misallocation models, the cause of excessive risk taking is market failure due to principal agent problems (e.g. when mortgage brokers are paid according to the number of loans that pass through their hands rather than according to the quality of the loans, and hence have no incentive to monitor risk). Market failures of this type can cause excessive risk taking because the person taking the risks does not face the full consequences of their decisions when the risky decisions turn out to be wrong. Why not take a big risk if you win on the upside, but you don't have to pay the full cost (or any of the costs) on the downside? However, unlike the first strand of risk misallocation models where there is too much government intervention, here the problem can arise when government fails to regulate markets properly, so the problem is often the result of too little government intervention rather than too much.

                      In a final class of models government is also blamed, but this time government is a bully that forces banks - through regulation or moral suasion - to make loans that are overly risky. The very thoroughly discredited models blaming the Community Reinvestment Act for the financial crisis fit into this class, and the models blaming the CRA are the most prominent member of this category. For that reason, I'll call these models "misguided" and set them aside.

                      So which was it, misperception, misrepresentation, or misallocation? In the following, Tyler Cowen focuses on the misallocation of risk due to government induced moral hazard. My own view is that misallocation of risk did play a role, but I think risk misallocation due to market failures, i.e. the failure of regulation, was more important in generating the crisis than moral hazard brought about by implicit or explicit government guarantees. I also think the misperception of risk was important, perhaps even more important than the misallocation of risk (though these are sometimes hard to separate):

                      Here's Tyler Cowen:

                      Bailout of Long-Term Capital: A Bad Precedent?, by Tyler Cowen, Commentary, NY Times: The financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad. ...

                      At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed. ...

                      The Long-Term Capital episode ... was important precisely because the fund was not a major firm. At the time of its near demise, it was not even a major money center bank, but a hedge fund with about 200 employees. Such funds hadn’t previously been brought under regulatory protection this way. After the episode, financial markets knew that even relatively obscure institutions — through government intervention — might be able to pay back bad loans.

                      The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.

                      What would have happened without a Fed-organized bailout of Long-Term Capital? ... Fed inaction might have had grave ... economic consequences,... and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.

                      In 1998, there was no collapsed housing bubble, the government’s budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.

                      The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew. ... So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.

                      While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery. ...

                      I should add that I agree with Tyler that government action, or in some cases inaction, and in still other cases poorly though out action, particularly by the Treasury, has left far too much uncertainty in markets.

                        Posted by on Sunday, December 28, 2008 at 03:33 AM in Economics, Financial System | Permalink  TrackBack (1)  Comments (62) 

                        links for 2008-12-28

                          Posted by on Sunday, December 28, 2008 at 02:34 AM in Links | Permalink  TrackBack (0)  Comments (31) 

                          Saturday, December 27, 2008

                          Are Workers Unwilling to Work?

                          Inventory to Sales Ratio

                          I am going to go out on a limb and assume this is the result of unintended inventory accumulation rather than, say, firms building up inventories in anticipation of an economic boom that is just around the corner. If so, then this is not a good omen for labor demand.

                          Why is the word demand highlighted? The graph is mostly an excuse to note this from Brad Delong:

                          Casey Mulligan says--wait for it--that the reason that unemployment is the 7% it is right now rather than the 4.4% it was two years ago because workers today face "financial incentives that encourage them not to work":

                          Are Employers Unwilling to Hire, or Are Some Workers Unwilling to Work?: Employment has been falling over the past year... if total hours worked had continued the upward trend they had been on in the years before the recession, they would be 4.7 percent higher than they are now.... [Today s]ome employees face financial incentives that encourage them not to work.... [T]he decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire)...

                          pgl adds:

                          Believe it or not this explanation made it in print:

                          Because productivity has been rising ... the decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).

                          As pgl notes, Casey Mulligan doesn't tell us why labor supply suddenly shifted inward, he promises that will be divulged later, but he does have a solution to the unemployment problem. He calls for--wait for it--tax cuts:

                          Why would some people have fewer incentives to take a job in 2008 than they did in 2006 and 2007 (and employers fewer incentives to create jobs)? I will tackle that question in my next post, but even without a specific answer we learn a lot about today’s recession from the conclusion that labor supply – not labor demand – should be blamed. First of all, it suggests that a fundamental solution to the recession would encourage labor supply (perhaps cutting personal income tax rates, so people can keep more of their wages), rather than tinker with demand.

                          Tax cuts could also work by increasing the demand for goods and services and hence the demand for labor, but this is a supply-side explanation where workers refuse to work at the wages being offered to them and decide to stay home instead, so that is not the mechanism he has in mind.

                          Dean Baker isn't buying the labor supply explanation. As he notes, a key component of this explanation is the claim by Mulligan that, "Unlike in the severe recessions of the 1930s and early 1980s, productivity has been rising." But why has productivity been rising relative to previous recessions? Dean Baker explains:

                          The one piece of data that drives this story is the apparent strength of productivity growth in this downturn relative to prior ones. But, there is a real simple story that can explain this pattern.

                          If we assume that in prior downturns firms were reluctant to lay off workers, both because of union contracts and also because they recognized the cost of turnover and hiring new workers, then we would expect sharp downturns in productivity growth as soon as there is a downturn in demand.

                          Now, imagine that firms are not constrained by union contracts and don't worry about long-term costs, so that they quickly layoff workers when there is a falloff in demand. Voila! productivity does not fall off in the same way in this downturn.

                          That would be my story. We can try to do some more careful examination of declines in productivity sector by sector, but I suspect that this is what explains the difference in productivity patterns across downturns.

                          Whatever the explanation - and productivity is not easy to measure so the relationships in the data can be questioned - I find it highly implausible that worker's unwillingness to accept the jobs being offered to them is the source of the current employment problem.

                            Posted by on Saturday, December 27, 2008 at 02:34 PM in Economics | Permalink  TrackBack (0)  Comments (64) 

                            The American Recovery and Reinvestment Plan

                            Larry Summers outlines the incoming administration's plans for economic recovery:

                            Obama's Down Payment, by Lawrence Summers, Commentary, Washington Post: ...President-elect Barack Obama ... will face what may well be the bleakest economic outlook since World War II.  ...

                            As difficult as these conditions are, however, the Obama administration also inherits an economy with great potential for the medium and long terms. Investments in an array of areas -- including energy, education, infrastructure and health care -- offer the potential of extraordinarily high social returns...

                            In this crisis, doing too little poses a greater threat than doing too much. Any sound economic strategy in the current context must be directed at both creating the jobs ... and doing the work that our economy requires. ... Our president-elect ... is crafting a broad proposal, the American Recovery and Reinvestment Plan, to support the jobs and incomes essential for recovery while also making a down payment on our nation's long-term financial health.

                            A key pillar of the Obama plan is job creation. In the face of deteriorating economic forecasts, Obama has revised his goal upward, to 3 million. .... The Obama plan represents not new public works but, rather, investments that will work for the American public. Investments to build the classrooms, laboratories and libraries our children need to meet 21st-century educational challenges. Investments to help reduce U.S. dependence on foreign oil by spurring renewable energy initiatives... Investments to put millions of Americans back to work rebuilding our roads, bridges and public transit systems. Investments to modernize our health-care system, which is ... key to driving down costs across the board. ...

                            We must focus not on ideology but on drawing the best ideas from all quarters. That is why, for example, in key sectors such as energy, Obama is pushing for both public investments and the removal of barriers to private investment. It is also why his plan relies on both government spending and tax cuts to raise incomes and promote recovery. ...

                            There will be no earmarks. Investments will be chosen ... based on what yields the highest rate of return for the economy and monitored closely not just by officials but also by the public as government becomes more transparent. We expect to evaluate and to be evaluated rigorously to ensure that Washington is held accountable for how tax dollars are spent.

                            Some argue that instead of attempting to both create jobs and invest in our long-run growth, we should focus exclusively on short-term policies that generate consumer spending. But that approach led to some of the challenges we face today -- and it is that approach that we must reject if we are going to strengthen our middle class and our economy over the long run. ...

                              Posted by on Saturday, December 27, 2008 at 12:24 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (62) 

                              links for 2008-12-27

                                Posted by on Saturday, December 27, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (21) 

                                Friday, December 26, 2008

                                Paul Krugman: Barack Be Good

                                How can the incoming administration manage to navigate the "treacherous political waters safely" as it attempts to rescue the economy?:

                                Barack Be Good, by Paul Krugman, Commentary, NY Times: Times have changed. In 1996, President Bill Clinton, under siege from the right, declared that “the era of big government is over.” But President-elect Barack Obama, riding a wave of revulsion over what conservatism has wrought, has said that he wants to “make government cool again.”

                                Before Mr. Obama can make government cool, however, he has to make it good. Indeed, he has to be a goo-goo.

                                Goo-goo, in case you’re wondering, is a century-old term for “good government” types, reformers opposed to corruption and patronage. Franklin Roosevelt was a goo-goo extraordinaire. He simultaneously made government much bigger and much cleaner. Mr. Obama needs to do the same thing. ...

                                Like the New Deal, the incoming administration must greatly expand the role of government to rescue an ailing economy. But also like the New Deal, the Obama team faces political opponents who will seize on any signs of corruption or abuse — or invent them, if necessary — in an attempt to discredit the administration’s program.

                                F.D.R. managed to navigate these treacherous political waters safely, greatly improving government’s reputation even as he vastly expanded it. ... How did F.D.R. manage to make big government so clean?

                                A large part of the answer is ...oversight... The Works Progress Administration, in particular, had a powerful, independent “division of progress investigation” devoted to investigating complaints of fraud. This division was so diligent that ... a Congressional subcommittee ... couldn’t find a single serious irregularity that the division had missed.

                                F.D.R. also made sure that Congress didn’t stuff stimulus legislation with pork: there were no earmarks in the legislation ... for the W.P.A. and other emergency measures.

                                Last but not least, F.D.R. built an emotional bond with working Americans, which helped carry his administration through the inevitable setbacks ... that beset its attempts to fix the economy.

                                So what are the lessons for the Obama team?

                                First, the administration of the economic recovery plan has to be squeaky clean. Purely economic considerations might suggest cutting a few corners in the interest of getting stimulus moving quickly, but the politics of the situation dictates great care in how money is spent. And enforcement is crucial: inspectors general have to be strong and independent, and whistle-blowers have to be rewarded, not punished as they were in the Bush years.

                                Second, the plan has to be really, truly pork-free. Vice President-elect Joseph Biden recently promised that the plan “will not become a Christmas tree”; the new administration needs to deliver on that promise.

                                Finally, the Obama administration and Democrats in general need to do everything they can to build an F.D.R.-like bond with the public. Never mind Mr. Obama’s current high standing in the polls based on public hopes that he’ll succeed. He needs a solid base of support that will remain even when things aren’t going well. ...

                                Democrats are off to a bad start on that front. The attempted coronation of Caroline Kennedy as senator plays right into 40 years of conservative propaganda denouncing “liberal elites.” And surely I wasn’t the only person who winced at reports about the luxurious beach house the Obamas have rented, not because there’s anything wrong with the first family-elect having a nice vacation, but because symbolism matters, and these weren’t the images we should be seeing when millions of Americans are terrified about their finances.

                                O.K., these are early days. But that’s precisely the point. Fixing the economy is going to take time, and the Obama team needs to be thinking now, when hopes are high, about how to accumulate and preserve enough political capital to see the job through.

                                  Posted by on Friday, December 26, 2008 at 12:33 AM in Economics, Politics | Permalink  TrackBack (0)  Comments (55) 

                                  "An Eisenhower Moment" for Infrastructure?

                                  What can the incoming administration learn about infrastructure spending from Eisenhower's experience in creating the interstate highway system?:

                                  Eisenhower's roads to prosperity, by Tom Lewis, Commentary, LA Times: ...President-elect Barack Obama vowed to "create millions of jobs by making the single largest new investment in our national infrastructure since the creation of the federal highway system..." The story of President Eisenhower's decision in 1956 to create the interstate highway system ... holds lessons that the new president and the country would do well to heed.

                                  Eisenhower was the first Republican to occupy the White House after Herbert Hoover, who in the 1950s still wore a mantle of shame for his role in the market crash of 1929 and its aftermath. Eisenhower had an almost pathological, but healthy, fear that he might be blamed for allowing the nation to fall into another depression. When a mild recession ... pushed the unemployment rate above 5%, Eisenhower ... asked for solutions.

                                  The highwaymen at the Bureau of Public Roads ... heeded the call. They reported that each federal dollar invested in construction generated close to one half-hour of employment. ... Workers across America, not just those who built the roadways, would benefit -- in cement and steel plants (50 tons of concrete and 20 tons of reinforcing steel go into each mile), in paint and sign manufacturers and in heavy equipment factories and oil refineries. ...

                                  Eisenhower realized that he could not fail with highways. Americans wanted more roads for their postwar cars. Construction would prime the economic pump ... and help secure the nation's future. He signed ... the $25-billion Federal-Aid Highway Act to build a 42,000-mile interstate highway system by 1972. Ultimately the cost would escalate to more than $130 billion, and workers would not finish the roads until 1993...

                                  Eisenhower wasn't afraid to create a huge public works program, and unlike today's presidents, he wasn't afraid of taxes. ... The 1956 highway bill levied a tax of 3 cents on each gallon of fuel -- equal to 24 cents today. The revenue went into a dedicated highway trust fund. ...

                                  Eisenhower's interstates are an essential part of our culture. ... In 1956, Eisenhower likely didn't fully realize that he was creating not just a public works program but an economic and social blueprint for the next 50 years. Now, along with every other aspect of our infrastructure, the interstates are crumbling. Irresponsible legislators rail against the current federal highway tax of 18.4 cents a gallon -- far less in today's prices than Eisenhower's 3 cents. Seduced by easy money, governors consider leasing parts of the highway system to foreign companies.

                                  So the lessons for Obama are clear: Don't be afraid to propose bold -- and often expensive -- programs that improve the nation's infrastructure and peoples' lives, and don't be afraid to pay for them with taxes.

                                  It is said the 44th president is taking office at a Lincoln moment and a Roosevelt moment. True enough, but it can be an Eisenhower moment as well.

                                  Keeping the budget in balance while the economy is struggling is not good policy. If the goal is to stimulate the economy and to create new jobs, then the "clear" lesson - the advice to pay for the spending on infrastructure by raising taxes - is wrong. The new infrastructure does need to be paid for, but the time to do that is when the economy is healthy, not when it is under performing.

                                    Posted by on Friday, December 26, 2008 at 12:24 AM in Economics, Fiscal Policy, Politics, Taxes | Permalink  TrackBack (0)  Comments (37) 

                                    links for 2008-12-26

                                      Posted by on Friday, December 26, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (4) 

                                      Thursday, December 25, 2008

                                      Stiglitz: We Need Bold Action

                                      Joseph Stiglitz doesn't think policymakers are likely to support a stimulus package that is large enough to avoid a "vicious negative spiral":

                                      The dismal economist’s joyless triumph, by Joseph E. Stiglitz, Project Syndicate: ...Economists are good at identifying underlying forces, but they are not so good at timing. The dynamics are, however, much as anticipated. America is still on a downward trajectory for 2009 — with grave consequences for the world as a whole. ...

                                      [E]ven if Obama and other world leaders do everything right, the US and the global economy are in for a difficult period. The question is not only how long the recession will last, but what the economy will look like when it emerges.

                                      Will it return to robust growth, or will we have an anemic recovery, à la Japan in the 1990’s? Right now, I cast my vote for the latter, especially since the huge debt legacy is likely to dampen enthusiasm for the big stimulus that is required. Without a sufficiently large stimulus (in excess of 2 percent of GDP), we will have a vicious negative spiral: a weak economy will mean more bankruptcies, which will push stock prices down and interest rates up, undermine consumer confidence, and weaken banks. Consumption and investment will be cut back further.

                                      Many Wall Street financiers, having received their gobs of cash, are returning to their fiscal religion of low deficits. It is remarkable how, having proven their incompetence, they are still revered in some quarters. What matters more than deficits is what we do with money; borrowing to finance high-productivity investments in education, technology, or infrastructure strengthens a nation’s balance sheet.

                                      The financiers, however, will argue for caution: let’s see how the economy does, and if it needs more money, we can give it. But a firm that is forced into bankruptcy is not un-bankrupted when a course is reversed. The damage is long-lasting.

                                      If Obama follows his instinct, pays attention to Main Street rather than Wall Street, and acts boldly, then there is a prospect that the economy will start to emerge from the downturn by late 2009. If not, the short-term prospects for America, and the world, are bleak.

                                        Posted by on Thursday, December 25, 2008 at 02:34 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (56) 

                                        "Taking the Long-View"

                                        Ban Ki-moon, Secretary General of the United Nations, says "We stand on the threshold of a new multilateralism":

                                        Taking the Long View, by Ban Ki-moon, Project Syndicate: The coming year will be a narrative of tension - a series of difficult choices between the imperatives of the present and those of tomorrow. How we resolve this tension will be the measure of our vision and our leadership.

                                        As a community of nations, we face three immediate tests in the coming year.

                                        Continue reading ""Taking the Long-View"" »

                                          Posted by on Thursday, December 25, 2008 at 02:25 AM in Economics | Permalink  TrackBack (0)  Comments (2) 

                                          Our Unconscious Rationality

                                          As long as we don't think about things consciously, we appear to be "really good decision makers after all":

                                          Our unconscious brain makes the best decisions possible, EurekAlert: Researchers at the University of Rochester have shown that the human brain—once thought to be a seriously flawed decision maker—is actually hard-wired to allow us to make the best decisions possible with the information we are given. ...

                                          Neuroscientists Daniel Kahneman and Amos Tversky received a 2002 Nobel Prize for their 1979 research that argued humans rarely make rational decisions. Since then, this has become conventional wisdom among cognition researchers

                                          Contrary to Kahnneman and Tversky's research, Alex Pouget ... has shown that people do indeed make optimal decisions—but only when their unconscious brain makes the choice.

                                          "A lot of the early work in this field was on conscious decision making, but most of the decisions you make aren't based on conscious reasoning," says Pouget. "You don't consciously decide to stop at a red light or steer around an obstacle in the road. Once we started looking at the decisions our brains make without our knowledge, we found that they almost always reach the right decision, given the information they had to work with."

                                          Continue reading "Our Unconscious Rationality" »

                                            Posted by on Thursday, December 25, 2008 at 01:44 AM in Economics | Permalink  TrackBack (0)  Comments (9) 

                                            links for 2008-12-25

                                              Posted by on Thursday, December 25, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (6) 

                                              Wednesday, December 24, 2008

                                              Keynes and Morality Plays

                                              Paul Krugman says  this is a "Great piece by Martin Wolf":

                                              Keynes offers us the best way to think about the financial crisis, by Martin Wolf, Commentary, Financial Times: ...Like all prophets, Keynes offered ambiguous lessons to his followers. ... Now,... in another era of financial crisis and threatened economic slump, it is easier for us to understand what remains relevant in his teaching. I see three broad lessons. ...

                                              The ... most important lesson is that one should not treat the economy as a morality tale. In the 1930s, two opposing ideological visions were on offer: the Austrian; and the socialist. The Austrians ... argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order; the latter in the idea that the identical motivation could lead only to exploitation, instability and crisis.

                                              Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge. He wished to preserve as much liberty as possible, while recognising that the minimum state was unacceptable to a democratic society with an urbanised economy. He wished to preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds.

                                              This same moralistic debate is with us, once again. Contemporary “liquidationists” insist that a collapse would lead to rebirth of a purified economy. Their leftwing opponents argue that the era of markets is over. And even I wish to see the punishment of financial alchemists who claimed that ever more debt turns economic lead into gold.

                                              Yet Keynes would have insisted that such approaches are foolish.

                                              Continue reading "Keynes and Morality Plays" »

                                                Posted by on Wednesday, December 24, 2008 at 05:04 PM in Economics, Macroeconomics | Permalink  TrackBack (0)  Comments (20) 

                                                "Economists' Pretensions About Science"

                                                Gavin Kennedy continues his crusade against the myth of the invisible hand:

                                                An Evolutionist Speaks Out About Economists' Pretensions About Science, by Gavin Kennedy: Massimo Pigliucci, professor in the departments of Ecology and Evolution, Stony Brook, NY, contributes an important piece of work in the Blog, Rationallyspeakingout.org (‘a site devoted to positive scepticism') (here):

                                                Economics learns a thing or two from evolutionary biology

                                                Economics is supposed to be a solid discipline, founded on complex mathematical models (and we all know math is really, really difficult). They even give Nobel prizes to economists, for crying out loud! And yet, economics has always had to fight off the same reputation of being a “soft” science that has plagued sociology, psychology, and to some extent even some of the biological sciences, like ecology and evolutionary biology. Indeed, like practitioners in those other fields of inquiry, some economists admit of being guilty of “physics envy,” that is, of using the physical sciences as the model for what their field ought to be like. Turns out even the assumption that a good science should be modeled on physics is “flawed,” to use Greenspan’s apt phrase.

                                                A recent article by Chelsea Wald in Science (12 December 2008) puts things in perspective by asking how it is possible that so many smart people in the financial sector made irrational decisions over a period of years, despite clear data showing there was a problem, and eventually leading to a worldwide economic crisis that is at the least poking at, if not shaking, the foundations of capitalism itself.

                                                Part of the answer is to be found in the persistent idea in economics that “markets” work because people are rational agents who act in their own self-interest and have perfect, instantaneous access to relevant information about the businesses they are considering investing in. Economists are not stupid, and they know very well that perfect rationality, complete information and instant access are all light years away from the reality of how markets operate. And in fact recent models have relaxed these assumptions to some extent. But it is so much more tractable to model things that way! After all, physicists do it too: remember those problems in Physics 101 that started “consider a spherical cow…”?

                                                Continue reading ""Economists' Pretensions About Science"" »

                                                  Posted by on Wednesday, December 24, 2008 at 01:08 PM in Economics, History of Thought, Methodology | Permalink  TrackBack (0)  Comments (51) 

                                                  Hawkish Fiscal Policy

                                                  Martin Feldstein argues that military spending should be part of the stimulus package:

                                                  Defense Spending Would Be Great Stimulus, by Martin Feldstein, Commentary, NY Times: The Department of Defense is preparing budget cuts in response to the decline in national income. The ... budgeteers ... apparently reason that a smaller GDP requires belt-tightening by everyone.

                                                  That logic is exactly backwards. As President-elect Barack Obama and his economic advisers recognize, countering a deep economic recession requires an increase in government spending to offset the sharp decline in consumer outlays and business investment... Although tax cuts for individuals and businesses can help, government spending will have to do the heavy lifting. ...

                                                  A temporary rise in DOD spending ... should be a significant part of that increase in overall government outlays. ... The increase in government spending needs to be a short-term surge ... but then tail ... off sharply in 2011 when the economy should be almost back to its prerecession level of activity. Buying military supplies and equipment, including a variety of off-the-shelf dual use items, can easily fit this surge pattern. ...

                                                  An important challenge for those who are designing the overall stimulus package is to avoid wasteful spending. One way to achieve that is to do things during the period of the spending surge that must eventually be done anyway. It is better to do them now when there is excess capacity...

                                                  Replacing the supplies that have been depleted by the military activity in Iraq and Afghanistan is a good example of something that might be postponed but that should instead be done quickly. ...

                                                  Industry experts and DOD officials confirm that military suppliers have substantial unused capacity... With industrial production in the economy as a whole down sharply, there is no shortage of potential employees who can produce supplies and equipment. ...

                                                  Now is also a good time for the military to increase recruiting and training. ... As a minimum this would provide education in a variety of technical skills -- electronics, equipment maintenance, computer programming, nuclear facility operations, etc. -- that would lead to better civilian careers for this group. It would also provide a larger reserve force...

                                                  The current two-year stimulus period provides an opportunity for additional temporary spending increases with high payoffs. Investments in port security would reduce a major homeland vulnerability. Expanding the government's language training programs ... would provide more translators... Additional infrastructure for the FBI would remove an important constraint on the number of new FBI agents. ...

                                                  A substantial short-term rise in spending on defense and intelligence would both stimulate our economy and strengthen our nation's security.

                                                    Posted by on Wednesday, December 24, 2008 at 02:34 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (78) 

                                                    In the Long-Run, We are All Healthier

                                                    Jacob Hacker argues that health care reform should be part of the stimulus package:

                                                    A Healthy Economy Medicine is the best stimulus, by Jacob S. Hacker, The New Republic: As we move deeper into the recession, most economists are urging President-elect Obama to spend big money right away in order to stimulate ... the economy. The sticking point for a lot of people, however, is the long-term budget picture...

                                                    In fact, we have a magic bullet for short-term spending and long-term saving--health care reform. During the campaign, skeptics complained that a health care overhaul would involve a lot of upfront costs and that the saving would only come later. But that's exactly what we need right now. Health care involves major spending in the near future, but, more than other initiatives, it will put a brake on federal outlays in the far future.

                                                    All this argues for temporarily throwing fiscal caution to the wind when it comes to health care reform. The idea of spiking the deficit now may seem frightening, but it's a lot better than the alternative--and it could actually make it easier to bring universal health care to America. ...

                                                    The typical items on the stimulus menu--infrastructure spending, general aid to the states, benefits for the jobless, investments in new forms of energy--have a lot going for them. But they shouldn't blind us to the fact that government health spending is also an extraordinarily effective way to boost the economy. ...

                                                    [F]ixing health care isn't just a recipe for better access to medical care. It's an immediate economic lifeline for working families, giving them back part of their income to use on other things. It's also a rescue package for state and local governments burdened by Medicaid and S-CHIP, for doctors and hospitals who treat the uninsured and inadequately insured, for community institutions that help people in distress--in short, for all the rapidly fraying threads of our health care safety net. Put simply, most of the money we spend upgrading coverage and spreading it to the uninsured is going to go directly into the pockets of people who need help now. ...

                                                    The beauty of all this spending is that it will mean higher wages and employment, a more flexible labor market in which people feel free to change jobs or strike out on their own without risking their health and finances, and, yes, less pressure on public and private budgets down the road. We'll be running up hefty federal bills for a while. But we'll be doing so confident we're going to improve the economic standing of millions of Americans and our long-term budget situation in the bargain.

                                                      Posted by on Wednesday, December 24, 2008 at 01:17 AM in Economics, Fiscal Policy, Health Care | Permalink  TrackBack (0)  Comments (34) 

                                                      links for 2008-12-24

                                                        Posted by on Wednesday, December 24, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (40) 

                                                        Tuesday, December 23, 2008

                                                        "Friedman would be Roiled..."

                                                        Is this the end of the line for the Chicago School?:

                                                        Friedman Would Be Roiled as Chicago Disciples Rue Repudiation, by John Lippert, Bloomberg:  John Cochrane was steaming as word of U.S. Treasury Secretary Henry Paulson’s plan to buy $700 billion in troubled mortgage assets rippled across the University of Chicago in September.

                                                        Cochrane had been teaching at the bastion of free-market economics for 14 years and this struck at everything that he -- and the school -- stood for.

                                                        “We all wandered the hallway thinking, How could this possibly make sense?” says Cochrane, 51, recalling his incredulity at Paulson’s attempt to prop up the mortgage industry and the banks that had precipitated the housing market’s boom and bust.

                                                        During a lunch..., Cochrane, son-in-law of Chicago efficient-market theorist Eugene Fama, and some colleagues made their stand. They wrote a petition attacking Paulson’s proposal, sent it to economists nationwide and collected 230 signatures. Republican Senator Richard Shelby of Alabama waved the document as he scorned the rescue. ... “We should have a recession,” Cochrane said...

                                                        [M]uch of the academic world is reassessing Chicago School hallmarks. ... Off campus, the global meltdown is stirring anti-Chicago economists, who were voices in the wilderness during decades of lax government oversight of markets.

                                                        Joseph Stiglitz ... says the approach of Friedman and his followers helped cause today’s turmoil. “The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self- adjusting and the best role for government is to do nothing,” says Stiglitz...

                                                        Continue reading ""Friedman would be Roiled..."" »

                                                          Posted by on Tuesday, December 23, 2008 at 02:07 PM in Economics | Permalink  TrackBack (0)  Comments (68) 

                                                          Lucas: Monetary Policy Can Still be Effective

                                                          Robert Lucas says monetary policy can still effectively stimulate new spending even though the target interest rate is already at or near zero, and that monetary policy is preferable to fiscal policy:

                                                          Bernanke Is the Best Stimulus, by Robert E. Lucas Jr., Commentary, WSJ: The Federal Reserve's lowering of interest rates last Tuesday was ... received with skepticism. Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

                                                          It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused. Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.

                                                          There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector... This action has been the boldest exercise of the Fed's lender-of-last-resort function in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue ... this discounting activity as long as the situation dictates.

                                                          Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality" that is very much analogous to the "flight to currency" that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety. Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets. The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession. Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending. ...

                                                          Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.

                                                          There are many ways to stimulate spending, and many of these methods are now under serious consideration. ... But monetary policy ... has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues.

                                                          There's a reason they used to be called "monetarists". If we wait to see if monetary policy does, in fact, work as advertised and we find out that it doesn't, it will be too late to implement effective fiscal policy. So yes, by all means use monetary policy to the best of our ability, but let's not forget about fiscal policy. If monetary policy is as fast and flexible as claimed, then it can always be reversed in the event that fiscal policy kicks in with more force than expected.

                                                          As to the argument that fiscal policy distorts the allocation of capital, that doesn't necessarily happen. As I've argued in the past:

                                                          One reason I am not as concerned with the efficiency aspect as others is that I believe there are a lot of public goods - goods the private sector won't invest in on its own due to market failures - that we need to repair or put into place that are crucial to our long-run growth potential. Cutting taxes won't bring these goods about... For this reason, I don't think government spending [necessarily] loses to tax cuts on ... the efficiency ... margin...

                                                          And as Paul Krugman argued yesterday:

                                                          Bad anti-stimulus arguments: A number of conservative economists have been arguing against a stimulus plan centered on government spending. Fair enough. But one argument I keep reading bugs me: it’s the claim that spending-based stimulus is bad because economic theory tells us that a marginal dollar of private spending is better than a marginal dollar of government spending.

                                                          That’s just wrong... Yes, the standard theory of consumer choice says that a consumer gains more utility if he or she gets to freely allocate a dollar of spending than if someone else makes the choices: I’d rather buy myself a $10 meal than have you feed me $10 worth of food that you select.

                                                          But that’s not what we’re talking about when we talk about stimulus spending: we’re not talking about the government buying consumption goods for the public at large. Instead, we’re talking about spending more on public goods: goods that the private market won’t supply, or at any rate won’t supply in sufficient quantities. things like roads, communication networks, sewage systems, and so on. And every Econ 101 textbook explains that the provision of public goods is a necessary function of government.

                                                          When we’re asking whether it’s better to have the government stimulate the economy or to try to stimulate private spending, we’re asking among other things whether a marginal dollar spent on public goods is worth more or less than a marginal dollar spent on private consumption. And there’s nothing, even in Econ 101, that clearly favors private spending on private goods over public spending on public goods. ...

                                                          The misallocation point is not central to Lucas' argument about why fiscal policy is inferior to monetary policy, but it is part of it. Among conservatives who do believe fiscal policy is needed, however, the misallocation argument is a central part of their insistence that tax cuts dominate government spending as a fiscal stimulus measure. But, again, this ignores the public goods aspect of the spending.

                                                            Posted by on Tuesday, December 23, 2008 at 02:07 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  TrackBack (0)  Comments (56) 

                                                            links for 2008-12-23

                                                              Posted by on Tuesday, December 23, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (13) 

                                                              Monday, December 22, 2008

                                                              What Decoupling?

                                                              A proposal to rebalance consumption and investment in China:

                                                              The China Growth Fantasy, by Yasheng Huang, Commentary, WSJ: Remember the hype about "decoupling"? Not so long ago, Western analysts -- in particular investment-bank economists -- were peddling the idea that China had become ... able not only to drive its own growth independent of the United States but also to power the global economy forward.

                                                              To the extent that these Wall Street economists are still employed, few would make that argument now. The economic numbers emerging out of China are sobering. ... Clearly China is not bucking global trends.

                                                              So how did all the decoupling theorists get it so wrong? ...

                                                              Continue reading "What Decoupling?" »

                                                                Posted by on Monday, December 22, 2008 at 07:30 PM in China, Economics | Permalink  TrackBack (0)  Comments (15) 

                                                                The Value of Reliable Information

                                                                At the Free Exchange Greenspan Roundtable:

                                                                The Value of Reliable Information, by Mark Thoma, Greenspan Roundtable, The Economist: Analysts writing about the credit crisis often have more certainty about the source of the problems in financial markets than I think is warranted. Thus, rather than advocating robust solutions, these analysts tend to come up with narrow answers to the problems they have identified. Yet evidence from previous crises suggests that America needs to take a broad approach to the current turmoil.

                                                                Janet Yellen, the president of the Federal Reserve Bank of San Francisco, recently returned from her annual fact-finding trip to Japan. While there, the country's policymakers and economic officials reflected on their experience with Japan's "lost decade" (during the 1990s) and suggested several approaches for resolving the crisis in America. Summarising the recommended approaches, Ms Yellen writes

                                                                One is to provide a safety net for the financial system during a crisis by extending deposit insurance and to enhance interbank liquidity by guaranteeing debt. Another emphasizes the importance of the government's role in recapitalizing the banks, provided that there are conditions about reducing risky lending and that the government stands to gain from future bank profits.

                                                                Finally, analysts universally concluded that the government needs to help banks get toxic assets off their balance sheets. Otherwise, banks will remain focused on the potential for further deterioration of these loans at the expense of looking forward and making new loans. Thus, new capital will be hoarded to protect against potential new losses. Equally important is price discovery. In Japan, the government took severe haircuts in purchasing assets from banks (in 2000). This policy reduced uncertainty by establishing a floor price for future asset sales. Everyone we met with urged the U.S. to move forward with an asset disposition program, as originally envisioned for the Troubled Asset Relief Program (TARP).

                                                                Thus, the recapitalisation that Alan Greenspan advocates (public or private) is part of the process needed to help repair financial markets, but if Japan's experience tells us anything—and it's one of the few examples we have to look at—it is by no means the only step that should be taken. There may be a single key to unlocking the whole mess, but if there is we aren't sure what it is, and that also points to a multi-pronged approach. Capital injections are one part of that approach, but capital injections do not, by themselves, adequately address problems such as the risk and information issues that Brad DeLong outlines. A successful solution must address all of the elements of the problem.

                                                                So where do the solutions that have been suggested come up short? If you read across the spectrum of serious proposals, and look at what has actually been implemented, most of the underlying problems have at least been recognised. But one area that has not received nearly enough attention is the information problem. Previous financial crises did not cause us to seriously question our informational architecture like this one has. This crisis has wiped out or discredited major sources of financial-market information that are crucial for credit markets to function. The ratings agencies are an obvious example. They are supposed to solve an asymmetric information problem between borrowers and lenders by giving those doing the lending a reliable assessment of the riskiness of financial investments. They failed in that mission.

                                                                Likewise, the balance sheets of financial institutions are no longer trusted—assessing a firm's solvency is largely a guess at this point. People are not going to part with their money until they are confident that the information about potential investments, and about the firms managing those investments, is reliable. That is true for both depositors and potential equity holders who could help with recapitalisation. We can take toxic assets off the books, but how will investors know for sure that new financial assets are safe, or that the firms doing the investing won't repeat the mistakes of the past and take huge losses yet again? How will investors know that the mathematical models used to assess these assets in terms of risk and return are reliable?

                                                                I don't think anything trustworthy can replace the ratings agencies in the short-run—nobody has much faith in the risk-assessment models being used in the industry—and that will be a problem as firms begin to issue new securities, a step that is needed to get credit flowing. There might be more we can do with respect to balance-sheet information, but this problem also seems to stem from the difficulty investors have in valuing financial assets.

                                                                The solution to this problem, then, is to provide insurance against the risks caused by the lack of information during the time period when the information flows are being restored. Private-sector agents may not want to risk putting their money into the banking system right now as equity holders if they believe they might lose everything. But if the downside risk is limited through some insurance provision—something that puts a limit on losses—they might not be so reluctant (and government may be the only one capable of such guarantees). Similarly, private-sector agents may be unwilling to invest in financial assets, or to trust money managers if they believe their money can suddenly disappear. Again, though, if the downside losses are limited, they might not be so reluctant. There are many, many forms this type of insurance can take, and the solutions can be based in both the public and private sectors. The important thing is to get the insurance into place.

                                                                So my recommendation would be to continue to pursue a broad-based strategy that addresses the many problems that have been suggested as potential causes of the crisis, and to bolster the initiatives that help to overcome the information and credibility issues that have arisen as big barriers to the flow of new credit. On the information and credibility issue, it's important to recognise that even if we recapitalise every bank that is in trouble, remove every existing toxic asset on every bank balance sheet, and refinance every mortgage so that it is not in danger of default, we still will not have fully repaired financial markets. We will still be left with a lack of trust—for good reason—in the informational architecture people use to make financial decisions. Until that is repaired—which will require a new regulatory structure, among other things—these markets will not perform to their full potential without some sort of insurance against the lack of credible information.

                                                                [Greenspan article, entire roundtable discussion with, in addition to the above, Luigi Zingales, Brad DeLong, Jan Hatzius, and Charles Calomiris.]

                                                                  Posted by on Monday, December 22, 2008 at 12:24 PM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (23) 

                                                                  Paul Krugman: Life Without Bubbles

                                                                  It may take a lot longer than many people think for the economy to be ready to stand on its own:

                                                                  Life Without Bubbles, by Paul Krugman, Commentary, NY Times: Whatever the new administration does, we’re in for months, perhaps even a year, of economic hell. After that, things should get better, as President Obama’s  ... economic recovery plan ... begins to gain traction. Late next year the economy should begin to stabilize, and I’m fairly optimistic about 2010.

                                                                  But what comes after that? ... Too much of the economic commentary I’ve been reading seems to assume ... that ... once a burst of deficit spending turns the economy around we can quickly go back to business as usual.

                                                                  In fact, however, things can’t just go back to the way they were... I hope the Obama people understand that.

                                                                  The prosperity of a few years ago, such as it was — profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks. And since the housing bubble isn’t coming back, the spending that sustained the economy in the pre-crisis years isn’t coming back either. ... Consumers will eventually regain some of their confidence, but they won’t spend the way they did...

                                                                  So what will support the economy if cautious consumers and humbled homebuilders aren’t up to the job? ... Something new could come along..., perhaps ... a boom in business investment.

                                                                  But this boom would have to be enormous, raising business investment to a historically unprecedented percentage of G.D.P., to fill the hole left by the consumer and housing pullback. While that could happen, it doesn’t seem like something to count on.

                                                                  A more plausible route to sustained recovery would be a drastic reduction in the U.S. trade deficit, which soared at the same time the housing bubble was inflating. ...

                                                                  But it will probably be a long time before the trade deficit comes down enough to make up for the bursting of the housing bubble. For one thing, export growth ... has stalled, partly because nervous international investors, rushing into assets they still consider safe, have driven the dollar up against other currencies...

                                                                  Furthermore, even if the dollar falls again, where will the capacity for a surge in exports and import-competing production come from? ...U.S. manufacturing ... has a lot of catching up to do.

                                                                  Anyway, the rest of the world may not be ready to handle a drastically smaller U.S. trade deficit. ...China’s economy in particular is built around exporting to America, and will have a hard time switching...

                                                                  In short, getting to the point where our economy can thrive without fiscal support may be a difficult, drawn-out process. And as I said, I hope the Obama team understands that.

                                                                  Right now, with the economy in free fall and everyone terrified of Great Depression 2.0, opponents of a strong federal response are having a hard time finding support. John Boehner, the House Republican leader, has been reduced to using his Web site to seek “credentialed American economists” willing to add their names to a list of “stimulus spending skeptics.”

                                                                  But once the economy has perked up a bit, there will be a lot of pressure on the new administration to pull back, to throw away the economy’s crutches. And if the administration gives in to that pressure too soon, the result could be a repeat of the mistake F.D.R. made in 1937 — the year he slashed spending, raised taxes and helped plunge the United States into a serious recession.

                                                                  The point is that it may take a lot longer than many people think before the U.S. economy is ready to live without bubbles. And until then, the economy is going to need a lot of government help.

                                                                    Posted by on Monday, December 22, 2008 at 12:33 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (148) 

                                                                    links for 2008-12-22

                                                                      Posted by on Monday, December 22, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (30) 

                                                                      Sunday, December 21, 2008

                                                                      Soros: The Theory of Market Equilibrium is Wrong

                                                                      George Soros says we need to revise regulation to keep bubbles "within tolerable bounds," but we also need to be careful of going too far:

                                                                      Revise regulation, the theory of market equilibrium is wrong, by George Soros, Commentary, Project Syndicate: We are in the midst of the worst financial crisis since the 1930s. The salient feature of the crisis is that it was not caused by some external shock like OPEC raising the price of oil. It was generated by the financial system itself. This fact - a defect inherent in the system - contradicts the generally accepted theory that financial markets tend toward equilibrium and deviations from the equilibrium occur either in a random manner or are caused by some sudden external event to which markets have difficulty in adjusting. The current approach to market regulation has been based on this theory, but the severity and amplitude of the crisis proves convincingly that there is something fundamentally wrong with it.

                                                                      I have developed an alternative theory which holds that financial markets do not reflect the underlying conditions accurately. They provide a picture that is always biased or distorted in some way or another. More importantly, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. ...[...continue reading...]...

                                                                        Posted by on Sunday, December 21, 2008 at 06:59 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (25) 

                                                                        "Effective Nationalization of the Mortgage Finance Sector"

                                                                        James Kwak says it's likely that the new administration will get behind the Hubbard and Mayer plan to have Fannie and Freddie buy mortgages and refinance them at 4.5%:

                                                                        We Have a Winner?, by James Kwak: After seeing dozens of mortgage proposals emerge over the past several months, there are news stories that Larry Summers and the Obama economic team are converging on an unlikely candidate: the proposal by Glenn Hubbard and Christopher Mayer... Hubbard and Mayer published a summary of the plan in the WSJ last week; a longer version of the op-ed is available from their web site; and you can also download the full paper, with all the models.

                                                                        I say “unlikely” not only because Hubbard was the chairman of President Bush’s Council of Economic Advisors, but because it doesn’t look like a Democratic plan; then again, it doesn’t look much like a Republican plan, either. ... Before getting to the policy specifics, though, I want to outline two of the premises...

                                                                        Continue reading ""Effective Nationalization of the Mortgage Finance Sector"" »

                                                                          Posted by on Sunday, December 21, 2008 at 10:17 AM in Economics, Housing, Policy | Permalink  TrackBack (0)  Comments (57) 

                                                                          The Pursuit of Wealth

                                                                          Tim Duy:

                                                                          For A Sunday Morning, by Tim Duy: An unusually quiet Sunday morning – the kids are with their grandparents, leaving me with a chance to think of something beyond the immediate economic data. This morning that meant a stream of thoughts triggered by Paul Krugman’s most recent op-ed, particularly this:

                                                                          Most of all, the vast riches being earned — or maybe that should be “earned” — in our bloated financial industry undermined our sense of reality and degraded our judgment.

                                                                          Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? How, for example, could Alan Greenspan have declared, just a few years ago, that “the financial system as a whole has become more resilient” — thanks to derivatives, no less? The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

                                                                          In this paragraph, Krugman sounds less like an economist and more like a philosopher. But I am not complaining in the least; economists lost a sense of the essential humanity of their topic when they gravitated down a path of sanitized mathematical and statistical methodology. Indeed, I often think that economists share no small blame for our current economic challenges, as the profession provided the intellectual basis for free markets but often failed to place that ideology in a larger social perspective. It is as if the profession followed the path of The Wealth of Nations but forgot The Theory of Moral Sentiments. The latter is Adam Smith’s philosophical tome, and if you can only read one of these two, it is my recommendation. I suspect that Krugman had TMS in mind when he wrote the above paragraphs. An excerpt from Smith:

                                                                          Continue reading "The Pursuit of Wealth" »

                                                                            Posted by on Sunday, December 21, 2008 at 09:54 AM in Economics, History of Thought, Income Distribution | Permalink  TrackBack (0)  Comments (88) 

                                                                            links for 2008-12-21

                                                                              Posted by on Sunday, December 21, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (23) 

                                                                              Saturday, December 20, 2008

                                                                              Blanchard: How to Emerge from the Crisis in 2009

                                                                              Olivier Blanchard, chief economist of the IMF, says that if the right policies are followed, it's possible to begin emerging from the crisis before the end of 2009:

                                                                              How to emerge from the crisis in 2009, by Olivier Blanchard, Project Syndicate: ...Let me first set the scene by making three observations on where we are today. First, in the advanced countries, we have probably seen the worst of the financial crisis. There are still land mines,... but the worst days ... are probably over.

                                                                              Second, and unfortunately, the financial crisis has moved to emerging countries. In crossing borders, the sharp portfolio reallocations and the rush to safer assets are creating not only financial but also exchange-rate crises. Add to this the drop in output in advanced countries, and you can see how emerging countries now suffer from both higher credit costs and decreased export demand.

                                                                              Third, in the advanced economies, the hit to wealth, and even more so the specter of another Great Depression, has led people and firms to curtail spending sharply... The result has been a sharp drop in output and employment, reinforcing fears about the future, and further decreasing spending.

                                                                              Let me now turn to policy. If my characterization of events is correct, then the right set of policies is straightforward:

                                                                              Continue reading "Blanchard: How to Emerge from the Crisis in 2009" »

                                                                                Posted by on Saturday, December 20, 2008 at 09:45 PM in Economics, Financial System, International Finance, Policy | Permalink  TrackBack (0)  Comments (14) 

                                                                                "George Bailey Explains Bank Runs"

                                                                                [via Richard Green]

                                                                                  Posted by on Saturday, December 20, 2008 at 08:46 PM in Economics, Financial System, Video | Permalink  TrackBack (0)  Comments (0) 

                                                                                  "Missing the Target With $700 Billion"

                                                                                  Alan Blinder isn't happy with Treasury Secretary Paulson's use of TARP money:

                                                                                  Missing the Target With $700 Billion, by Alan S. Blinder, Economic View, NY Times: ...It pains me to say this, because I was among the first to call upon Congress to create two institutions to deal with the financial crisis: one to buy and refinance home mortgages, the other to buy what came to be called “troubled assets.” The legislation signed in October empowered the TARP to do both. Sadly and amazingly, it has done neither. ... Instead, taxpayer money has been used [by Treasury Secretary Henry M. Paulson Jr.] mainly to recapitalize ailing banks. ...

                                                                                  Because about half of the $700 billion remains uncommitted, let’s review the arguments supporting the three main uses of the TARP:

                                                                                  Mortgages: The financial crisis began with falling home prices and fears of rampant mortgage defaults — fears that are now coming true. Those fears depressed the values of securities based on mortgages, making them “troubled.” ... It is hard to see a way out of this mess without seriously reducing foreclosures. Understanding that, Congress directed the Treasury secretary to use the TARP to get mortgages refinanced. But he has not.

                                                                                  Mortgage-Related Securities: There were several rationales for buying troubled mortgage-backed securities. First, panic had virtually shut down the markets for these securities... Second, one source of that panic was that nobody knew what the securities were worth. A functioning market would establish objective valuations. Third, many mortgages are buried in complex securities. Buying the securities would let government refinance the underlying mortgages.

                                                                                  Mr. Paulson says he changed his mind about buying troubled assets because the facts changed. I’m sure that many facts changed. But what new facts invalidate the rationales above? ...

                                                                                  Recapitalizing Banks: Granting the secretary catch-all authority to buy “any other financial instrument” was a sensible addendum to the law. It offered much-needed flexibility to respond to unforeseen circumstances — an auto bailout, for example. But whoever imagined that the addendum would consume nearly all the TARP money, leaving nothing for its two stated purposes?

                                                                                  But suppose you believe (though I don’t) that recapitalizing banks was the best use of all the money. Even then, the secretary’s execution leaves much to be desired. Never mind the lack of transparency and the management issues recently cited by the Government Accountability Office. Think about this:

                                                                                  Treasury has bought preferred stock with no control rights. The 5 percent dividend rate that taxpayers will generally receive is half what Warren Buffett got from Goldman Sachs. Banks receiving capital injections through the front door are generally allowed to pay dividends out the back door. And there are no public-purpose quid pro quos, such as a minimal lending requirement. So banks can just sit on the capital... Clearly, Mr. Paulson bent over backward to make the terms attractive to banks. ...

                                                                                  So here we are, looking at an all-too-familiar story. The administration that brought you the Iraq war and the Katrina response is locking in another disaster before it leaves town. What to do?

                                                                                  Fortunately, the TARP legislation ... Congress a mechanism for blocking release of the second $350 billion. With the first tranche now committed, Mr. Paulson said he would soon request release of the second. Based on his performance to date, Congress should reject that request unless he agrees to spend most of the next installment on TARP’s two stated purposes.

                                                                                  Failing that, we can wait a month for the new Treasury secretary, Timothy Geithner.

                                                                                    Posted by on Saturday, December 20, 2008 at 05:58 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (23) 

                                                                                    "A Solution to the Principal-Agent Problem"

                                                                                    How to solve the moral hazard problem involved in body swapping:

                                                                                    The Bible Meets Science Fiction: A Solution to the Principal-Agent Problem, Suggested by Lawrence H. Officer, JPE Back Cover, vol. 110, no. 1: “Next, you and the Martian Gentleman will both sign a Reciprocal Damage Clause. This states that any damage to your host body, whether by omission or commission, and including Acts of God, will, one, be recompensed at the rate established by interstellar convention, and, two, that such damage will be visited reciprocally upon your own body in accordance with the lex talionis.

                                                                                    “Huh?” Marvin said.

                                                                                    “Eye for eye, tooth for tooth,” Mr. Blanders explained. “It's really quite simple enough. Suppose you, in the Martian corpus, break a leg on the last day of Occupancy. You suffer the pain, to be sure, but not the subsequent inconvenience, which you avoid by returning to your own undamaged body. But this is not equitable. Why should you escape the consequences of your own accident? Why should someone else suffer those consequences for you? So, in the interests of justice, interstellar law requires that, upon reoccupying your own body, your own leg be broken in as scientific and painless a manner as possible.”

                                                                                    “Even if the first broken leg was an accident?”

                                                                                    Especially if it were an accident. We have found that the Reciprocal Damage Clause has cut down the number of such accidents quite considerably.” [Robert Sheckley, Mindswap (New York: Dell, 1966), p. 17.]

                                                                                    Instead of borrowing somebody's body, Wall Street borrows their money. But when they do the equivalent of breaking your leg - when they damage the deposits they are holding - they don't always suffer any consequences. In fact, many of them get to keep the large bonuses they earned for managing the money so poorly, e.g. see Krugman's latest column. A broken leg clause is a bit on the thuggish side, of course, financial penalties are more acceptable, but this does make clear the need for money managers to "feel your pain" in order to get the incentives correct.

                                                                                      Posted by on Saturday, December 20, 2008 at 09:36 AM in Economics, Financial System, Market Failure | Permalink  TrackBack (0)  Comments (35) 

                                                                                      links for 2008-12-20

                                                                                        Posted by on Saturday, December 20, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (62) 

                                                                                        Friday, December 19, 2008

                                                                                        "Experts & the Demand for Certainty"

                                                                                        What is the purpose of experts? Chris Dillow says it's to provide certainty, not knowledge:

                                                                                        Experts & the demand for certainty, by Chris Dillow: It’s a bad day for experts. The Times complains that economic forecasters are as blind as ancient soothsayers, whilst proof that Colin Stagg was innocent discredits Paul Britton’s expertise as a forensic pyschologist.

                                                                                        To point out that experts are wrong, however, is to misunderstand the purpose of them. Their function is not to provide knowledge, and still less clear thinking. Instead, it is to provide certainty. People hate dissonance, doubt and uncertainty. Experts help dispel these. So, Paul Britton’s function was to tell the police that they had the right man, whilst economic forecasters’ job is to provide an impression that the future is knowable; no-one wants to hear about standard errors, parameter uncertainty or the Lucas critique.

                                                                                        What’s so pernicious here, though, is that people have ways of achieving an illusory certainty anyway. As Sir Harry Ognall - the judge who acquitted Stagg - says: “The police closed their minds to any other possibility than that of his guilt.”

                                                                                        There are several ways they got these closed minds. All have analogues in corporate planning and financial trading.

                                                                                        Continue reading ""Experts & the Demand for Certainty"" »

                                                                                          Posted by on Friday, December 19, 2008 at 01:17 PM in Economics | Permalink  TrackBack (0)  Comments (42) 

                                                                                          Talk is Fine, but Rules are Needed Too

                                                                                          One more at TPM Cafe Book Club:

                                                                                          Talk is Fine, But Rules are Needed Too, by Mark Thoma: Dean Baker says that Alan Greenspan should have used his public appearances to warn people about the stock and housing bubbles, and if he had, the bubbles would not have inflated to such dangerous levels.

                                                                                          Continue reading "Talk is Fine, but Rules are Needed Too" »

                                                                                            Posted by on Friday, December 19, 2008 at 11:07 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (13) 

                                                                                            Paul Krugman: The Madoff Economy

                                                                                            The costs of "America's Ponzi Era":

                                                                                            The Madoff Economy, by Paul Krugman, Commentary, NY Times: The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

                                                                                            Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

                                                                                            The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s ... had a corrupting effect on our society as a whole.

                                                                                            Let’s start with those paychecks. ... The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

                                                                                            But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

                                                                                            Consider the hypothetical example of a money manager who leverages up his clients’ money..., then invests the bulked-up total in high-yielding but risky assets... For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

                                                                                            O.K., maybe my example wasn’t hypothetical after all.

                                                                                            So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. ... Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

                                                                                            We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

                                                                                            But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

                                                                                            At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics... Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

                                                                                            Most of all, the vast riches ... undermined our sense of reality and degraded our judgment. Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? ... The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

                                                                                            After all, that’s why so many people trusted Mr. Madoff.

                                                                                            Now, as we survey the wreckage and try to understand how things can have gone so wrong, so fast, the answer is actually quite simple: What we’re looking at now are the consequences of a world gone Madoff.

                                                                                              Posted by on Friday, December 19, 2008 at 12:33 AM in Economics, Financial System, Income Distribution | Permalink  TrackBack (1)  Comments (192) 

                                                                                              links for 2008-12-19

                                                                                                Posted by on Friday, December 19, 2008 at 12:06 AM in Links | Permalink  TrackBack (0)  Comments (18) 

                                                                                                Thursday, December 18, 2008

                                                                                                Fed Watch: Zero, But Not Quite Quantitative Easing

                                                                                                Can the Fed's current policy be described as quantitative easing?:

                                                                                                Zero, But Not Quite Quantitative Easing, by Tim Duy: On the surface, the Fed’s recent statement should not have been much of a surprise. It was remarkably consistent with Fed Chairman Ben Bernanke’s recent policy speech. And it leaves little illusion that the US economy is mired in anything but the worst recession since the Great Depression.

                                                                                                My takeaways from the statement were straightforward:

                                                                                                1.) Since the effective funds rate was trading well below the Fed’s target, and it was economically unimportant in any event, just take the target to a range near zero. I assume that given the instability of financial markets, they thought it best not to prescribe a specific target, but a range instead.

                                                                                                2.) The Fed committed to low rates indefinitely, giving market participants faith that they can extend Treasury purchases further out along the yield curve without fear of a sharp policy reversion in the near future. (Does the Fed’s commitment to low rates leave Treasuries as the last one way bet?)

                                                                                                3.) Not surprisingly, economic weakness, not inflation, is the primary concern. There is no reason for near term optimism.

                                                                                                4.) Policy will focus on the tools that reveal themselves in the Fed’s balance sheet. Those tools may be expanded to include outright purchases of longer dated Treasuries.

                                                                                                The final point is worth considering further, especially since the Fed brought forth a “senior Fed official” to elaborate on the statement. I don’t quite understand the need for secrecy – why not have Bernanke himself just step up to the plate? In any event, the secret official took pains to explain that this policy did not constitute quantitative easing. First, the statement:

                                                                                                The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.

                                                                                                What struck me on the first read was the commitment to maintain the balance sheet at a high “level.” I think the use of the word “level” was deliberate – quantitative easing implies a commitment to a steady expansion, or rate of change, in the balance sheet. The Fed is offering no such commitment at this time. Is this the proper interpretation? From the senior official:

                                                                                                The Fed said in its statement today that it will be using its balance sheet to support credit markets and the economy. Some analysts have called the approach quantitative easing — effectively expanding the money supply once interest rates cannot be eased further — as Japan did during its economic turmoil.

                                                                                                But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did.

                                                                                                What, stop….the arrogance of Fed officials never ceases to amaze me! Note that this official accuses “[S]ome analysts” as misinterpreting the Fed’s policy stance. I have written on this in the past:

                                                                                                …What we have now is an expansion of the balance sheet to accommodate liquidity measures. This may pave the way to quantitative easing, but still maintains the Fed Funds rate as the primary target.

                                                                                                But then why do they keep saying they have a policy of quantitative easing? This first crossed my radar when reviewing a recent interview with Dallas Federal Reserve President Richard Fisher. I discounted his reference to quantitative easing as Fisher is something of a colorful character who often talks before he thinks. But subsequent policymakers repeated the term. Earlier this week New York Fed President Gary Stern was quoted by Stephen Beckner:

                                                                                                Asked whether the doubling in size of the balance sheet represents "quantitative easing," Stern said "I don't think that's a bad statement. I think the world is a little more complicated than that, but I don't think that's a bad statement."

                                                                                                So, just to be clear, it is not just “some analysts” who are confused by the Fed’s policy – the confusion spills over to Fed policymakers as well. Maybe analysts would not be confused if Fed officials would simply stick to one set of talking points.

                                                                                                According to the official, we are not in the realm of quantitative easing. What is the distinction?

                                                                                                The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.

                                                                                                Fed policy has been directed at improving credit market functioning, thereby acquiring assets, of which the expansion of liabilities is simply a side affect of the policy, not the policy itself. The Fed apparently views deliberate expansion of liabilities – a commitment of x% percent growth in some monetary aggregate via Treasury purchases – as quantitative easing. A commitment to increase the balance sheet at a steady pace (the first derivative) rather than maintain a high level. We are not there yet.

                                                                                                Is this distinction important? Or just semantics? I believe it is important, as the latter, a move to target the liabilities side of the balance sheet, would imply that the Fed is deliberately trying to stoke an inflationary fire. This may become the future policy, but for now the Fed is simply trying to keep the financial system from collapsing. Inflation would be an accident, not a deliberate policy effort, at least from the Fed’s point of view. For the moment, the policy remains insufficient to ward off deflationary pressures long as the rest of the world refuses to accept the burden of global adjustment.

                                                                                                The problem, in my mind, is that the rest of the world either refuses or is simply incapable of shouldering some of the burden of global adjustment. This inability to adjust appears to be the end result of almost thirty years of global acceptance and US indifference to external imbalances. Global consumption and production patterns, both spacially and intertemporally, are so misaligned that it looks like we are all now in a race to the bottom together. An amazing global policy failure. So, so depressing.

                                                                                                So when does Fed policy truly become inflationary? Currently, I am thinking it becomes inflationary when policymakers become desperate enough to attempt to use monetary policy to entirely offset the headwinds blowing against economic activity. When they truly attempt to target asset prices to “fix” the housing market. When they decide the easiest answer to the excessive build up of debt is to inflate it away. At that point, policy will shift from the asset side of the balance sheet to the liability side. That is when Treasury and the Fed will risk a disorderly adjustment of the Dollar. Hopefully we will not get there. But I suspect that is when the tide will turn for the Fed.

                                                                                                  Posted by on Thursday, December 18, 2008 at 09:09 PM in Economics, Fed Watch, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (25) 

                                                                                                  Avoiding "An Inefficient Credit Squeeze"

                                                                                                  A proposal to get credit flowing again:

                                                                                                  How to give banks confidence to lend to businesses, by Lucian Bebchuk and Itay Goldstein, Commentary, Financial Times: An important aspect of the economic crisis has been the drying up of credit... Why does credit fail to flow despite the infusion of so much additional capital into the financial sector? ...

                                                                                                  In a modern economy, the prospects of businesses are likely to be inter­dependent, with each company’s success (and ability to repay) depending on whether other companies obtain financing. Companies commonly use components and services from other businesses and often sell their output to other companies or their employees.

                                                                                                  Consider a bank choosing whether to lend to companies or park its capital in treasuries. Suppose that lending to any given company will generate an expected return of 10 per cent if other businesses obtain financing but an expected loss of 5 per cent if they do not. In such circumstances, the economy may get stuck in an inefficient credit freeze in which banks expect other banks to avoid lending and, given these expectations, rationally choose to hoard their capital to avoid the expected loss from lending when other banks do not.

                                                                                                  Unfortunately, we cannot count on interest rate cuts and capital infusions into banks to get the economy out of such a credit freeze..., avoiding the 5 per cent expected loss will remain each bank’s rational choice as long as other banks are not lending.

                                                                                                  Is there anything more the government could do? Yes, it can ... take on ... some of the credit risks involved in extending substantial new lending to businesses.

                                                                                                  Suppose that the government wishes to get at least $200bn of additional lending to companies. Under one possible mechanism, the government would facilitate ... loans by agreeing to bear part of any losses ... in return for a share of the upside. In the example considered above, to induce banks to put together ... new loans it would be sufficient for the government to agree to bear any losses ... up to 10 per cent of the value of the extended loans.

                                                                                                  The share of the upside received by the government could be determined through a competitive process. ... Under an alternative mechanism, the government would place $200bn in a number of funds. Each would be run by a private manager charged with putting together a portfolio of loans and compensated with a share of the profits generated by the fund. ...

                                                                                                  When capital infusions and interest rate cuts do not work, the mechanisms we propose might provide effective tools for unfreezing credit markets.

                                                                                                  The demand for loans is also a limiting factor, and I don't think making more loans available to businesses will be enough to jump-start the economy at this point. So more help for the economy than just making additional credit available will be required.

                                                                                                  However, Ricardo Caballero says the problem isn't as hard to fix as most people believe:

                                                                                                  Normality is just a few policy steps away: Economic agents of all sorts, from creditors to consumers, are frozen waiting for some sense of normality to be restored amid the financial crisis. However, normality is much closer —just a few bold policy steps away— than is the conventional wisdom. ...

                                                                                                  I do not mean to say that this recession is an imaginary one. On the contrary, I believe it is a very serious recession. My point is simply that good policy has an opportunity to bring the recession back to familiar turf by defeating the extra gloom, and if this happens, the recession will become a manageable one from which current asset prices, on average, will look like once-in-a-lifetime deals. ...

                                                                                                  Slow recoveries follow the typical credit crunch... But ... this ... is very different in nature. It is a systemic run on all forms of explicit and implicit insurance contracts, but with no shortage of resources on the side. If confidence recovers, the resources to support the recovery are abundant and ready. ...

                                                                                                    Posted by on Thursday, December 18, 2008 at 02:34 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (31) 

                                                                                                    Why Didn't the Dollar Crash?

                                                                                                    Brett Dobbs at The Big Think asked me to submit a question for Paul Krugman. I asked, "Many people thought the crash of the dollar would lead the economic downturn. Why didn't that happened?"

                                                                                                    The complete interview is here (and he answers much more interesting questions than the one I asked!). The topics and questions are:

                                                                                                      Posted by on Thursday, December 18, 2008 at 10:17 AM in Economics, International Finance | Permalink  TrackBack (0)  Comments (46)