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Monday, March 23, 2009

"Toxic Car" Follow-Up: Pricing Toxic Assets

Sandro Brusco at noiseFromAmeriKa, a blog with other Italian economists Alberto Bisin, Michele Boldrin, Gianluca Clementi, Andrea Moro and Giorgio Topa, sent this to me in response to the post on toxic cars. One of the key problems in the example, and in the toxic asset problem more generally, is finding the right price for the assets when there is no market for them. Sandro uses an example similar to the "toxic car" example to show how mechanism design theory can be applied to the problem of evaluating toxic assets:

Mechanism Desing and the Bailout: Introduction Since the explosion of the banking crisis we have seen many analyses and many proposals for solution; hardly a day seems to pass by without the appearance of a new plan to save the banks. So, you may ask, why do we need plan n+1? Well, I am not going to propose a full-fledged plan. Rather, I would like to make a partial proposal related to one aspect of the problem, the evaluation of the so-called ''toxic assets''. The theoretical underpinnings of many of the existing proposals are often quite opaque: I would like to do the opposite, so I will try to explain in some detail the theoretical basis of my proposal.

Continue reading ""Toxic Car" Follow-Up: Pricing Toxic Assets" »

    Posted by on Monday, March 23, 2009 at 02:34 PM in Economics, Financial System, Market Failure | Permalink  TrackBack (0)  Comments (5) 

    "Toxic Car" Follow-Up: The Free Insurance in TALF

    The post on toxic cars prompts an explanation of the free insurance that is part of the Geithner plan:

    The Geithner CDS, by Cheap Talk: This post from Mark Thoma is useful in spelling out some of the accounting behind the Geithner plan and its old incarnation due to Paulson and co.  But we cannot assess the policy unless we come to grips with the Treasury’s motives for intervening in the first place.  When we do the picture changes a lot and it becomes clear that this amounts to a blanket insurance policy for the banks.

    Continue reading ""Toxic Car" Follow-Up: The Free Insurance in TALF" »

      Posted by on Monday, March 23, 2009 at 01:26 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (3) 

      Which Bailout Plan is Best?

      Which plan is best, the original Paulson plan where the government buys bad paper directly, the Geithner plan where the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, or straight up nationalization?

      Last March, before Paulson had announced his plan, I said that I thought it was time for the government to begin aggressively purchasing toxic assets to solve this problem once and for all:

      I’m starting to think that the Fed should drop the term part of the TSLF and instead trade permanently for risky assets (with the haircut sufficient to provide some compensation for the risk), bonds for MBS, money for MBS, or whatever, and don’t limit trades to banks.

      The Fed would act as “risk absorber of last resort.” Why should it do this? There has been an unexpected earthquake of risk, a financial disaster on the scale of a natural disaster like Katrina, and the government can step in and sop some of it up by trading non-risky assets (money, bonds, etc.) for risky assets at an attractive risk-adjusted price. ...

      I still think that this would have worked then, I called the government a "risk absorber of last resort," and the prices of the assets at that time were high enough to keep banks solvent. But it would have involved a massive transfer to the banks without giving taxpayers any share of the upside. In addition, as time has passed and prices have fallen, solvency issues have come to the forefront - the balance sheet problems are no longer hidden by overpriced assets - and the solvency problems must be addressed directly. That means that if there is no separate program to provide an infusion of capital, simply removing the toxic assets from the balance sheets through government purchases at current prices - prices so low that the banks are insolvent - won't be resolve the problem.

      So if it was to work, the Paulson plan had to be amended, it needed to both get assets off the banks' books somehow, and it also needed to provide recapitalization in a way that is politically acceptable (which means no giveaways - the asset purchase plan I proposed above would have been a giveaway without some sort of redistributive mechanism attached to the plan).

      So which plan is best? Any plan that does these two things, removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has these two features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. The plan for nationalization most certainly has these features, but it has political problems as well.

      So I do not take a binary (or, I suppose, trinary), either/or approach to the proposals where I think one plan will work and the others will fail miserably. All three plans have their pluses and minuses. The politics of the Paulson plan make it a non-starter, I have no quarrel with the view that it constitutes a giveaway that is not justified, so the only way the Paulson plan will work is if we can convince people that equity stakes or some other mechanism makes the plan sufficiently equitable. I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear. So all three plans do the requisite things - get assets off the books and provide recapitalization - and each comes with its own set of political worries.

      So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none - to me - is so off the mark that I am filled with despair because we are following a particular course of action.

      The post quoted above was from over a year ago, and we had been aware of growing problems in the financial sector for some time before that. There were programs in place, but nothing of sufficient scale to get the bad paper off the books, so we've been at this for a long time without any big, decisive, effective policy action. What's important to me is that we do something, that we adopt a reasonable plan that has a decent shot at working and that satisfies the political test it must pass (though the administration could certainly do more to sell the plan to the public and help with this part, so passing the test is partly a reflection of the effort that is put into selling it). We've been spinning our wheels for too long, and it's time to get this done. We can't wait any longer.

      So I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

        Posted by on Monday, March 23, 2009 at 11:52 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (53) 

        Paul Krugman: Financial Policy Despair

        We'll likely only get one attempt at rescuing the banking sector, and Paul Krugman prefers we use the "time-honored procedure for dealing with the aftermath of widespread financial failure" rather than the Geithner plan:

        Financial Policy Despair, by Paul Krugman, Commentary, New York Times: Over the weekend The Times and other newspapers reported leaked details about the Obama administration’s bank rescue plan... If the reports are correct, Tim Geithner ... has persuaded President Obama to recycle ... the “cash for trash” plan proposed, then abandoned, six months ago by ... Henry Paulson.

        This is more than disappointing. In fact, it fills me with a sense of despair. ... It’s as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street. ...

        Right now, our economy is being dragged down by our dysfunctional financial system... As economic historians can tell you, this is an old story... And there’s a time-honored procedure for dealing with the aftermath of widespread financial failure...: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.

        That’s what Sweden did in the early 1990s. It’s also what we ourselves did after the savings and loan debacle of the Reagan years. And there’s no reason we can’t do the same thing now.

        But the Obama administration, like the Bush administration, apparently wants an easier way out. The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay... In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.

        And so the plan is to use taxpayer funds to drive the prices of bad assets up to “fair” levels. Mr. Paulson proposed having the government buy the assets directly. Mr. Geithner instead proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The idea, says Mr. Obama’s top economic adviser, is to use “the expertise of the market” to set the value of toxic assets.

        But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets. ...

        But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks ... that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.

        You might say, why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.

        Even more important, however, is the way Mr. Obama is squandering his credibility. If this plan fails — as it almost surely will — it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place.

        All is not lost... But time is running out.

          Posted by on Monday, March 23, 2009 at 12:33 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (113) 

          links for 2009-03-23

            Posted by on Monday, March 23, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (20) 

            Sunday, March 22, 2009

            Geithner: My Plan for Bad Bank Assets

            Timothy Geithner explains and defends his new plan to repair financial markets:

            My Plan for Bad Bank Assets, by Timothy Geithner, Commentary WSJ: ...Over the past six weeks we have put in place a series of ... initiatives ... to help lay the financial foundation for economic recovery. ... Together, actions over the last several months by the Federal Reserve and ... initiatives by this administration are already starting to make a difference. ...

            However, the financial system as a whole is still working against recovery. ... Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity.

            Our new Public-Private Investment Program will ... purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

            The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. ...

            Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

            Continue reading "Geithner: My Plan for Bad Bank Assets" »

              Posted by on Sunday, March 22, 2009 at 09:27 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (28) 

              Government Intervention in the Market for Toxic Cars

              Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer's "balance sheet" - the cars on its lot - are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.

              If all the cars were in perfect shape, they would sell for $20,000 each. Thus, there are (50)*($20,000) = $1,000,000 in assets on the books according to one way of doing the accounting, but that doesn't necessarily represent the true value of the cars on the lot.

              The town where this dealership is located relies upon this business for jobs, it is essential, but, unfortunately, business has fallen off to nothing. Nobody is willing to risk losing $20,000 by purchasing a car that might die just after purchase, so the price has fallen. The expected value of a car is $10,000, but it's an all or nothing proposition, the car runs or it dies, and since people are risk averse nobody is wiling to pay the $10,000 expected value. In fact, the highest price they are willing to pay, $6,000, is lower than the minimum price the dealer is willing to accept (I've assumed a reservation price of $7,500 for illustration, and a horizontal supply curve to make the illustration easier):


              So how could the government fix the problem?

              1. Government purchases of toxic cars

              The government could buy the cars itself, say at $7,500 per car, or $750,000 total for the lot, drive them around a bit (stress test them), wait for the bad ones to blow up, then sell the 50 good cars back to the public (who will no longer be fearful since the bad cars are out of the mix). If they can get anything more than $15,000 for each good car, they will make money on the deal (well, there would be overhead and other costs to cover, but let's abstract from minor details). But if cars end up selling for less than $15,000, they will take a loss.

              (In the graph, the government intervention shifts the demand curve outward until it intersects at the kink in the supply curve at Q=100).

              The problem with this option is knowing what price to offer for the cars. There is no market, and the firm's reservation price may be too high, i.e. paying the reservation price will eventually lead to a loss. And it's worse. In this example the percentage of bad cars is known, but the percentage of bad cars would also be unknown in a more realistic example, so there's no way to know how many good cars there are for sure, and what price they will sell for after the defective cars have been culled out of the herd. If the government pays $7,500 per car, and more than 62.5% of them go bad (not that much more than the 50% estimate), then taxpayers will lose money even if they sell for $20,000. With the percentage unknown, there's no way to know for sure what the breakeven price will be.

              This is, in essence, the original Paulson plan. The only twist is that the price - the $7,500 in the example above, would be determined by an auction among many dealers with the government accepting the lowest bid (which could be $7,500 in this example since that is the price the firm is willing to accept). As you can see by thinking this through, there are questions about what price such an auction would reveal.

              One danger in this plan is that if you overpay for the cars, e.g. give $7,500 when the breakeven price was, say, actually $5,000, then you have given the owner of the car lot $250,000 more than the cars were actually worth (this will be the loss to taxpayers). The dealer may need this money to stay solvent and stay in business, but, nevertheless, it is a windfall.

              There are a lot of uncertainties here, and lots of ways to lose money. But it's possible to make money too.

              2. Subsidies and Public-Private partnerships

              Here, the government offers a subsidy to private sector buyers. Suppose that the demand curve intersects the vertical line in the graph (at Q=100) at a price of $4,000. Then in order to sell 100 cars, the government must subsidize buyers by $3,500 so that the $4,000 offer is raised to the $7,500 the firm is willing to accept (notice that the buyer willing to pay $6,000 gets a $2,000 windfall, so, except at the margin, this plan gives surplus to people purchasing the assets - as with the first plan, this shifts the demand curve out until it intersects at the kink in the supply curve).


              However, once again, the government will not know if it is getting this right or not. Suppose it offers a $1,000 subsidy thinking that is generous enough. In this example, that won't bridge the gap between the highest offer of $6,000, and the reservation price of $7,500. Thus, the subsidy would be too small to restart the market and the plan would fail. So the answer is to make the subsidy large enough to encourage buyers, but the problem is that if it is too large, the government will be giving money away unnecessarily.

              And there's another problem. If there's a large gap between what people are willing to pay and what dealers are willing to accept(the gap between $6,000 and $7,500 in the example), this would be problematic politically since it would require subsidies that are unacceptably large.

              And I should note that it doesn't have to be a subsidy. That's one way to do this - as a giveaway - but another way is through a no recourse loan (what is being called a partnership). Suppose that the government gives (up to) a $3,500 loan to a private sector buyer to purchase the car for $7,500. If it's a good car and the value rises above $7,500, say to $15,000, then government will get paid back (with interest) since the asset can be sold profitably (another option is for the government to demand a share of this profit through warrants or other means). But if it's a bad car, the price falls to zero and the loan is forgiven - it does not need to be repaid. So the private sector agents only have to put up a fraction of the price to control the asset, and their losses are limited to the amount they put up while the gains are potentially large.

              This is, in essence, the Geithner Plan. If many of the loans are not repaid, or if the subsidy is too large, it could lose a lot of money, but it could also make money too.

              3. Nationalization

              Now for the Saab story. Another option is for the government to simply take over the car dealership. The dealership is essential to the economy of the town, without it people will struggle, and the government - for that reason - might consider temporarily taking over the dealership to prevent failure. In doing so, it would make an evaluation of the company's assets, pay off the people who loaned the business money up to this amount, which may require having them take a haircut, i.e. accept some percentage of what they are owed on the bad loans they made, and the owner would simply be wiped out (which is a benefit since the business is insolvent and this allows the owner to escape the loans that cannot be paid through liquidation).

              After taking over, the government would stress test the cars it now owns, put the bad ones in the junk pile, and sell the rest back to the public. So long as it didn't pay the creditors too much when it took over, i.e. the haircut is sufficiently large, it ought to make money on the deal. But it could lose money here too.

              The Point

              But, and I want to stress this, the point of these plans is not to make money, the point is to keep the economy of the town going, to keep people employed. If people place a large value on security, then even if the government takes a loss on paper, it may not be an economic loss. That is, we must put a value on the jobs that are saved and the security it brings (simply imagine that the utility function has risk as one of its arguments - by lowering the risk of job loss and the associated household disruption, you have made the agent better off, and this must be counted against any loss from any of the programs above). There is value in economic stability and security over and above whatever the government makes (or loses) on the actual financial transactions, and this must be factored into the evaluation of the policy.

                Posted by on Sunday, March 22, 2009 at 01:08 PM in Economics, Financial System, Market Failure, Policy | Permalink  TrackBack (0)  Comments (64) 

                "Ricardian Equivalence in Practice"

                This discussion at Brad DeLong's makes the point that Ricardian equivalence fails for deficit financed temporary changes in government spending. But what's not clear from the discussion is that there's no reason to expect Ricardian equivalence to hold in any case in practice, even for deficit financed tax cuts where it can be true in theory.

                This is from the third edition of Brad's colleague David Romer's Advanced Macroeconomics text where he explains why "there is little reason to expect Ricardian equivalence to provide a good first approximation in practice":

                11.3 Ricardian Equivalence in Practice

                An enormous amount of research has been devoted to trying to determine how much truth there is to Ricardian equivalence. There are, of course, many reasons that Ricardian equivalence does not hold exactly. The important question, however, is whether there are large departures from it.

                Continue reading ""Ricardian Equivalence in Practice"" »

                  Posted by on Sunday, March 22, 2009 at 12:24 AM in Economics, Fiscal Policy, Taxes | Permalink  TrackBack (0)  Comments (19) 

                  links for 2009-03-22

                    Posted by on Sunday, March 22, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (2) 

                    Saturday, March 21, 2009

                    Short-Run and Long-Run Deficits

                    Robert Frank says its important to separate the cyclical component of the budget from its long-run trajectory, and that when evaluating deficits, how the money is spent matters:

                    When ‘Deficit’ Isn’t a Dirty Word, by Robert H. Frank, Commentary, NY Times: ...Because important policy decisions hinge on whether deficits matter, this is an opportune moment to take stock of what we know. The good news is that there is little disagreement among economists who have studied the issue. The consensus is that short-run deficits help end recessions, and that whether long-run deficits matter depends entirely on how government spends the borrowed money. If failure to borrow meant forgoing productive investments, bigger long-run deficits would actually be better than smaller ones. ...

                    Continue reading "Short-Run and Long-Run Deficits" »

                      Posted by on Saturday, March 21, 2009 at 06:48 PM in Budget Deficit, Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (17) 

                      "Despair over Financial Policy"

                      Reactions to the leaked details of the administration's bank bailout plan. If I find any posts in support of the plan, I will add those in an update.

                      First, Paul Krugman:

                      Despair over financial policy, by Paul Krugman: The Geithner plan has now been leaked in detail. It’s exactly the plan that was widely analyzed — and found wanting — a couple of weeks ago. The zombie ideas have won.

                      The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

                      To this end the plan proposes to create funds in which private investors put in a small amount of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad — I mean misunderstood — assets. This is supposed to lead to fair prices because the funds will engage in competitive bidding.

                      But it’s immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem. ...

                      This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized. And I fear that when the plan fails, as it almost surely will, the administration will have shot its bolt: it won’t be able to come back to Congress for a plan that might actually work.

                      What an awful mess.

                      Calculated Risk:

                      Geithner's Toxic Asset Plan, Calculated Risk: The NY Times has some details ...

                      Toxic Asset Plan Foresees Big Subsidies for Investors: The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell.

                      In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money.

                      In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Secure Lending Facility, a joint venture with the Federal Reserve.

                      More approaches doesn't make a better plan.

                      The FDIC plan involves almost no money down. The FDIC will provide a low interest non-recourse loan up to 85% of the value of the assets. ...

                      With almost no skin in the game, these investors can pay a higher than market price for the toxic assets (since there is little downside risk). This amounts to a direct subsidy from the taxpayers to the banks.

                      Oh well, I'm sure Geithner will provide details this time ...

                      Yves Smith:

                      Private Public Partnership Details Emerging, Yves Smith:  The New York Times seems to have the inside skinny on the emerging private public partnership ... program. And it appears to be consistent with (low) expectations: a lot of bells and whistles to finesse the fact that the government will wind up paying well above market for crappy paper. ...

                      If the money committed to this program is less than the book value of the assets the banks want to unload (or the banks are worried about that possibility), the banks have an incentive to try to ditch their worst dreck first.

                      In addition, it has been said in comments more than once that the banks own some paper that is truly worthless. This program won't solve that problem. ...

                      And notice the hint of skepticism from the Times regarding the Administration's supposition that the bidding will result in fair prices. Huh? First, the banks, as in normal auctions, will presumably set a reserve price equal to the value of the assets on their books. If the price does not meet the reserve (and the level of the reserve is not disclosed to the bidders), there is no sale; in this case, the bank would keep the toxic instruments.

                      Having the banks realize a price at least equal to the value they hold it at on their books is a boundary condition. If the banks sell the assets as a lower level, it will result in a loss, which is a direct hit to equity. The whole point of this exercise is to get rid of the bad paper without further impairing the banks.

                      So presumably, the point of a competitive process (assuming enough parties show up to produce that result at any particular auction) is to elicit a high enough price that it might reach the bank's reserve, which would be the value on the bank's books now.

                      And notice the utter dishonesty: a competitive bidding process will protect taxpayers. Huh? A competitive bidding process will elicit a higher price which is BAD for taxpayers! ...

                      Paul Krugman again:

                      More on the bank plan, Paul Krugman: Why was I so quick to condemn the Geithner plan? Because it’s not new; it’s just another version of an idea that keeps coming up and keeps being refuted. It’s basically a thinly disguised version of the same plan Henry Paulson announced way back in September. ...

                      [W]e have a bank crisis. Is it the result of fundamentally bad investment, or is it because of a self-fulfilling panic?

                      If you think it’s just a panic, then the government can pull a magic trick: by stepping in to buy the assets banks are selling, it can make banks look solvent again, and end the run. Yippee! And sometimes that really does work.

                      But if you think that the banks really, really have made lousy investments, this won’t work at all; it will simply be a waste of taxpayer money. To keep the banks operating, you need to provide a real backstop — you need to guarantee their debts, and seize ownership of those banks that don’t have enough assets to cover their debts; that’s the Swedish solution, it’s what we eventually did with our own S&Ls.

                      Now, early on in this crisis, it was possible to argue that it was mainly a panic. But at this point, that’s an indefensible position. Banks and other highly leveraged institutions collectively made a huge bet that the normal rules for house prices and sustainable levels of consumer debt no longer applied; they were wrong. Time for a Swedish solution.

                      But Treasury is still clinging to the idea that this is just a panic attack, and that all it needs to do is calm the markets by buying up a bunch of troubled assets. Actually, that’s not quite it: the Obama administration has apparently made the judgment that there would be a public outcry if it announced a straightforward plan along these lines, so it has produced what Yves Smith calls “a lot of bells and whistles to finesse the fact that the government will wind up paying well above market...”

                      Why am I so vehement about this? Because I’m afraid that this will be the administration’s only shot — that if the first bank plan is an abject failure, it won’t have the political capital for a second. So it’s just horrifying that Obama — and yes, the buck stops there — has decided to base his financial plan on the fantasy that a bit of financial hocus-pocus will turn the clock back to 2006.

                      Here is a Defense of Private Funds for Jump-Starting the Market for Troubled Assets by Lucian Bebchuk.

                      The main objection is that the government will (in essence) overpay for these assets, and that will cost the taxpayers money. In the meantime, the banks - which get a windfall from the overpayment for the assets - could recover and do just fine. If the administration insists on moving in this direction rather than adopting a version of the Swedish plan, why not require some insurance against future taxpayer losses, e.g. require firms participating in the bailout to sacrifice future equity shares equal to the value of any losses that fall on taxpayers? There are probably better ways to structure this, but having such insurance in place could help with the politics of the bailout which the administration does not seem to get. Taxpayers are in no mood to be giving away money to failed banks without assurances that it is justified, that there is no other plan that will well enough to provide a substitute and that they have been protected as much as possible in the process. This plan, at least what we know about it so far, does not meet those conditions. In particular, there are alternative plans such as the proposed derivatives of the Swedish plan that can be expected to work just as well, yet do not involve giveaways to failed banks.

                      Update: More from Yves Smith, Investor on Private Public Partnership: "One would have to be a criminal to participate in this":

                      Hoisted from comments:

                      I am SAC Capital. I get to be one of the bidders on bank assets covered by the program

                      Citi holds $100mm of face-value securities, carried at $80mm.

                      The market bid on these securities is $30mm. Say with perfect foresight the value of all cash flows is $50mm.

                      I bid Citi $75mm. I put up $2.25mm or 3%, Treasury funds the rest.

                      I then buy $10mm in CDS directly from Citi [or another participant (BOA, GS, etc)] on the bonds for a premium of $1mm.

                      In the fullness of time, we get the final outcome, the bonds are worth $50mm

                      SAC loses $2.25mm of principal, but gets $9mm net in CDS proceeds, so recovers $6.75mm on a $2.25mm investment. Profit is $4.5mm

                      Citi writes down $5mm from the initial sale of the securities, and a $9mm CDS loss. Total loss, $14mm (against a potential $30mm loss without the program)

                      U.S. Treasury loses $22.75mm

                      Great program.

                      It's just a scheme to transfer losses from the bank to the taxpayer with an egregious payout to a middleman (SAC) to effectively money launder the transaction.

                      You've also transmuted a $30mm economic loss into a $36.75mm economic loss because of the laundering. So its incredibly inefficient.

                      How did fraud and money laundering become the national economic policy of the US?

                      One would have to be a criminal to participate in this.

                      Folks, this IS even worse than I thought, and you know I have a constitutional predisposition to take a dim view of things...

                      Update: Jamie Galbgraith responds to the plan.

                      I've just been reading the NYT report. The central Treasury assumption, at least for public consumption, seems to be that the underlying mortgage loans will largely pay off, so that if the PPIP buys and holds, at an above-present-market price governed by auction, the government's loan to finance the purchase will not go bad.

                      Recovery rates on sub-prime residential mortgage-backed securities (RMBS) so far appear to belie this assumption. ...

                      The way to find out who is right is ... examination of the underlying loan tapes -- and comparison to the IndyMac portfolio -- would help determine whether these loans or derivatives based on them have any right to be marketed in an open securities market, and any serious prospect of being paid over time at rates approaching 60 cents on the dollar, rather than 30 cents or less.

                      Note that even a small loss of capital, relative to the purchase price, completely wipes out the interest earnings on the Treasury's loans, putting the government in a loss position and giving the banks a windfall.

                      If I'm right and the mortgages are largely trash, then the Geithner plan is a Rube Goldberg device for shifting inevitable losses from the banks to the Treasury, preserving the big banks and their incumbent management in all their dysfunctional glory. The cost will be continued vast over-capacity in banking, and a consequent weakening of the remaining, smaller, better- managed banks who didn't participate in the garbage-loan frenzy. ...

                      If I were a member of Congress, I would offer a resolution blocking Treasury from making the low-cost loans it expects to offer the PPIPs, until GAO or the FDIC has conducted an INDEPENDENT EXAMINATION OF THE LOAN TAPES underlying each class of securitized assets, and reported on the prevalence of missing documentation, misrepresentation, and signs of fraud. In the absence of a credible rating, this is the minimum due diligence that any private investor would require.

                      I hope what I'm driving at, here, is clear...

                      Update: From James Kwak, This Time I’m Not the One Calling It a Subsidy.:

                      Instead of coming up with one plan to buy troubled assets, it looks like the government has come up with three. ... For now, I think the concerns I expressed last month still hold. If we take as given that the government will only negotiate at arm’s length with the banks (meaning the banks can decide at what price they are willing to sell the assets), then the most important thing is for the plan to work. But it’s not clear if the degree of subsidy offered will be enough to close the gap between what investors are willing to pay and what banks are willing to sell at. Having multiple buyers and using cheap Fed financing will increase the willingness-to-pay for these assets, but we won’t know a priori if it will exceed the reserve price of the sellers.

                      In the best-case scenario: (a) the government’s willingness to bear most of the risk encourages private investors to bid enough to get the banks to sell; (b) the economy recovers and the assets increase in price from the prices paid; (c) the investment funds pay back the Fed (which makes a small spread between the interest rate and the Fed’s low cost of money); and (d) the government gets some of the upside through its capital investments. (I think the main purpose of that government capital is to deflect the criticism that all of the upside belongs to the private sector.) In the worst-case scenario, the market stays stuck because the banks have unrealistic reserve prices. Perhaps the idea is that, in that case, the TALF will allow the government to (over)pay whatever it takes to bail out the banks.

                      Most encouragingly, the headline in the Times was “Toxic Asset Plan Foresees Big Subsidies for Investors,” indicating that the mainstream media have figured out the game. ...

                      Update: Brad DeLong in The Geithner Plan FAQ notes that having a large share of the downside also means having a large share of the upside, so if the downtrodden assets appreciate after the government gains control of them, the Geithener plan could make money:

                      Q: What is the Geithner Plan?

                      A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.

                      Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?

                      A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

                      Q: Where does the trillion dollars come from?

                      A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.

                      Q: Why is the government making hedge and pension fund managers kick in $30 billion?

                      A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.

                      Q: Why then should hedge and pension fund managers agree to run this?

                      A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.

                      Q: Why isn't this just a massive giveaway to yet another set of financiers?

                      A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.

                      Q: Why do we think that the government will get value from its hiring these hedge and pension fund managers to operate this program?

                      A: They do get 17% of the equity return. 17% of the return on equity on a $1 trillion portfolio that is leveraged 5-1 is incentive.

                      Q: So the Treasury is doing this to make money?

                      A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.

                      Q: How does having the U.S. government invest $1 trillion in the world's largest hedge fund operations reduce unemployment?

                      A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lousy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.

                      Q: So?

                      A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.

                      Q: And firms that ought to be expanding can then get financing on good terms again, and so they hire, and unemployment drops?

                      A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.

                      Q: Oh.

                      A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.

                      Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.

                      Q: This sounds very different from the headline of the Andrews, Dash, and Bowley article in the New York Times this morning: "Toxic Asset Plan Foresees Big Subsidies for Investors."

                      A: You are surprised, after the past decade, to see a New York Times story with a misleading headline?

                      Q: No.

                      A: The plan I have just described to you is the plan that was described to Andrews, Dash, and Bowley. They write of "coax[ing] investors to form partnerships with the government" and "taxpayers... would pay for the bulk of the purchases..."--that's the $30 billion from the private managers and the $150 billion from the TARP that makes up the equity tranche of the program. They write of "the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money..."--that's the debt slice of the program. They write that "the government will provide the overwhelming bulk of the money — possibly more than 95 percent..."--that is true, but they don't say that the government gets 80% of the equity profits and what it is owed the FDIC on the debt tranche. That what Andrews, Dash, and Bowley say sounds different is a big problem: they did not explain the plan very well. Deborah Solomon in the Wall Street Journal does, I think, much better. David Cho in tomorrow morning's Washington Post is in the middle.

                      Update: Paul Krugman responds to Brad DeLong:

                      Brad DeLong’s defense of Geithner, by Paul Krugman: Brad gives it the old college try. But he shies away, I think, from the central issue: the non-recourse loans financing 85 percent of the purchases.

                      Brad treats the prospect that assets purchased by public-private partnership will fall enough in value to wipe out the equity as unlikely. But it isn’t: the whole point about toxic waste is that nobody knows what it’s worth, so it’s highly likely that it will turn out to be worth 15 percent less than the purchase price. You might say that we know that the stuff is undervalued; actually, I don’t think we know that. And anyway, the whole point of the program is to push prices up to the point where we don’t know that it’s undervalued.

                      So default on those non-recourse loans is a substantial possibility, which means that there is a large implicit subsidy involved. That’s why Christie Romer’s claim that we’re relying on the “expertise of the market” rings so hollow: we’re giving investors a big subsidy, so this has nothing to do with letting markets work.

                      And a final point: I’m with Atrios here. If getting the prices of toxic assets “right” isn’t enough to rescue the banks, that doesn’t mean that we’re doomed; it means that we actually have to, you know, rescue the banks, Swedish style, rather than rely on fancy financial engineering to make the problem go away.

                      Update: A follow-up post, Government Intervention in the Market for Toxic Cars, attempts to shed light on some of the proposed policy options.

                      Update: Brad DeLong replies:

                      I Think Paul Krugman Is Wrong: I find that a scary sentence to write. If the past decade has taught me anything, it has taught me that mistakes are avoided if you follow two rules:

                      1. Remember that Paul Krugman is right.
                      2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.

                      So why do I have a positive and Paul a negative view of the Geithner Plan? I see three reasons:

                      1. The half empty-half full factor: I see the Geithner Plan as a positive step from where we are. Paul seed it as an embarrassingly inadequate bandaid.
                      2. Politics: I think Obama has to demonstrate that he has exhausted all other options before he has a prayer of getting Voinovich to vote to close debate on a bank nationalization bill. Paul thinks that the longer Obama delays proposing bank nationalization the lower it's chances become.
                      3. I think the private-sector players in financial markets right now are highly risk averse--hence assets are undervalued from the perspective of a society or a government that is less risk averse. Paul judges that assets have low values beceuse they are unlikely to pay out much cash.

                      More on this third later...

                      UPDATE: LATER: One way to think about it is that the privates are placing a low market price on distressed securities because they place a high weight on future scenarios in which the prices of distressed securities fall still further: in such scenarios they will really need cash really badly, and the additional losses that would be generated if they further extending their positions and if such scenarios came to past would be extremely painful--institution-destroying, and hence to be avoided at all costs.

                      The government, however, is the agent of society at large. As such, it is close to risk neutral: only the losses associated with truly great depressions get substantial extra weight. It doesn't care much about bad news that leads to further declines in the values of toxic assets it holds: if worst comes to worst, it can always offset them by printing more money and so generating an inflation that is annoying and painful but not something to be avoided at all costs.

                      It is this difference between the (extremely low) risk tolerance of private financial intermediaries and the (relatively high) risk tolerance of the government and of society at large that creates the rationale for a program like the Geithner Plan.

                        Posted by on Saturday, March 21, 2009 at 11:07 AM in Economics, Financial System, Policy, Politics | Permalink  TrackBack (0)  Comments (96) 

                        "Global Imbalances and the Crisis"

                        Michael Dooley and Peter Garber believe that most people have the source of the crisis wrong:

                        Global imbalances and the crisis: A solution in search of a problem, by Michael Dooley and Peter Garber, voxeu.org: The current crisis is likely to be one of the most costly in our history, and the desire to reform the system so that it will not happen again is overwhelming. Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda:

                        1. That the crisis was caused by current account imbalances, particularly by net flows of savings from emerging markets to the US.
                        2. That the crisis was caused by easy monetary policy in the US.
                        3. That the crisis was caused by financial innovation.    

                        In our view, a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices. The important implication of the crisis itself is that for the next few years, at least, the misbehaviour that flourished in this environment will not be a problem, unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything, excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry.

                        When markets recover, the key lesson is that the industrial countries need to focus on moral hazard, public and private, as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows, to ask central banks to abandon inflation targeting, to stifle financial innovation, or to regulate entities such as hedge funds1  that do not generate systemic risks. 

                        Continue reading ""Global Imbalances and the Crisis" " »

                          Posted by on Saturday, March 21, 2009 at 02:25 AM in Economics, Financial System | Permalink  TrackBack (1)  Comments (36) 

                          links for 2009-03-21

                            Posted by on Saturday, March 21, 2009 at 12:33 AM in Economics, Links | Permalink  TrackBack (0)  Comments (21) 

                            Friday, March 20, 2009

                            "The Cyclicality of Geographic Mobility"

                            Chris Nekarda disagrees with Connor Dougherty's assertion that geographic mobility is procyclical, i.e. that more people move when times are good than when times are bad:

                            Cyclicality of Geographic Mobility, by Chris Nekarda: Connor Dougherty discusses a dramatic decline in geographic mobility during 2008 (via Economist’s View):

                            U.S. Migration Falls Sharply, by Conor Dougherty, WSJ: Migration around the U.S. slowed to a crawl last year, especially for this decade’s boom towns, as a weak housing market and job insecurity forced many Americans to stay put. ...

                            <p>HTML clipboard</p>As asset values rose fairly steadily in the past decade, Americans young and old moved around the country in search of jobs or better weather. In many cases, people living in higher-cost housing markets such as San Francisco and New York cashed in their real-estate winnings and moved to outlying counties, or to states like Florida and Nevada, hoping to find a cheaper house and pocket the difference. Now, “people are hanging tight; they’re too scared to do anything,” said Mr. Frey.

                            Migration typically slows during recessions. But in past downturns, the slowdown has been more regional in scope, with workers fleeing weaker job markets for places where companies were still hiring. In the deep 1980s recession, for instance, laid-off auto workers fled the industrial Midwest for energy-rich states in the South with more plentiful jobs.

                            What’s unique this time is migration has slowed almost everywhere. The sharpest year-to-year changes were among what demographers call “domestic migrants,” people who moved within the U.S. That doesn’t count population changes that result from births, deaths or immigration.

                            Although I agree with the trend behavior described above, Dougherty is incorrect about the cyclicality of geographic mobility. In fact, geographic mobility is moderately countercyclical—that is, more people move during recessions than during booms (relative to trend). This may seem counter-intuitive but makes economic sense.

                            Geographic mobility is a means of reallocating resources, in this case labor, to more efficient uses. In the past, 70 percent of people who move indicated having moved for economic reasons and up to 50 percent of those moves occurred because of a job separation [Lansing and Morgan (1967); Bartel (1979)]. In particular, there is a significant positive relationship between unemployment and geographic mobility [Bartel (1979); Schlottmann and Herzog Jr. (1981, 1984)]. Thus, countercyclical mobility is consistent with reallocation of idle workers across space.

                            I assess the cyclicality of geographic mobility in a recent working paper. I the measure the rate of geographic mobility as one minus the share of persons living at the same address one year later reported by the U.S. Census Bureau. These data come from the March supplement to the Current Population Survey, so the 2007 data do not reflect much of the distress in mortgage markets—and any concomitant effects on mobility—that began later in 2007.

                            Removing the low-frequency trend is important because it represents structural changes—such as demographic changes or, say, innovations in mortgage finance—that are unassociated with the business cycle. I isolate the component of the time series that moves at business cycle frequency using an unobserved components model (see paper for details). The figure below plots the cyclical component of the mobility rate together with that of the unemployment rate for comparison.


                            The cyclical component of mobility tends to follow the unemployment rate, indicating that more people move during recessions than during booms. This is consistent with geographic mobility as a means for reallocating idle labor to more productive uses. The contemporaneous correlation of the cyclical component of the mobility rate with the unemployment rate is 0.50, indicating moderate countercyclicality. Also note that mobility is substantially less volatile over the business cycle than unemployment.

                            Of course, the problems in the housing market beginning in 2007, notably the dramatic decline in prices, will undoubtedly reduce geographic mobility during this recession. This will further slow recovery because unemployed persons cannot move to areas with more favorable labor markets as easily or quickly as before.

                              Posted by on Friday, March 20, 2009 at 08:10 PM in Economics, Housing, Unemployment | Permalink  TrackBack (0)  Comments (9) 

                              "AIG Still Isn't Too Big to Fail"

                              Lucian Bebchuk says AIG is not too big to fail:

                              AIG Still Isn't Too Big to Fail, by Lucian Bebchuk, Commentary, WSJ: The AIG bailout -- at $170 billion and rising -- may end up as the costliest rescue of a single firm in history. There is much debate about bonuses paid to AIG's executives. But there is far too little debate on the government's willingness to back all of AIG's obligations.

                              The company claims any failure by the government to do so would have catastrophic consequences. This claim is exaggerated. Serious consideration should be given to forcing AIG's partners in derivative transactions -- which are mainly buyers of credit default swaps from the company -- to take a substantial haircut. ...

                              While AIG has thus far been able to cover derivative losses using government funds, the possibility of large additional losses must be recognized. AIG recently stated that it still has about $1.6 trillion in "notional derivatives exposure." Suppose, for example, that AIG ends up with losses equal to, say, 20% of this exposure -- that is, $320 billion. Suppose also that the value of AIG's current assets ... is $160 billion. In this scenario, the government's fully backing AIG's obligations would produce an additional loss of $160 billion for taxpayers. Should the government be prepared to do so?

                              The alternative would be to put AIG into Chapter 11. In this case, AIG's creditors, including its derivative counterparties, would obtain the company's assets. They would end up with a 50% recovery on their claims, bearing those $160 billion of losses themselves.

                              AIG recently stated that failure to meet all of the company's obligations could lead to a "run on the bank" by customers seeking to surrender insurance policies and "would have sweeping impacts across the economy." But insurance policyholders wouldn't be at risk if AIG failed to meet its obligations. The insurance subsidiaries are not responsible for the debts of their parent AIG, and insurance policy claims are backed both by the subsidiaries' required reserves and state insurance funds.

                              Still, what about the concern that losses to derivative counterparties -- which are now known to include major U.S. and foreign banks -- would substantially deplete the capital of some of them? That concern would be best addressed by the U.S. government (or foreign governments in the case of their banks) infusing capital directly -- in return for shares -- into the banks that need it. There is no reason to back AIG's obligations as an instrument for infusing capital (with taxpayers getting nothing in return) into, say, Goldman Sachs or Spain's Banco Santander.

                              It is true that the collapse of Lehman Brothers last September led to a crisis of confidence among depositors..., which had a dramatic effect on markets. Letting AIG's derivative counterparties take a significant haircut, however, should not lead to such a crisis. AIG's obligations are to derivative counterparties, not to depositors. Moreover, governments world-wide are now committed to backing fully the claims of depositors in financial institutions.

                              It is important to understand that the government can also employ intermediate approaches between fully backing AIG's derivative obligations and no backing. ... At a minimum, the government should conduct "stress tests," estimating potential losses in alternative scenarios, and formulate a policy on the magnitude and fraction of derivative losses it would be willing to cover. A policy that doesn't fully back AIG's obligations should be seriously considered.

                              Monetary policy makers often run potential policies through a wide variety of models under differing assumptions about the state of the economy, and they avoid policies that have a very bad downside even if the upside is potentially very attractive. The proposal above can be interpreted within this type of risk management approach to policy that tries to insure against really bad policy outcomes. It may very well be that financial markets can withstand the failure of AIG, but the potential downside if that assumption is wrong is very large, larger than any policymaker wants to take the blame for. Thus, in such cases, you often observe policymakers pursuing what they feel is the safest policy that moves the ball forward rather than policies that might have a better upside, but also come with the possibility of, say, market meltdown. I'm sympathetic to the argument that we should put AIG through a carefully managed failure, but saying, as above, that letting "AIG's derivative counterparties take a significant haircut ... should not lead to ... a crisis" still leaves the door open, even if only a crack, to an outcome that no policymaker wants to be responsible for.

                              Update: James Kwak:

                              Now, the government has not explicitly guaranteed AIG’s liabilities. But the main reason for bailing out AIG in the first place was the fear that an uncontrolled failure would have ripple effects that would take down many other financial institutions who were dependent in some way on AIG; most commonly, they had bought insurance, in the form of credit default swaps... And a major usage of bailout money has been to make whole AIG’s counterparties...

                              I still think it was a mistake to let Lehman fail, because of the sudden panic it created. But we are in a very different situation today. Many people now believe that the government may decide to let bank creditors lose some of their money. As Bebchuk says, instead of continually giving AIG taxpayer money that is effectively used to bail out other banks (many of which are in Europe, allowing European governments to free ride on the U.S.), the government could let AIG fail and bail out those other banks directly, thereby at least getting increased ownership stakes in return. Bebchuck also explains that AIG’s insurance subsidiaries would not become insolvent if the AIG holding company went bankrupt, because they have their own reserves. ...  Furthermore, he argues, failure is not an all-or-nothing proposition...

                              I think that the government could let AIG fail, if - and this is a big if - it can first identify which creditors and counterparties would be hurt, determine which of those cannot be allowed to fail (which should not be all of them), design a program to provide them enough capital directly, and announce everything on the same day. The net cost to the taxpayer cannot be higher than under the Too Big To Fail strategy, which implies a 100% guarantee for all counterparties and creditors...

                              There was clearly no time to do this between September 15 and September 16. But the government by now has had six months to study the books of AIG and its major domestic counterparties. People are no longer willing to take it on faith that the future of the free world depends on an implicit blanket guarantee for AIG. At least we want to see some evidence.

                              How sure are we that if we let AIG fail all of the necessary pieces - all the big and little ifs above - will fall into place, how sure are we of any evidence based upon asset valuations when there's no market price for them, and how sure are we that we've thought of all of the things that could go wrong?

                                Posted by on Friday, March 20, 2009 at 12:06 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (31) 

                                "Kick Them Out"

                                James Kwak and Simon Johnson say the arguments made to support paying bonuses at AIG - that the bonuses are needed to retain people with specialized knowledge - do not withstand closer scrutiny. Not only can the "discredited insiders" be replaced, it's best when they are:

                                Off With the Bankers, by Simon Johnson and James Kwak, Commentary, NY Times: A.I.G. can hardly claim that its generous bonuses attract the best and the brightest. So instead, it defends the payments by arguing they’re needed to retain employees who are crucial for winding down transactions that are “difficult to understand and manage.” ... There is no reason to believe this.

                                Similar arguments made during the 1997 Asian financial crisis ... turned out to be a smokescreen to protect the executives who were partly responsible for the mess. Recovery from that crisis required Indonesia, South Korea and Thailand to close or consolidate banks. In all three countries, bankers protested, claiming that their connections with borrowers were critical to recovery. ...

                                The leaders of Thailand and South Korea did not listen to such arguments, and thank goodness. Some of the leading Thai banks were taken over by the government. After the crisis, a civil servant in charge of one such bank noted that its bad loans were much bigger than had been indicated before the takeover, largely because of an internal coverup. Only when outsiders took over did the public discover the full scope of the losses. ...

                                But these reforms made all the difference. Banks became healthy and resumed lending within a few years after the crisis broke. ...

                                Indonesia did not respond to the crisis so wisely, and the costs were severe. ... The lesson of all this is that when insiders have broken a financial institution, the most direct remedy is to kick them out. Traders are hardly in short supply, and you don’t need to rely on the ones who made the toxic trades in the first place. Companies must always plan around the potential departure of even their star traders, or they are certain to fail. ...

                                If A.I.G. wants to argue that complex transactions, hedging positions and counterparty relationships require employees who are intimately familiar with those trades, it should at least provide evidence that the arguments for doing so are sounder than the ones made in Indonesia in 1997, when leading bank-owning conglomerates claimed that only they understood their financing arrangements... We heard variants of the same idea in Poland in 1990, Ukraine in 1994 (and in the Ukrainian crises subsequently), and Argentina in 2002.

                                Any grain of truth in these arguments must be weighed against the costs of allowing discredited insiders to manage institutions after they have blown them up. Even if the conclusion is that a few experts need to be retained, offering guaranteed bonuses to virtually the entire operation is hardly the way to achieve the desired results. We should not let people think that the best way to guarantee job security is to lose lots of money in a really complicated way. The argument that A.I.G.’s traders are the people that we must depend on to save the United States economy is ... weak and self-serving...

                                  Posted by on Friday, March 20, 2009 at 02:43 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (35) 

                                  "Obama is No Socialist"

                                  Alan Blinder is tired of hearing that Obama is "leading the country down the path of socialism":

                                  Obama Is No Socialist, by Alan S. Blinder, Commentary, WSJ: Ever since President Barack Obama released the budget..., we have been hearing a fusillade of criticism claiming that the president ... is ... a "leftie" intent on leading the country down the path of socialism.

                                  Let's see. Socialism means public ownership and control of businesses, right? So which industries does the president propose to nationalize?

                                  Banking? Well, no. Secretary of the Treasury Timothy Geithner has made it clear that he opposes nationalizing banks...

                                  What about health care? Doesn't Mr. Obama want "socialized medicine"? No. He wants to reform the current system so that it costs less and covers more people. ...

                                  Some reformers want the U.S. to adopt a single-payer system like ... "socialist" Canada and England... But regardless of whether single-payer is a good idea, it's not Mr. Obama's. His health-insurance reform plan emphasizes choice..., greater efficiency..., and portability... Which part of that is socialist?

                                  And ... the Obama budget recognizes, rather than hides, the need to pay the bills. Half the cost of health reform would be covered by a tax provision that has really raised a ruckus: Capping itemized deductions at the 28% bracket rate. Let's consider how socialist that idea is. ...

                                  Suppose ... three families each pay $10,000 a year in interest on their home mortgages. The cost to the non-itemizer is the full $10,000. For the family in the 25% bracket that itemizes, the net cost ... is only $7,500. And for the upper-income family in the 35% bracket that itemizes, the net cost is a mere $6,500. Just imagine a member of Congress proposing a homeownership subsidy like that directly...: 35% to the rich, 25% to the middle class, and nothing to the poor. Would anyone support it?

                                  Enter Mr. Obama, the alleged leftist. ... He would reduce the 35% subsidy rate to 28% -- which would still leave the costs of charitable giving, mortgage interest, and much else far lower for the rich than for the poor. That's hardly a radical proposal. Indeed, it has been under discussion since the 1980s.

                                  It's true: The president ... proposes letting the ... the top rate ... revert to where it was during the Clinton years: 39.6%. ... Unsurprisingly, the president's proposal ... unleashed a firestorm of criticism from people who claim that such radical redistribution would prolong the recession, destroy entrepreneurship, and pretty much end capitalism as we know it -- just as it did during the Great Prosperity of the 1990s, I suppose. Some claims parody themselves.

                                  So where does all this leave us on the road to socialism? If Mr. Obama is able to get all of these proposals through Congress, the U.S. will have a fully private banking system, propped up with temporary government support; a uniquely American health-care system that covers virtually everyone; and a somewhat more progressive income tax.

                                  If this is socialism, then let's make the most of it.

                                    Posted by on Friday, March 20, 2009 at 12:42 AM in Economics | Permalink  TrackBack (0)  Comments (42) 

                                    links for 2009-03-20

                                      Posted by on Friday, March 20, 2009 at 12:33 AM in Economics, Links | Permalink  TrackBack (0)  Comments (18) 

                                      "Things to Come"

                                      Paul Krugman a little over six years ago, on 3/18/03, the eve of the Iraq war:

                                      Things to Come, by Paul Krugman, Commentary, NY Times: Of course we'll win on the battlefield, probably with ease. I'm not a military expert, but I can do the numbers: the most recent U.S. military budget was $400 billion, while Iraq spent only $1.4 billion.

                                      What frightens me is the aftermath — and I'm not just talking about the problems of postwar occupation. I'm worried about what will happen beyond Iraq — in the world at large, and here at home.

                                      The members of the Bush team don't seem bothered by the enormous ill will they have generated in the rest of the world. They seem to believe that other countries will change their minds once they see cheering Iraqis welcome our troops, or that our bombs will shock and awe the whole world (not just the Iraqis), or that what the world thinks doesn't matter. They're wrong on all counts.

                                      Continue reading ""Things to Come"" »

                                        Posted by on Friday, March 20, 2009 at 12:24 AM in Economics, Iraq and Afghanistan | Permalink  TrackBack (0)  Comments (14) 

                                        Thursday, March 19, 2009

                                        Golden Geese

                                        Becker and Murphy:

                                        Do not let the ‘cure’ destroy capitalism, by Gary Becker and Kevin Murphy, Commentary, Financial Times: Capitalism has been wounded by the global recession, which unfortunately will get worse before it gets better. As governments continue to determine how many restrictions to place on markets, especially financial markets, the destruction of wealth from the recession should be placed in the context of the enormous creation of wealth and improved well-being during the past three decades. Financial and other reforms must not risk destroying the source of these gains in prosperity.

                                        Consider the following extraordinary statistics... World real gross domestic product grew by about 145 per cent from 1980 to 2007, or by an average of roughly 3.4 per cent a year. ... Global health, as measured by life expectancy at different ages, has also risen rapidly, especially in lower-income countries.

                                        Of course, the performance of capitalism must include this recession and other recessions along with the glory decades. Even if the recession is entirely blamed on capitalism, and it deserves a good share of the blame, the recession-induced losses pale in comparison with the great accomplishments of prior decades. ...

                                        Governments should not so hamper markets that they are prevented from bringing rapid growth to the poor economies of Africa, Asia and elsewhere... New economic policies that try to speed up recovery should follow the first principle of medicine: do no harm. ...

                                        The failure of financial innovations such as securities backed by subprime mortgages, problems caused by risk models that ignored the potential for steep falls in house prices and the overload of systemic risk represent clear market failures, although innovations in finance also contributed to the global boom over the past three decades.

                                        The people who made mistakes lost, and many lost big. Institutions that made bad loans and investments had large declines in their wealth, while investors that funded these institutions without proper scrutiny have seen their wealth cut in half or much more. Households that overextended themselves have also been badly hurt.

                                        Given the losses, actors in these markets have a strong incentive to correct their mistakes the next time. In this respect, many government actions have been counterproductive, shielding actors from the consequences of their actions and preventing private sector adjustments. ...

                                        The claim that the crisis was due to insufficient regulation is also unconvincing. For example, commercial banks have been more regulated than most other financial institutions, yet they performed no better... Regulators got caught up in the same bubble mentality as investors and failed to use the regulatory authority available to them. ...

                                        The Great Depression induced a massive worldwide retreat from capitalism, and an embrace of socialism and communism that continued into the 1960s. It also fostered a belief that the future lay in government management of the economy, not in freer markets. The result was generally slow growth during those decades in most of the undeveloped world, including China, the Soviet bloc nations, India and Africa.

                                        Partly owing to the collapse of the housing and stock markets, hostility to business people and capitalism has grown sharply again. Yet a world that is mainly capitalistic is the “only game in town”... We hope our leaders do not deviate far from a market-oriented global economic system. To do so would risk damaging a system that has served us well for 30 years.

                                        When the golden goose is too wild for its own good, you can clip its wings without killing it.

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

                                          Posted by on Thursday, March 19, 2009 at 05:04 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (31) 

                                          Galbraith: No Return to Normal

                                          Update: Speaking of Jamie Galbraith, he says to watch this Paul O'Neill video:

                                          This is by Jamie Galbraith. There's much, much more in the actual article:

                                          No Return to Normal, by James K. Galbraith, Commentary, Washington Monthly: ...CBO’s model is based on the postwar experience,... if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system. ... Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt’s ambition exceeded anything yet seen in this crisis:

                                          [Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

                                          In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

                                          The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

                                          What did not recover, under Roosevelt, was the private banking system. ... If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.

                                          It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. ... But the relaunching of private finance took twenty years, and the war besides.

                                          A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

                                          That being so, what must now be done?

                                          Continue reading "Galbraith: No Return to Normal" »

                                            Posted by on Thursday, March 19, 2009 at 12:24 PM in Economics, Financial System, Fiscal Policy | Permalink  TrackBack (0)  Comments (81) 

                                            "The Judgments of the Market are True and Righteous Altogether"

                                            Christopher Carroll with an evidence based rebuttal to the "risk-is-holy view" advocating a free market, hands off approach to the financial crisis, and a call for the Fed to do what it always does in a crisis, manage the price of risk (which means going beyond measures such as the purchase of long-term government securities and taking risky assets onto the Fed's balance sheet):

                                            Punter of last resort, Christopher D. Carroll, Vox EU: The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the “price of risk” is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that “If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether.”

                                            The deep origins of the cult, as always, are obscure; presumably they lie properly in the field of psychoanalysis. But to the extent that overt origins can be traced, the wellspring is the literature that attempts to explain the Mehra and Prescott (1985) ‘equity premium puzzle.’ The ‘puzzle,’ in a nutshell, is that asset prices have not, historically, exhibited a relationship between risk and return that is easy to reconcile with the rational behavior of a representative agent facing perfect markets. Many of the responses to this challenge start with the assumption that asset prices must be always and everywhere rational, and then proceed to work out the kind of preferences or environment that can rationalize observed prices. This game brings to mind Joan Robinson’s comment that “utility maximization is a metaphysical concept of impregnable circularity,” and Larry Summers’s remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent’s utility function was not a particularly good day for economic science. Oddly, even the failure of this literature to produce a widely agreed solution to the ‘puzzle’ does not seem to have weakened participants’ belief in the soundness of the intellectual framework within which asset prices are a puzzle.

                                            Nor does the assumption that asset prices are always and everywhere perfect reflect the actual past practice of economic policymaking during crises. As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the “lender of last resort” role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today’s terminology, ‘an increase in the price of risk’).1

                                            Some economists, of course, view narrative history in the DeLong and Kindleberger mode as irrelevant to the practice of their science; they prefer hard numbers to mere narrative. For the numerically inclined, however, Figures 1a and 1b should be persuasive; they show that controlling a market price of risk is something the Federal Reserve has done since it first opened up shop. The top figure depicts a measure of what we are now pleased to call the ‘risk-free’ rate of interest in the United States – essentially, the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed.2 Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as ‘risk-free’ is that the Fed takes away the risk.3

                                            Figure 1a

                                            Figure 1b

                                            Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last? It was, after all, the intolerable stresses caused by financial panics that ultimately led to the founding of the Federal Reserve, in the face of adamant opposition from people holding financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are eerily similar to dogmas that continue to be propounded today. The panic of 1907, in which J.P. Morgan effectively stepped in as a private lender of last resort, constituted the last straw for the unregulated financial system that preceded the managing of risky rates that we have had since the creation of the Fed.

                                            A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all. But there is, at least, a perception that this way of operating is hallowed by time and practice: Since the Fed, the story goes, has spent most of its history ignoring risk, it shouldn’t change that now.

                                            But even this milder dogma does not match the facts. Recent work by Robert Barbera, Charles Weise, and David Krisch,4 shows that over the “Taylor Rule” era of systematic monetary policy (roughly since 1984), the Federal Reserve’s choice of the short run interest rate has been powerfully correlated to market-based measures of risk such as the difference between the interest rates on corporate bonds and corresponding maturity Treasuries. When risk has been high, the Fed has felt the need to stimulate the economy by cutting short-term rates, and vice-versa.

                                            Given the Fed’s pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed’s balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

                                            The voices that say the Fed should do nothing at all, or nothing beyond perhaps some purchases of longer-dated Treasury securities, are not the voices of reason; they represent a howling dogma that was discredited in 1844 (when the Bank of England received its first implicit authority to intervene during panics; see DeLong (2008)), was discredited again in the panic of 1907, and again during the Great Depression (by being adopted in an extreme form), and is in the process of being discredited yet again today. (In fairness, during ordinary times it is probably wise for the authorities to avoid attempting systematic manipulation of the price of risk, for all the reasons Kindleberger (2005) and Robert Peel (1844) articulated. But this is no ordinary time).

                                            Let’s put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future.5 The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets. While I realize that some economists (and some politicians) might be willing even to undergo another Great Depression as the steep price of clinging to their faith, those of us who do not share that faith should not have to suffer such appalling consequences.

                                            As the Economist magazine might put it, the problem is that the ‘punters’ (investors) who normally populate the financial marketplace and risk their fortunes for the prospect of return, have fled from the field in terror. Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the ‘lender of last resort’ to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed’s appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks; it needs, in other words, to step up to the plate and become the punter of last resort.


                                            Continue reading ""The Judgments of the Market are True and Righteous Altogether"" »

                                              Posted by on Thursday, March 19, 2009 at 01:08 AM in Economics, Financial System, Market Failure, Monetary Policy | Permalink  TrackBack (0)  Comments (30) 

                                              "People are Hanging Tight"

                                              The end of the great migration:

                                              U.S. Migration Falls Sharply, by Conor Dougherty, WSJ: Migration around the U.S. slowed to a crawl last year ... as a weak housing market and job insecurity forced many Americans to stay put.

                                              Demographers say the dropoff in migration, shown in Census data to be released Thursday, is among the sharpest since the Great Depression. It marks the end of what Brookings Institution demographer William Frey calls a "migration bubble."

                                              As asset values rose fairly steadily in the past decade, Americans young and old moved around the country in search of jobs or better weather. In many cases, people living in higher-cost housing markets such as San Francisco and New York cashed in their real-estate winnings and moved to outlying counties, or to states like Florida and Nevada, hoping to find a cheaper house and pocket the difference. Now, "people are hanging tight; they're too scared to do anything," said Mr. Frey. ...

                                              Migration typically slows during recessions. But in past downturns, the slowdown has been more regional in scope, with workers fleeing weaker job markets for places where companies were still hiring. ... What's unique this time is migration has slowed almost everywhere. The sharpest year-to-year changes were among what demographers call "domestic migrants," people who moved within the U.S. ... The Census data show that the biggest falloffs were in the worst housing markets. ...

                                              Having a key resource - labor - largely frozen in place doesn't help the economy at all. People are in no mood to take risks by moving to a new job, they probably can't find a job anyway, and if they do, will they be able to sell their house? And if all that goes right, they find a job, it's a good enough opportunity to be a risk they're willing to take, and they found a buyer for their house, will the loan be so far underwater that they can't afford to sell it?

                                                Posted by on Thursday, March 19, 2009 at 12:33 AM in Economics, Housing, Unemployment | Permalink  TrackBack (0)  Comments (8) 

                                                links for 2009-03-19

                                                  Posted by on Thursday, March 19, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (21) 

                                                  Wednesday, March 18, 2009

                                                  "Selfish Punishment"

                                                  How does altruism survive?:

                                                  Thriving on Selfishness, by Marina Krakovsky, Scientific American: It’s the altruism paradox: If everyone in a group helps fellow members, everyone is better off—yet as more work selflessly for the common good, cheating becomes tempting, because individuals can enjoy more personal gain if they do not chip in. But as freeloaders exploit the do-gooders, everybody’s payoff from altruism shrinks.

                                                  All kinds of social creatures, from humans down to insects and germs, must cope with this problem; if they do not, cheaters take over and leech the group to death. So how does altruism flourish? Two answers have predominated...: kin selection, which explains altruism toward genetic relatives—and reciprocity— the tendency to help those who have helped us. Adding to these solutions, evolutionary biologist Omar Tonsi Eldakar came up with a clever new one: cheaters help to sustain altruism by punishing other cheaters, a strategy called selfish punishment.

                                                  “All the theories addressed how altruists keep the selfish guys out,” explains Eldakar... Because selfishness undermines altruism, altruists certainly have an incentive to punish cheaters—a widespread behavior pattern known as altruistic punishment. But cheaters, Eldakar realized, also have reason to punish cheaters...: a group with too many cheaters does not have enough altruists to exploit. ... That is why, he points out, some of the harshest critics of sports doping, for example, turn out to be guilty of steroid use themselves: cheating gives athletes an edge only if their competitors aren’t doing it, too. ...

                                                  In a colony of tree wasps..., a special caste of wasps sting other worker wasps that try to lay eggs, even as the vigilante wasps get away with laying eggs themselves. In a strange but mutually beneficial bargain, punishing other cheaters earns punishers the right to cheat. ...

                                                  [T]he idea of a division of labor between cooperators and policing defectors appeals to Pete Richerson, who studies the evolution of cooperation at the University of California, Davis. “It’s nothing as complicated as a salary, but allowing the punishers to defect in effect does compensate them for their services in punishing other defectors...,” he says. After all, policing often takes effort and personal risk, and not all altruists are willing to bear those costs.

                                                  Corrupt policing may evoke images of the mafia, and indeed Eldakar notes that when the mob monopolizes crime in a neighborhood, the community is essentially paying for protection from rival gangs—a deal that, done right, lowers crime and increases prosperity. But mob dynamics are not always so benign... “What starts out as a bunch of goons with guns willing to punish people [for breaching contracts] becomes a protection racket,” Richerson says. The next question, therefore, is, What keeps the selfish punishers themselves from overexploiting the group?

                                                  Wilson readily acknowledges this limitation of the selfish punishment model..., “there’s nothing telling us that that mix is an optimal mix,” he explains. The answer to that problem, he says, is competition not between individuals in a group but between groups. That is because whereas selfishness beats altruism within groups, altruistic groups are more likely to survive...

                                                    Posted by on Wednesday, March 18, 2009 at 11:07 PM in Economics, Science | Permalink  TrackBack (0)  Comments (14) 

                                                    "China Toys With Biting Hand Feeding Its Surplus"

                                                    John Berry:

                                                    China Toys With Biting Hand Feeding Its Surplus, by John M. Berry, Bloomberg: If Chinese Premier Wen Jiabao is so worried about the safety of China’s investment in U.S. Treasury securities, he can order the money be moved elsewhere.

                                                    Of course, that likely would drive down the value of the dollar, push up U.S. interest rates and cause huge losses in China’s $700 billion portfolio of Treasuries.

                                                    The reality is that Wen and China are stuck. They have no viable alternative so long as China continues to accumulate large amounts of foreign currencies as a result of its big trade surplus. ... [C]ontinuation of a big trade surplus is ... critical to China -- something Wen conveniently forgets. ...

                                                    There will still be a large deficit to be financed, and China and the U.S. will still be intertwined both economically and financially. Wen must know that.

                                                    What he doesn’t seem to accept is that anything he and other senior Chinese officials do to raise questions about U.S. creditworthiness or the value of the dollar could come back to haunt them.

                                                      Posted by on Wednesday, March 18, 2009 at 10:53 PM in China, Economics, International Finance | Permalink  TrackBack (0)  Comments (15) 

                                                      FOMC: "Economic Conditions are Likely to Warrant Exceptionally Low Levels of the Federal Funds Rate for an Extended Period"

                                                      The news in this press release from the FOMC is the plan to purchase "up to an additional $750 billion of agency mortgage-backed securities," to buy "up to $300 billion of longer-term Treasury securities over the next six months" and other moves such as "increased purchases of agency debt this year by up to $100 billion" designed to bring down long-term interest rates:

                                                      Continue reading "FOMC: "Economic Conditions are Likely to Warrant Exceptionally Low Levels of the Federal Funds Rate for an Extended Period"" »

                                                        Posted by on Wednesday, March 18, 2009 at 12:15 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (56) 

                                                        Who's the Villain in the Crisis?

                                                        Is there a single factor, or one predominant factor, that caused the crisis? I've been asked this a lot. Is there something we can point to and say that was the villain, that did it, that's who we should blame? Was it greedy CEOs, Greenspan and the Fed, lying homeowners, real estate agents with bad incentives, Chinese savers, the ratings agencies, the quants, the economists who didn't see it coming, the regulators who failed to regulate, is there a single, predominate cause?

                                                        I don't think so. For the crisis to have occurred, there must have been (1) a source of vast amounts of liquidity, (2) a reason for most of that liquidity to go to one sector, the housing sector, rather than being spread around to a variety of industries, and (3) a failure to detect and prevent the bubble from developing in the industry where the excess liquidity found a home.

                                                        The source of the excess liquidity is well known, it came from China, the oil producing countries, and low interest rate policy from the Fed. China could have accumulated less reserves, invested them at home, etc., and the US could have pursued a higher interest rate policy (but at what cost to the economy as it was trying to recover from the bursting of the tech stock bubble), that's true, and it might have made the bubble less severe, but were these things, and these things alone, the cause of the bubble?

                                                        There's no reason why the excess liquidity could not have been invested in a variety of industries rather than flowing mainly to housing. If that happens, the risks are spread far more broadly, and we don't have such a large bubble, one that endangers the broader economy when it pops. So we have to ask, why did the money flow almost entirely to one industry? It was the false perception that financial innovation could produce higher rewards without increasing risk, there were lots of complex mathematical models around to prove it, and there were ratings agencies to validate the claims. So the combination of excess liquidity with the false promise of higher returns without higher risk caused the money to flow into a particular industry rather than into a wide variety of investment opportunities. It was safe as houses.

                                                        But even that wasn't enough to produce a bubble by itself, we have to ask why the checks and balances within the housing sector, both from the market and from regulators, failed to stop the massive flow of money into these assets. The reason is that there were incentive problems all the way through the system. The homeowner gets a non-recourse loan which makes risks mostly one-sided, real estate agents are paid on commission giving them to incentive to maximize the number of houses sold at the highest price they can get, real estate appraisers were in the pocket of the real estate agents (that's obvious when you buy a house), if they don't give the values the agents are looking for, their phone stops ringing. The mortgage brokers were being paid, essentially, on commission and they were able to move these loans off their books - sell them as repackaged securities - so as to remove any long-run interest in the outcome of the loans (so they didn't care what the appraisers said). Their incentive was to sell as many loans as possible with no real concern for quality. Why did people buy these repackaged loans from banks and brokers? Here we come again to the ratings agencies and the poor risk assessment models, the culture within these institutions, moral hazard from implicit or explicit government guarantees, compensation structures, and so on. The incentives at just about every step of the process were to create as many loans as possible with little regard to quality, every check and balance that ought to be in place was missing. The market did not self correct, and regulators clearly fell down on the job, fixing any one of these incentives could have made a big difference by plugging up the pass-through of the excess liquidity from China and the Fed, but the regulators were absent. Whether this is due to incompetence, poorly structured regulatory procedures, or regulatory capture - money talks and nobody wanted to spoil the party - I don't know for sure. But the regulatory failures were clearly broad based.

                                                        So I can only narrow the villains down and place them into broad categories, I can't point fingers at any one of them and say you did it, you were the cause of this. The managers at places like AIG were part of the problem, and they surely don't deserve rewards for their performance, that is not the argument here, but they and others like them were only one part of the problems we now have, they didn't cause the problems by themselves. It was a combination of things working together that produced this crisis, that is, excess liquidity, very poorly structured incentives, and incorrect assessment of the risks all came together to produce the problems we are seeing. I wish I could point to a single villain, it would be easier in a many, many ways to be able to do that, but I don't think we can, and doing so runs the risk of delaying the reform that is needed by causing us to focus on only a small set of the larger set of "villains". There's plenty of blame - and reform - to spread around.

                                                          Posted by on Wednesday, March 18, 2009 at 10:08 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (98) 

                                                          "The Tipping Point?"

                                                          James Kwak hopes that the AIG scandal will compel the administration to take action:

                                                          The Tipping Point?, by James Kwak: $165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another. Yet it may turn out to be the $165 million that broke the camel’s back.

                                                          The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.

                                                          • The bonus contracts - which have still not been released to the public - reflect the instinct of Wall Street to favor its employees over any other stakeholders. ...
                                                          • The failure of the Treasury Department and the Federal Reserve to review and renegotiate the bonus plans as a condition of federal assistance last fall...
                                                          • The seeming inability of the government to do anything but throw up its hands reflects the failed strategy of the bailouts so far: provide as much cash as needed, but do everything you can to minimize the impact on the companies being bailed out. ...
                                                          • The testaments to “the best and the brightest” - here, referring to the people of AIG Financial Products - reflect, I don’t know, either absolute, brazen obscenity, or a world-historical example of making the mistake of believing your own hype. The fact that people on Wall Street believe that they are the best among us is bad enough. The fact that people in Washington are willing to accept it is worse.

                                                          However, this scandal may yet serve a purpose. ... The key issues throughout this crisis have been political as much as economic. In this case, the Obama administration has been taking a difficult political position - propping up financial institutions in their current form and insisting everything will be OK - when it would have been easier to play the populist card. This was by no means an inescapable choice; according to news reports in February, David Axelrod and Rahm Emmanuel were in favor of being tougher on the banks. Perhaps the AIG bonus scandal will force the administration’s hand toward the decisive action that we need.

                                                            Posted by on Wednesday, March 18, 2009 at 02:43 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (36) 

                                                            links for 2009-03-18

                                                              Posted by on Wednesday, March 18, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (9) 

                                                              Tuesday, March 17, 2009

                                                              The Temptation for Protectionism: Lessons from the Great Depression

                                                              The Wall Street Journal's Real Time Economics reports "Protectionism on Rise in 17 of the G20 — World Bank Report." Barry Eichengreen and Douglas Irwin say one way to reduce the temptation to enact protectionist measures is for countries to coordinate their monetary and fiscal policies:

                                                              What do we know about the spread of protectionism during the Great Depression and what are the implications for today’s crisis? This column says the lesson is that countries should coordinate their fiscal and monetary measures. If some do and some don’t, the trade policy consequences could once again be most unfortunate.

                                                              Here's the longer version:

                                                              The protectionist temptation: Lessons from the Great Depression for today, by Barry Eichengreen and Douglas Irwin, Vox EU: The Great Depression of the 1930s was marked by a severe outbreak of protectionism. Many fear that, unless policymakers are on guard, protectionist pressures could once again spin out of control. What do we know about the spread of protectionism then, and what are the implications for today?

                                                              Continue reading "The Temptation for Protectionism: Lessons from the Great Depression" »

                                                                Posted by on Tuesday, March 17, 2009 at 03:42 PM in Economics, International Trade | Permalink  TrackBack (0)  Comments (20) 

                                                                “Concentrations of Risk, Plagued with Deadly Correlations”

                                                                Brad Setser says we can think of AIG as the "insurer-of-last resort to the United States’ own shadow financial system":

                                                                “Concretations of risk, plagued with deadly correlations”, by Brad Setser: [Update: Brad DeLong gives this post the descriptive title "Why We Own AIG".] The FT’s Gillian Tett makes a simple but important point: AIG’s role in the credit default swap market meant that a lot of risk that the bank regulators thought had been dispersed into many strong hands ended up in a single weak hand.


                                                                ...during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

                                                                But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else. Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. ...

                                                                Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.

                                                                If the US creates a “systemic risk” regulator, it should be on the lookout for similar concentrations of risk.

                                                                One other point. The fact that several of AIG’s largest counterparties are European financial firms is by now well known. What is I think less well known is that the expansion of the dollar balance sheets of “European” financial firms — the BIS reports that the dollar-denominated balance sheets of major European financial institutions (UK, Swiss and Eurozone) increased from a little over $2 trillion in 2000 to something like $8 trillion (see the first graph in this report) — played a large role in the US credit boom.

                                                                As the BIS (Baba, McCauley and Ramaswamy) reports, many European banks were growing their dollar balance sheets so quickly that many started to rely heavily on US money market funds for financing. And if an institution is borrowing from US money market funds to buy securitized US mortgage credit, in a lot of ways it is a US bank, or at least a shadow US bank.

                                                                Consequently I think it is possible to think of AIG as the insurer-of-last resort to the United States’ own shadow financial system. That shadow financial system just operated offshore. There was a reason why investors in the UK were buying so many US asset backed securities during the peak years of the credit boom.

                                                                One of the selling points of financial innovation was that it would distribute risk widely thereby insulating the the financial sector from large shocks. Everyone would take a small loss, but no loss would be large enough to cause any real difficulties. That turned out to be a false promise in the face of a large, systemic shock. As problems began developing in these markets, it became evident that risk was far more concentrated than the promoters of new financial products had claimed.

                                                                  Posted by on Tuesday, March 17, 2009 at 10:44 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (52) 

                                                                  "Transatlantic Divergence in Tackling the Crisis"

                                                                  Here's a follow-up to Krugman's column A Continent Adrift:

                                                                  Transatlantic divergence in tackling the crisis, by Charles Wyplosz, Vox EU: While the US calls for a coordinated macroeconomic policy reaction to the ongoing recession, France and Germany are calling for microeconomic measures to prevent the next crisis. While the US is concerned about mounting unemployment and the associated distress of millions of households, France and Germany worry about their public debts. The G20 will not be able to paper over these differences, which reflect deep divergences in the way economic policies are prepared and understood.

                                                                  Denial in Europe

                                                                  It all looks like France and Germany, among other European countries, failed to realise the depth of the recession and the historical hardship that it is gradually creating. Alternatively, it looks like the US authorities are needlessly panicking, sowing the seeds of an outburst of inflation and massive public debt. History will eventually tell who is right. A good bet is that the Europeans are in denial or, worse that they cynically count on the US budget deficit to pull the world out of the recession. After all, the US is where the crisis was created.

                                                                  For a while, many political leaders in Europe and elsewhere, including in Asia, were soothed by the decoupling theory, according to which the crisis would not come their way. Even now that the decoupling theory is in shambles, many in high positions seem to believe that it will never be as bad in continental Europe as it is in the US. Besides believing that banks here are in better shape, they like to argue that Europe’s famed welfare systems have larger automatic stabilisers and should reassure consumers. This is not really supported by most empirical estimates, but we know that precision is not the hallmark of this corner of economic knowledge.

                                                                  In fact, our poor understanding of fiscal policy effects is spilling into widespread scepticism that most measures taken by the US will not do much of a difference. Coupled with concerns about public indebtedness, this view has swayed many political leaders into doing as little as possible, essentially dishing out transfers to sensitive industries, a thinly-veiled codeword for “friends”. When influential US economists such as Robert Barro support the view that fiscal policy is basically inefficient, no argument and no evidence will ever convince the sceptics.

                                                                  It is true that piling up public debt is a guaranteed implication of fiscal policy expansion, while no one really knows how much bang we will get from the bucks. It is also true that many countries had finally started to come to grip with endemic financial indiscipline when the crisis got under way. What is missing in this line of argument is the simple fact that a recession will worsen budget deficits. Containing the recession, therefore, is one way to limit the deficits. This is a lesson that, I thought, we had learnt from the Great Depression. But the debate about the New Deal is raging again. Arguments that it was ineffective are not new, and economic historians have not sorted it out. So, once again, we are in a situation where economists, as a profession, cannot come out with firm answers while individuals relish the possibility of making a clever argument. The problem is that, if clever arguments can get you a publication in a good journal, they may also confuse the laymen, including policymakers.

                                                                  Why the divide? Europe’s lack of expertise in high office

                                                                  Why, then, the growing divide between the US and Europe on how to respond to the recession? The size of public debts is one answer. Another answer is that the hallways of power in Washington (both in the Fed and the Treasury) are peopled with first-rate economists who happen to be of the saltwater variety who believe that fiscal policy works and have developed a clear view of what they want to see done. Several of them are also economic historians who have studied the Great Depression in great detail and concluded that, maybe, policy actions did not do as much good as is sometimes asserted, but that inaction under the Hoover administration transformed the financial crash into a full-blown recession.

                                                                  Now look at the hallways of power in continental Europe, and you will not find many economists, even fewer first-rate economists, and certainly no one who can claim any in-depth knowledge of the Great Depression. Confused policymakers cannot develop a macroeconomic strategy on their own. On the other hand, microeconomic policies are more reassuring, because they do not seem to involve general equilibrium reasoning. Policymakers like partial equilibrium reasoning – because it is easier but mainly because they can believe that they understand what they do. Of course, we know that partial equilibrium is dead wrong and that you never get what you expect.

                                                                  What can we expect from the G20 summit next month?

                                                                  Sadly, not much, as most agree. The Franco-German idea of focusing on the next crisis by rethinking financial regulation is disastrous. For one, there is no reason to choose between macroeconomic policies and financial regulation. Both are badly needed, although fiscal action is a matter of acute urgency while financial regulation is going to be a long drawn-out process that will take years to deliver its results. In addition, financial regulation is extraordinarily complicated, as it calls for sophisticated general equilibrium reasoning. Summit meetings are ideally unsuited to the task. It is one thing to ban tax havens, which played no role in the crisis; it is another thing to design incentives that will prevent financial firms from taking risks that yield vast private returns and even larger public losses.

                                                                  The US, with some support from the UK, Japan and, surprisingly, China, are highly unlikely to extract more than token fiscal policy commitments from the Europeans. Maybe this is not all that disastrous. These four countries account for about a hefty share of world GDP, so they can do a lot of good to themselves and to the rest of the world. Indeed, it is very likely that a significant portion of their fiscal expansion will feed imports from the other countries thus spreading relief internationally, especially if their currencies appreciate, but who knows? The problem is that free-riding by some countries may elicit protectionism from those that carry the burden. And that would be disastrous.

                                                                    Posted by on Tuesday, March 17, 2009 at 12:33 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (61) 

                                                                    links for 2009-03-17

                                                                      Posted by on Tuesday, March 17, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (24) 

                                                                      Monday, March 16, 2009

                                                                      The Hiring Activity Index

                                                                      Andrew Gelman sends this along:

                                                                      Are Small Businesses Starting to Hire Again?, by Andrew Gelman: Some statistical analysis says yes:

                                                                      The HAI [Hiring Activity Index] is essentially a measure of how actively our [Criteria Corp's] customers (made up mostly of SMBs of between 10 and 500 employees) are administering pre-employment tests through our system (and presumably, therefore, hiring) . . . the HAI is the percentage of our customers who are actively hiring (administering tests) in a given month. From January 2008 (when we began tracking the HAI) to October 2008 the HAI remained very steady, within a few points of 65%. (If this seems low, consider that even in the best of times many 30 or 40 person companies will not be hiring every month.)

                                                                      But as the financial markets plummeted and the unemployment rate surged in November, the HAI sunk about ten points, and by January reached its lowest level since we started tracking it, 53.28%. . . . So I [Josh Millet] was very pleasantly surprised to see a fairly strong uptick in the HAI in February, to 61.41%.

                                                                      Continue reading "The Hiring Activity Index" »

                                                                        Posted by on Monday, March 16, 2009 at 10:35 PM in Economics, Unemployment | Permalink  TrackBack (0)  Comments (6) 

                                                                        "Grading Obama on the Economy"

                                                                        I was asked about the grade of "F" the WSJ gave to the economic policies of Obama and Geithner:

                                                                        Grading Obama on the economy, by Mark Thoma, Comment is Free, UK Guardian: Obama hasn't received high marks for his handling of the financial crisis. Does he deserve a failing grade?

                                                                        The Obama administration's economic policies received a low average rating from 54 economists participating in a recent poll appearing in the Wall Street Journal, low enough to allow the paper to award an "F" grade to the president and US Treasury secretary Timothy Geithner. (Ben Bernanke fared a bit better.)

                                                                        However, there was considerable variation across the 54 responses, perhaps because the question was too broad. In particular, when assessing the administration's policy successes or failures to date, it's important to separate the stimulus package from the bailout package, and to separate the economics from the politics.

                                                                        Though they are often confused, the stimulus package is intended to jump-start the economy and is largely independent of Geithner and the Treasury, while the bailout policies are directed at repairing the financial sector and are, to a large extent, a direct product of the Treasury's efforts.

                                                                        The economic policies underlying the stimulus package do not, in my opinion, deserve a failing grade, or anything close to that. The policies the administration would have liked to have implemented were based upon solid principles. But I was disappointed with the actual legislation.

                                                                        The problem was the politics, not the economics. The administration did not get out in front and dominate the political message. Instead, the framing was left to the opposition, and that forced compromises in the stimulus legislation that limited its potential effectiveness, perhaps to the point of falling below the critical threshold needed to get the economy moving.

                                                                        For example, the bill that actually emerged slanted too much toward tax cuts that are likely to be saved rather than spent, thus reducing the impact on aggregate demand. There was not enough help for state and local governments, and there was not enough help for struggling households who have taken big balance sheet and employment hits as the crisis has unfolded. So while I would give the policy design decent marks, the actual implementation has fallen short, largely due to a tendency to compromise instead of taking control of the political battlefield.

                                                                        The financial bailout suffers from a similar problem, but here the economics have been problematic as well. The plan has been slow to develop, and does not seem to recognise the nature of the problem. However, this may be due to fear of the politics associated with nationalisation rather than a lack of understanding of the problem and then potential solutions to it. Or it could be from a genuine belief that nationalisation ought to be a last resort.

                                                                        But all of the false steps, the hesitation, the lack of a firm commitment to a particular course of action look to me like they have been driven by a desire to find some way, any way, of avoiding the political consequences of doing what they know needs to be done in their heart of hearts: take temporary control of the banks, separate the good assets from the bad, recapitalise the banks as necessary, then sell the reconstituted banks back to the private sector.

                                                                        But instead of leading the political argument, they have allowed the opposition to dominate the political landscape and that has forced the administration's hand in terms of the policies they are able to pursue. In the case of the financial sector, it's time to stop hoping that muddling along until the economy recovers will somehow solve the problem, and to get out in front and lead. As for the stimulus package, the message is the same. Given that the first package may not be enough due to the lack of a proper political foundation, and therefore that a second round may be needed, it would be helpful to begin paving the political path forward here as well.

                                                                          Posted by on Monday, March 16, 2009 at 01:44 PM in Economics, Financial System, Fiscal Policy, Monetary Policy, Politics | Permalink  TrackBack (0)  Comments (41) 

                                                                          Tim Duy: The Oregon Employment Report

                                                                          Tim Duy on today's employment report for Oregon. It's not good.

                                                                            Posted by on Monday, March 16, 2009 at 01:35 PM in Economics, Oregon, Unemployment | Permalink  TrackBack (0)  Comments (2) 

                                                                            "Should we Still Make Things?

                                                                            There is a symposium on Should We Still Make Things? at Dissent Magazine. Here's part of Dean Baker's entry:

                                                                            Should We Still Make Things?, by Dean Baker: I have often thought that economists should be required to have a better grasp of simple arithmetic. It would prevent them from repeating many silly comments that pass for conventional wisdom, such as that the United States will no longer be a manufacturing country in the future.

                                                                            Those who know arithmetic can quickly detect the absurdity of this assertion. The implication of course is that the United States will import nearly all of its manufactured goods. The problem is that unless we can find some country that will give us manufactured goods for free forever, we have to find some mechanism to pay for our imports.

                                                                            The end of manufacturing school argues that we will pay by exporting services. This is where arithmetic is so useful. The volume of U.S. trade in goods is approximately three and half times the volume of its trade in services. If the deficit in goods trade were to continue to expand, we would need an incredible growth rate in both the volume and surplus of service trade and our surplus on this trade in order to get to anything close to balanced trade.

                                                                            For example, if we lose half of our manufacturing over the next twenty years, and imported services continue to rise at the same pace as the past decade, then we would have to see exports of services rise at an average annual rate of almost 15 percent over the next two decades if we are to have balanced trade in the year 2028. ... It would take a very creative story to explain how we can anticipate the doubling of the growth rate of service exports on a sustained basis. ...

                                                                            [Also], the idea that U.S. workers are somehow too educated to be doing for manufacturing work, but instead will be making the beds, bussing the tables, and cleaning hotel toilets for foreign tourists is a bit laughable. Of course, with the right institutional structure (e.g. strong unions) these jobs can be well-paying jobs, but it is certainly not apparent that they require more skills than manufacturing. ...

                                                                            In short, the idea that the United States can survive without manufacturing is implausible: It implies an absurdly rapid rate of growth of service exports for which there is no historical precedent. Many economists and economic pundits asserted that house prices could keep rising forever in spite of the blatant absurdity of this position. The claim that the U.S. economy can be sustained without a sizable manufacturing sector is an equally absurd proposition. 

                                                                            I thought that if you looked at the value of US manufacturing, it hasn't fallen nearly as much as manufacturing employment. Thus, much of the change that has affected workers is due to changes in technology, not the exporting of jobs (this comes from a study done by the Peterson Institutute, more here). But from a worker's perspective, it doesn't matter all that much whether it's technology or jobs moving to other countries, the job is gone either way. The key, then, is to have good jobs waiting for workers when they are displaced due to inevitable (and desirable) technological change or to jobs moving overseas, jobs that are every bit as good or better than the jobs they left. That is where we are falling short. The new jobs we are creating are not as good as the jobs we are losing, when workers are forced to find new jobs they don't tend to do as well as they did in their previous job, and that is the source some of the stagnation we have seen in middle class incomes over the last few decades.

                                                                              Posted by on Monday, March 16, 2009 at 12:15 PM in Economics, International Trade, Technology, Unemployment | Permalink  TrackBack (0)  Comments (51) 

                                                                              Clarida and DeLong on Fiscal Policy

                                                                              Two views on fiscal policy from Brad DeLong and Richard Clarida. First, Clarida who has doubts about fiscal policy (and he isn't so sure about monetary policy either), then DeLong who, like me, is more supportive of fiscal policy efforts.

                                                                              Richard Clarida:

                                                                              A lot of bucks, but how much bang?, by Richard Clarida, Vox EU: “We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand” - John Maynard Keynes, “The Great Slump of 1930”, published December 1930.

                                                                              I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts to discuss the state of global markets, geopolitics, and the many and varied ways that Russia factors into these complex domains. The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me, from the two-and-half-hour session that included probing questions from a number of the audience members assembled for the event.

                                                                              That theme suggests the title I’ve chosen for this column; there are, at last, a ‘lot of bucks’ now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much ‘bang’ we can expect from these bucks.

                                                                              Continue reading "Clarida and DeLong on Fiscal Policy" »

                                                                                Posted by on Monday, March 16, 2009 at 09:54 AM in Economics, Fiscal Policy | Permalink  TrackBack (0)  Comments (26) 

                                                                                Paul Krugman: A Continent Adrift

                                                                                Was European integration and the creation of a common currency a mistake?:

                                                                                A Continent Adrift, by Paul Krugman, Commentary, NY Times: I’m concerned about Europe. Actually, I’m concerned about the whole world... But the situation in Europe worries me even more than the situation in America.

                                                                                Just to be clear, I’m not about to rehash the standard American complaint that Europe’s taxes are too high and its benefits too generous. Big welfare states aren’t the cause of Europe’s current crisis. In fact,... they’re actually a mitigating factor.

                                                                                The clear and present danger to Europe right now comes from ... the continent’s failure to respond effectively to the financial crisis.

                                                                                Europe has fallen short in terms of both fiscal and monetary policy... On the fiscal side, the comparison with the United States is striking. Many economists ... have argued that the Obama administration’s stimulus plan is too small... But America’s actions dwarf anything the Europeans are doing.

                                                                                The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates..., and it has shied away from any strong measures to unfreeze credit markets.

                                                                                The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.

                                                                                This is no small matter. Guaranteed health insurance and generous unemployment benefits ensure that, at least so far, there isn’t as much sheer human suffering in Europe as there is in America. And these programs will also help sustain spending in the slump.

                                                                                But such “automatic stabilizers” are no substitute for positive action.Why is Europe falling short? Poor leadership is part of the story. European banking officials ... still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany’s finance minister you have to listen to, well, Republicans.

                                                                                But there’s a deeper problem: Europe’s economic and monetary integration has run too far ahead of its political institutions. The economies of Europe’s many nations are almost as tightly linked as the economies of America’s many states... But unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.

                                                                                This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to ... finance a stimulus that will convey many if not most of its benefits to voters in other countries.

                                                                                You might expect monetary policy to be more forceful. After all, while there isn’t a European government, there is a European Central Bank. But the E.C.B. isn’t like the Fed, which can afford to be adventurous because it’s backed by a unitary national government — a government that has already moved to share the risks of the Fed’s boldness, and will surely cover the Fed’s losses if its efforts to unfreeze financial markets go bad. The E.C.B., which must answer to 16 often-quarreling governments, can’t count on the same level of support.

                                                                                Europe, in other words, is turning out to be structurally weak in a time of crisis. ... Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe.

                                                                                But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?

                                                                                  Posted by on Monday, March 16, 2009 at 12:33 AM in Economics, Financial System, Fiscal Policy | Permalink  TrackBack (0)  Comments (55) 

                                                                                  links for 2009-03-16

                                                                                    Posted by on Monday, March 16, 2009 at 12:06 AM in Economics, Links | Permalink  TrackBack (0)  Comments (7) 

                                                                                    Sunday, March 15, 2009

                                                                                    Bernanke on 60 Minutes

                                                                                    [Ben Bernanke's Greatest Challenge]

                                                                                      Posted by on Sunday, March 15, 2009 at 04:50 PM in Economics, Monetary Policy, Video | Permalink  TrackBack (0)  Comments (13) 

                                                                                      Animal Spirits

                                                                                      Some history of the phrase "animal spirits":

                                                                                      ...Needed now, say today’s contrarians, is an infusion of animal spirits. In a New York Times Op-Ed a few weeks ago ... Robert Shiller, the author with his fellow economist George Akerlof of a new book, ‘‘Animal Spirits,’’ which carries a depressingly lengthy subtitle about psychology, noted that... ‘‘The attention paid to the Depression story ... is a cause of the current situation — because the Great Depression serves as a model for our expectations, damping what John Maynard Keynes called our ‘animal spirits,’ reducing consumers’ willingness to spend and businesses’ willingness to hire and expand. The Depression narrative could easily wind up as a self-fulfilling prophecy.’’

                                                                                      Keynes was surely the popularizer of the phrase in his 1936 book ‘‘The General Theory of Employment, Interest and Money.’’ He held that economic instability..., often the result of speculation, was also caused partly by ‘‘spontaneous optimism rather than mathematical expectations. Most, probably, of our decisions to do something positive can only be taken as the result of animal spirits — a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.’’

                                                                                      In that passage, he was warning about overconfidence; in another, he encouraged risk-taking: ‘‘If the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.’’ I like that one more.

                                                                                      The phrase that Keynes made famous in economics has a long history. ‘‘Physitions teache that there ben thre kindes of spirites,’’ wrote Bartholomew Traheron in his 1543 translation of a text on surgery, ‘‘animal, vital, and naturall. The animal spirite hath his seate in the brayne called animal, bycause it is the first instrument of the soule, which the Latins call animam.’’

                                                                                      Novelists seized the expression’s upbeat sense with enthusiasm. Daniel Defoe, in ‘‘Robinson Crusoe’’: ‘‘That the surprise may not drive the Animal Spirits from the Heart.’’ Jane Austen used it to mean ‘‘ebullience’’ in ‘‘Pride and Prejudice’’: ‘‘She had high animal spirits.’’ Benjamin Disraeli, a novelist in 1844, used it in that sense: ‘‘He had great animal spirits, and a keen sense of enjoyment.’’ Feel better?...

                                                                                        Posted by on Sunday, March 15, 2009 at 03:42 PM in Economics | Permalink  TrackBack (0)  Comments (8) 

                                                                                        links for 2009-03-15

                                                                                          Posted by on Sunday, March 15, 2009 at 04:32 AM in Economics, Links | Permalink  TrackBack (0)  Comments (36) 

                                                                                          Saturday, March 14, 2009

                                                                                          "Blame Economists, Not Economics"

                                                                                          Dani Rodrik says economics is fine, but its practitioners are not (the full version points to macroeconomists in particular):

                                                                                          Blame economists, not economics, by Dani Rodrik, Project Syndicate: As the world economy tumbles off the edge of a precipice, critics of the economics profession are raising questions about its complicity in the current crisis. Rightly so: economists have plenty to answer for. ...

                                                                                          So is economics in need of a major shake-up? Should we burn our existing textbooks and rewrite them from scratch? Actually, no. Without recourse to the economist's toolkit, we cannot even begin to make sense of the current crisis.

                                                                                          Why, for example, did China's decision to accumulate foreign reserves result in a mortgage lender in Ohio taking excessive risks? If your answer does not use elements from behavioral economics, agency theory, information economics, and international economics, among others, it is likely to remain seriously incomplete.

                                                                                          The fault lies not with economics, but with economists. The problem is that economists (and those who listen to them) became over-confident in their preferred models of the moment: markets are efficient, financial innovation transfers risk to those best able to bear it, self-regulation works best, and government intervention is ineffective and harmful.

                                                                                          They forgot that there were many other models that led in radically different directions. Hubris creates blind spots. If anything needs fixing, it is the sociology of the profession. The textbooks -- at least those used in advanced courses -- are fine.

                                                                                          Non-economists tend to think of economics as a discipline that idolizes markets and a narrow concept of (allocative) efficiency. ... But ... spend some time in advanced seminar rooms, and you will get a different picture. ... Advanced training in economics requires learning about market failures in detail, and about the myriad ways in which governments can help markets work better. ...

                                                                                          Economics is really a toolkit with multiple models -- each a different, stylized representation of some aspect of reality. One's skill as an economist depends on the ability to pick and choose the right model for the situation.

                                                                                          Economics' richness has not been reflected in public debate because economists have taken far too much license.

                                                                                          Instead of presenting menus of options and listing the relevant trade-offs -- which is what economics is about -- economists have too often conveyed their own social and political preferences. Instead of being analysts, they have been ideologues, favoring one set of social arrangements over others.

                                                                                          Furthermore, economists have been reluctant to share their intellectual doubts with the public, lest they 'empower the barbarians.' ...

                                                                                          Paradoxically, then, the current disarray within the profession is perhaps a better reflection of the profession's true value added than its previous misleading consensus. Economics can at best clarify the choices for policymakers; it cannot make those choices for them.

                                                                                          When economists disagree, the world gets exposed to legitimate differences of views on how the economy operates. It is when they agree too much that the public should beware.

                                                                                            Posted by on Saturday, March 14, 2009 at 07:29 PM in Economics, Methodology | Permalink  TrackBack (0)  Comments (50) 

                                                                                            Who's Responsible for the Budget Deficit?

                                                                                            Dean Baker:


                                                                                              Posted by on Saturday, March 14, 2009 at 02:07 PM in Budget Deficit, Economics | Permalink  TrackBack (0)  Comments (20) 

                                                                                              "The Agenda for 'Understanding Society' is an Old One"

                                                                                              Daniel Little:

                                                                                              Proto social inquiry, Understanding Society: We sometimes imagine that the current disciplines and methods of the social sciences represent a more or less inevitable set of approaches to the problem of understanding social phenomena. But really, the latter task is much larger than the specific sets of disciplines and methods we have currently developed. It is worth turning back the dial a bit and reflecting on the intellectual currents that led to contemporary programmes for the social sciences.

                                                                                              Reflective people have been curious about the workings of the social world for as long as they have observed and commented upon the world of actions and institutions that they found around themselves. The Greeks were particularly interested in such things as the causes and outcomes of war (Thucydides), the properties of different kinds of states (Plato), the nature of the family (Aristotle), and so on. Often the focus was on the question of “justice”—the features of social arrangements that were justified on moral grounds. But there are also many examples of philosophers and writers who were interested in the question of the how and why of social life: how does it work, what sorts of causes are at work, and why do certain kinds of outcomes occur (poverty, war, violence)? These reflections often represented systematic thinking and observation, but they did not amount to what we would call “social science” today.

                                                                                              Several important changes occurred in Europe in the eighteenth and nineteenth centuries that created a new impulse towards a different kind of study of the social world.

                                                                                              Continue reading ""The Agenda for 'Understanding Society' is an Old One"" »

                                                                                                Posted by on Saturday, March 14, 2009 at 01:44 PM in Economics | Permalink  TrackBack (0)  Comments (6) 

                                                                                                links for 2009-03-14

                                                                                                  Posted by on Saturday, March 14, 2009 at 03:33 AM in Economics, Links | Permalink  TrackBack (0)  Comments (31) 

                                                                                                  Friday, March 13, 2009

                                                                                                  Positive Trends in Economic Development

                                                                                                  William Easterly:

                                                                                                  When Will There Be Good News?, William Easterly: In the midst of the general doom and gloom, fears about how the crisis will affect poor countries, and fierce criticism of markets, states, and aid agencies, perhaps it’s healthy to step back to the big picture, to recognize there has already been some very real good news. The graph below shows some overall statistics for the developing world:


                                                                                                  This graph has a mixture of good news that all of the much-criticized triad of markets, states, and aid can take partial credit for. Markets obviously get at least some credit for the reduction in global poverty and increase of global average income. States supply public goods like education, water, and health, and there has been progress on all of these. Aid deserves some credit for successes in health, as already stressed in a previous blog post.

                                                                                                  One group that doesn’t deserve much credit is “development experts,” because there is a terrible crisis of confidence in development economics now, where we all freely confess we don’t really know what to advise governments on how to speed up development. ...

                                                                                                  Yes, there is a terrible crisis now, not to mention that all of these indicators are still deeply unsatisfactory, so we all keep criticizing and holding accountable the market, state, and aid actors who fall so woefully short. But let none of us forget how much development already happened over the last half-century, which may inspire us with hope that more step-by-step improvements in markets, states, and aid could make even more development possible.

                                                                                                    Posted by on Friday, March 13, 2009 at 08:37 PM in Development, Economics | Permalink  TrackBack (0)  Comments (18) 

                                                                                                    Summers at Brookings

                                                                                                      Posted by on Friday, March 13, 2009 at 01:53 PM in Economics, Fiscal Policy, Universities, Video | Permalink  TrackBack (0)  Comments (14)