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Tuesday, July 21, 2009

Should Carbon be Sequestered?

Robert Stavins explains why he believes that biological carbon sequestration should be part of U.S. climate policy:

What Role for U.S. Carbon Sequestration?, by Robert Stavins: With the development of climate legislation proceeding in the U.S. Senate, a key question is whether the United States can cost-effectively reduce a significant share of its contributions to increased atmospheric CO2 concentrations through forest-based carbon sequestration.  Should biological carbon sequestration be part of the domestic portfolio of compliance activities?

Continue reading "Should Carbon be Sequestered?" »

    Posted by on Tuesday, July 21, 2009 at 06:26 PM in Economics, Environment, Policy | Permalink  Comments (24) 

    "Bernanke's Bold Prose"

    Mohammed El-Arian says Ben Bernanke can talk all he wants, but the credibility of his message about inflation depends upon the actions of fiscal authorities and is thus largely out of his hands:

    Mohamed El-Erian on Bernanke’s bold prose, FT Alphaville: From Pimco’s chief executive…

    While it may not rank quite as high as his appearance on the US news show ‘60 Minutes’ a few months ago, Chairman Bernanke’s Op Ed in today’s Wall Street Journal is nevertheless notable and important. It represents a bold attempt by the Federal Reserve to reach out broadly and pre-empt mounting concerns about the challenges facing monetary policy.

    Bernanke’s bottom line is clear:  “Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so.”   ... Bernanke is signaling that the Fed is aware of the need to re-assure markets of its ability to strike that delicate balance between deflationary and inflationary concerns. ...

    While ... this is important, it does not constitute major news as such.  Indeed, Bernanke has today confirmed a view that has increasingly prevailed in financial markets:  there will be no early hike in interest rates; and when the time comes to tighten monetary policy, the sequence will involve dealing first with the excess reserves. Yet this is not sufficient to ensure that the US is indeed able to balance well deflationary and inflationary risks.

    To move from a necessary condition to one that is both necessary and sufficient, one must also consider what, increasingly, is the large elephant in the room when it comes to policies — namely, the design and conduct of fiscal policy.  This is an area where challenging short and longer-term imperatives need to be reconciled over time, and at several level of local, state and national governments. ...

    After being heavily involved in stabilizing a highly disrupted economy, the Fed is transitioning from the driver seat to the passenger seat.

    By virtue of its greater flexibility and responsiveness, the Fed ended up assuming the main role in responding to the crisis, with fiscal and other agencies (including the FDIC) playing important support roles. It is now the turn of the fiscal agencies to assume the main role, with the Fed and others playing the support roles.

    Bottom line:  we have now entered the phase where fiscal policy is the more important determinant of the ability of the US to balance the risks of deflation and those of inflation. And, here, the jury is still out.

    If we fail to make the changes in health care reform that are needed to bring the long-term budget into better balance, there will come a time when the Fed faces a choice about whether to monetize the debt and create inflation, or to refuse to monetize the debt potentially send interest rates very high causing the economy to stall. So it's not completely out of their hands. The Fed has faced this choice before, and its independence allowed it to send a message to fiscal authorities that it was willing to take whatever steps are necessary, including causing a recession, to prevent monetizing the debt and creating an inflationary environment. As Thomas Sargent notes in his book "Dynamic Macroeconomic Theory":

    A game of chicken seemed to be occurring in the United States from 1981 to 1985 because the Fed announced a policy that is feasible only if the budget swings toward balance in a present value sense, whereas Congress and the President set in place plans for government expenditures and taxes that imply prospective net-of-interest deficits so large that they are feasible only if the Fed eventually creates more inflation. In such a situation, something has to give.

    And, due to the degree of independence that it had, it wasn't the Fed that eventually gave in. With a less independent Fed, I'm not sure we get that outcome. (I should note that people such as Jamie Galbraith argue that fighting inflation during this time period was the wrong policy to pursue - one part of the the argument is that it suppressed wages and made workers worse off - but this is a point on which we disagree, and the general view within the profession is that the Volcker Fed acted wisely.)

      Posted by on Tuesday, July 21, 2009 at 04:37 PM in Economics, Inflation, Monetary Policy | Permalink  Comments (18) 

      "Three Myths about the Consumer Financial Product Agency"

      Elizabeth Warren responds to some of the worries about creating a Consumer Financial Product Agency:

      Three Myths about the Consumer Financial Product Agency, by Elizabeth Warren: I’ve written a lot about the creation of a new Consumer Protection Financial Agency (CFPA)... Today, though, I’d like to post specifically about some of the push back that has developed on this issue.  In particular, I’d like to focus on three big myths – myths designed to protect the same status quo that triggered the economic crisis.

      MYTH #1:  CFPA Will Limit Consumer Choice and Hinder Innovation

      Continue reading ""Three Myths about the Consumer Financial Product Agency"" »

        Posted by on Tuesday, July 21, 2009 at 04:01 PM in Economics, Financial System, Regulation | Permalink  Comments (9) 

        Ben Bernanke: The Fed's Exit Strategy

        Ben Bernanke says that when the economy starts to recover, the Fed will take the steps needed to prevent an outbreak of inflation (the substance of the arguments can be found in the full version):

        The Fed’s Exit Strategy, by Ben Bernanke, Commentary, WSJ: The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the ... federal-funds rate ... nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

        These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets...

        My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem... We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

        The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds ... ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. ...

        But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy. ...

        [W]e have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination. ... [T]hese policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

        Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

        As I've said many times, I'm not particularly worried about inflation, reserves can be removed or neutralized as described. The worry is not so much that they will be too slow at removing reserves, it's that they will get trigger happy and start raising interest too soon potentially stalling the recovery or perhaps even sending the economy back downward. The Fed will need to be sure that things are getting better before beginning to raise interest rates, that's why it's good to hear them use the phrase "extended period" twice when describing how long interest rates will stay low. But there are long lags associated with monetary policy, and by the time the Fed knows for sure that economy is heading solidly in the right direction, it won't have much time left to reverse course and begin removing reserves. Even so, they need to be patient and avoid the more serious mistake of raising interest rates too soon.

          Posted by on Tuesday, July 21, 2009 at 01:11 AM in Economics, Inflation, Monetary Policy | Permalink  Comments (23) 

          Milton Friedman's Letter: I Do Believe There is Gold in Them There Hills

          I came across this letter today while digging in my desk for something else, and decided I should make a digital copy since it was starting to show its age. Having done so, I decided to post it here (after thinking about whether it would seem to self-serving, or whatever, which it probably does).

          This is why I will always have a soft spot for Milton Friedman. I was a relatively new assistant professor when I received this in response to a paper I sent to him. The paper was based on his Plucking Model, but I never expected a reply, and given the demands on his time, I'm still amazed he responded at all. Some parts, such as this, relate at least tangentially to debates we are having today:

          In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components.

          Milton Friedman was my dissertation advisor's dissertaion advisor, so I guess he's my intellectual grandpa. Here's the letter (at this time, monetary aggregates were used to measure policy, and the debate over the use of M1 versus M2 in empirical work was not yet fully resolved) (pdf):

          Stanford, California 94305-60I0
          June 24, 1991
          Professor Mark Thoma
          Department of Economics
          University of Oregon
          Eugene, Oregon 97403-1285

          Dear Mark Thoma:
          I was delighted to receive your paper "Asymmetries and the Effects of Money." Needless to say, I am pleased that my paper stimulated you to do further work along these lines. I do believe there is gold in them there hills.

          Continue reading "Milton Friedman's Letter: I Do Believe There is Gold in Them There Hills" »

            Posted by on Tuesday, July 21, 2009 at 01:08 AM in Economics | Permalink  Comments (17) 

            "A More Pleasant Society will then Evolve"

            Do egalitarian societies cause egalitarian beliefs?:

            How to upgrade human values, by Andrew Leonard: "As Karl Marx would have said," writes Yale economist John Roemer in the newest edition of the Economist's Voice, "under feudal rules we get serfs who desire only to subsist; under capitalism, we get capitalists who desire to maximize their wealth. Each mode of production (set of rules) determines to a large extent the values and the social ethos of the people who live within it."
            But most economists, says Roemer, don't see people's values as contingent on modes of production; so when they think about ways to tinker with the "system" so that global economic meltdowns are less likely to clobber us, their premise is "that we must accept people as they are and design new rules that will prevent bad results from occurring."
            Roemer believes that in a capitalist society individuals will always figure out ways to break or twist the rules. So he proposes what he calls "a less ambitious aim": Changing people. "If we follow a path leading to a society whose individuals are more solidaristic, then I believe it is much easier to design rules that will guarantee good outcomes."
            So how does one go about this? Basically, Roemer suggests that if you build a more egalitarian system, people will change to reflect more egalitarian beliefs. He uses the oh-so-topical issue of healthcare as an example.
            There is of course no social engineer who can command either that people change their preferences, or who can impose a new set of rules. Because we value democracy, rules must ultimately be approved by the voters. Nevertheless, history may produce a path that would engender the desired change in preferences and rules. Suppose, for example, that America succeeds in implementing universal health insurance; that is, that voters in their majority demand it. A more pleasant society will then evolve: people will be under less from the fear of losing their health insurance when unemployed, or because they contract a major disease; emergency rooms will be less clogged with poor, uninsured persons; insurers will have incentives to urge people to undertake more healthy life styles (to keep costs down), and so on. There is a good chance that citizens generally will like these changes -- not only because of their own increased financial security, but because civility will increase, and poverty will be, at least along one dimension, less glaring. Citizens may come to value equality of condition more than they previously did. This change in preferences may well render politically feasible other insurance innovations and increased financing of public goods -- more support for the unemployed with job training, perhaps more direct income support for the unemployed, and more support for intensive education for the disadvantaged.
            Well, one can dream, can't one? ...

              Posted by on Tuesday, July 21, 2009 at 01:01 AM in Economics | Permalink  Comments (81) 

              links for 2009-07-21

                Posted by on Tuesday, July 21, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (6) 

                Monday, July 20, 2009

                The State of Macroeconomics

                Because of these three articles in The Economist, everyone seems to be weighing in on the state of macroeconomics. I haven't because I've already said everything I want to say about this, and I didn't want to be repetitive. The links are:

                Here's one bit:

                Let me a bit more specific, and add something more to problems with macroeconomics I discussed in The Great Multiplier Debate and "The Unfortunate Uselessness of Most 'State of the Art' Academic Monetary Economics". The main mechanism generating fluctuations and policy effects in modern New Keynesian models is Calvo type sluggish price adjustment. I think this model is useful for “normal” times as a way of understanding economic fluctuations, and for learning about optimal policy, and it represents a step forward in understanding monetary policy in particular. But do people really think that all would be fine right now if prices – and they must have housing prices in mind when they think about sticky prices as an explanation for the current episode – had only adjusted faster? If housing prices had dropped even faster than they have already, all would be well in the world?

                Okay, so maybe they don’t have housing prices in mind. Still, do we really think that sluggish price adjustment is the main mechanism at work in the present crisis? If not, then what use is the evidence from those models? Why do we keep hearing about theoretical simulations that give values for the multiplier that are small, large, zero, less than one, whatever? Do we really think that sluggish price adjustment captures the essence of the factors driving the present crisis? I don't.

                That is, the mechanism driving real effects in the standard versions of these models is sluggish price adjustment, but do we really believe this is the main mechanism through which real effects are being generated in the current crisis? if not, how much faith should we put in estimates derived from these models?

                Update: Mark Gertler emails a response to this post (this also appeared at Free exchange earlier today):

                The current crisis has naturally led to scrutiny of the economics profession. The intensity of this scrutiny ratcheted up a notch with the Economist’s interesting cover story this week on the state of academic economics.
                I think some of the criticism has been fair. The Great Moderation gave many in the profession the false sense that we had handled the problem of the business cycle as well as we could. Traditional applied macroeconomic research on booms and busts and macroeconomic policy fell into something of a second class status within the field in favor of more exotic topics.
                At the same time, from the discussion thus far, I don’t think the public is getting the full picture of what has been going on in the profession. From my vantage, there has been lots of high quality “middle ground” modern macroeconomic research that has been relevant to understanding and addressing the current crisis.
                Here I think, though, that both the mainstream media and the blogosphere have been confusing a failure to anticipate the crisis with a failure to have the research available to comprehend it. Predicting the crisis would have required foreseeing the risks posed by the shadow banking system, which were missed not only by academic economists, but by just about everyone else on the planet (including the ratings agencies!).
                But once the crisis hit, broadly speaking, policy-makers at the Federal Reserve made use of academic research on financial crises to help diagnose the situation and design the policy response. Research on monetary and fiscal policy when the nominal interest is at the zero lower bound has also been relevant. Quantitative macro models that incorporate financial factors, which existed well before the crisis, are rapidly being updated in light of new insights from the unfolding of recent events. Work on fiscal policy, which admittedly had been somewhat dormant, is now proceeding at a rapid pace.
                Bottom line: As happened in both the wake of the Great Depression and the Great Stagflation, economic research is responding. In this case, the time lag will be much shorter given the existing base of work to build on. Revealed preference confirms that we still have something useful to offer: Demand for our services by the ultimate consumers of modern applied macro research – policy makers and staff at central banks – seems to be higher than ever.
                Mark Gertler,
                Henry and Lucy Moses Professor of Economics
                New York University

                I have also posted a link to his Mini-Course, "Incorporating Financial Factors Within Macroeconomic Modelling and Policy Analysis" in the daily links for tomorrow. This course looks at recent work on integrating financial factors into macro modeling, and is a partial rebuttal to the assertion above that New Keynesian models do not have mechanisms built into them that can explain the financial crisis. We still have work to do, but as Mark Gertler notes, "economic research is responding," and as I noted at the end of one of the posts linked above, "The models will be built - I guarantee you they are being built presently."

                  Posted by on Monday, July 20, 2009 at 04:31 PM in Economics, Methodology | Permalink  Comments (10) 

                  "Obamacare Is At War With Itself"

                  Robert Reich believes that if health care reform is delayed beyond the August recess, it's unlikely to happen:

                  Universal health care is so complicated -- touching on so much of the economy, stepping on the toes of so many vested interests -- that to allow the bills to languish past recess risks the entire goal. Speed is essential. Recall that after Bill Clinton was elected, universal health insurance looked inevitable; a year later, it was doomed. As Lyndon Johnson warned his staff after the 1964 landslide, "every day while I'm in office, I'm gonna lose votes."

                  Republicans don't want any bill. Blue Dog Democrats are afraid of the costs of any bill. The AMA, private insurers, and pharmaceutical companies would be delighted if universal health care died. If bills aren't passed in the House and Senate before August 7th, the fights in both chambers over the public option and money will carry over into the Fall, where they'll become more intense and more prolonged. Obama won't have a bill on his desk before the end of the end of the year. That's a death sentence for health-care reform. The gravitational pull of the mid-term elections of 2010 will frighten off Blue Dogs and delight Republicans.

                  However, it appears that the tension between the costly giveaways being used to get the votes needed to pass the legislation and Blue Dogs worried about the costs of the giveaways is going to delay the process past the August recess:

                  Obamacare Is At War With Itself Over Future Costs, by Robert Reich: Right now, Obamacare is at war with itself. Political efforts to buy off Big Pharma, private insurers, and the AMA are all pushing up long-term costs... But this is setting off alarms among Blue Dog Democrats worried about future deficits -- and their votes are critical.

                  Big Pharma, for example, is in line to get just what it wants. The Senate health panel’s bill protects biotech companies from generic competition for 12 years after their drugs go to market, which is guaranteed to keep prices sky high. Meanwhile, legislation expected from the Senate Finance committee won't allow cheaper drugs to be imported from Canada and won't give the federal government the right to negotiate Medicare drug prices directly with pharmaceutical companies. ... No wonder Big Pharma is now running "Harry and Louise" ads -- the same couple who fifteen years ago scared Americans into thinking the Clinton plan would take away their choice of doctor -- now supportive of Obamacare.

                  Private insurers, for their part, have become convinced they'll make more money with a universal mandate accompanied by generous subsidies for families with earnings up to ... $80,000 ... than they might stand to lose. Although still strongly opposed to a public option, the insurance industry is lining up behind much of the legislation. The biggest surprise is the AMA, which has also now come out in favor -- but only after being assurred that Medicare reimbursements won't be cut nearly as much as doctors first feared.

                  But all these industry giveaways are obviously causing the healthcare tab to grow. And as these long-term costs rise, the locus of opposition to universal health care is shifting away from industry and toward Blue Dog and moderate Democrats who are increasingly worried about future deficits. My sources on the Hill tell me there aren't enough votes in the House to get either major bill through, even with a provision that would pay for it with a surcharge on the richest 1 percent of taxpayers. House members don't want to vote for a tax increase before their Senate counterparts commit to one. Yet the Senate continues to be in suspended animation because Max Baucus and his Senate Finance Committee still haven't come up with a credible way of paying for health care. In his testimony last week, Elmendorf favored limiting tax-free employer-provided health benefits, but organized labor remains strongly opposed.

                  Obama has less than three weeks before August recess. Chances are dimming that he can get some form of universal health care passed in both Houses before the clock runs out. The Democratic National Committee is running ads favoring passage in Blue Dog states and districts, but that won't be enough. Now is the time for the President to begin twisting arms and knocking heads. To control long-term costs, he'll also have to take away some of the goodies that have been promised to the health-industrial complex, and maybe even cross Big Labor. He also needs to come out clearly and forcefully in favor of a way to pay for the whole thing -- ideally, in my view, a surtax on the top.

                  Will legislation pass before the break? Will it happen at all? I expect that we will get some sort of legislation, if not before the break then after, but it will be weakened to the point where nobody is very happy with the outcome. The hope, and likely the main supporting argument for whatever legislation emerges, is that it will provide the foundation for further reform down the road, and set the stage in a way that makes that reform inevitable. But there's no guarantee that will happen.

                  Update: Tyler Cowen comments.

                  Update: Megan McArdle comments on the comments.

                    Posted by on Monday, July 20, 2009 at 02:20 PM in Economics, Health Care, Politics | Permalink  Comments (51) 

                    Video: Martin Feldstein Lecture by John Taylor

                      Posted by on Monday, July 20, 2009 at 12:19 PM in Economics, Video | Permalink  Comments (4) 

                      Innovative Financial Shennanigans

                      Isn't this special?:

                      Cashing In, Again, on Risky Mortgages, by Peter Goodman, NYTimes: ...Jack Soussana delivered staggering numbers of mortgages to homeowners during the real estate boom, amassing a fortune. By Mr. Soussana’s own account, his customers fared less happily. He specialized in the exotic mortgages that have proved most prone to sliding into foreclosure, leaving many now scrambling to save their homes.
                      Yet the dangers assailing Mr. Soussana’s clients have yielded fresh business for him: Late last year, he and his team — ensconced in the same office where they used to broker mortgages — began working for a loan modification company [called FedMod]. For fees reaching $3,495, with most of the money collected upfront, they promised to negotiate with lenders to lower payments on the now-delinquent mortgages they and their counterparts had sprinkled liberally across Southern California. ...
                      Despite making promises of relief to homeowners desperate to keep their homes, FedMod and other profit making loan modification firms often fail to deliver, according to a New York Times investigation...
                      “Our job was to get the money in and then we’re done,” said Paul Pejman, a former sales agent... He recounted his experience, he said, because “I really feel bad.”
                      “I had people calling me crying, and we were telling them, ‘You can pay me or you can lose your house,’ ” Mr. Pejman said. “People were giving me every dime they had, opening credit cards. But I never saw one client come out of it with a successful loan modification.” ...
                      FedMod is among dozens of similar companies that have been accused by state and federal authorities of fraudulent business practices. ... Many of the companies formerly operated as mortgage brokers... The three original partners brought in [a lawyer] to gain a crucial asset: his law license. Having a lawyer in charge enabled them to market their venture as a law firm and thus collect upfront payments under California rules. ...
                      Mr. Pejman, 22, ... had worked at three wholesale mortgage brokerages. Now, a trainer emphasized he was at a law center.
                      “Our big sales pitch was that an attorney could do a better job with your loan modification,” Mr. Pejman said. “If you told them these were basically washed-up people from the mortgage industry, or just people sending in paperwork, they would say, ‘Well, why bother? I might as well do this myself.’ ” He went on: “It was misleading to the client. Attorneys never touched those files.”
                      Among the 700-plus full-time employees who worked for FedMod this spring, only nine were lawyers...
                      Mr. Pejman and his fellow agents urged homeowners to send FedMod $3,495; the agents were promised a 30 percent commission for fees they took in. ... “They basically told us, ‘Do whatever you need to do,’ ” he said. “ ‘It’s a sales floor. You’re here to sell.’ People would quote success rates and just pull them out of thin air. People would say 60 percent, 80 percent, 90 percent. ...
                      “I’d hear people say, ‘Would you pay $1,000 to save your home? To save your marriage? Your kids’ education?’ ” he recalled. “I’d hear people say, ‘Yeah, we’re the federal government.’ There were a lot of corrupt people working there.” ...
                      Each case manager was responsible for as many as 200 files at a time... “You’re paying the sales agent upfront,” ... “So what motivation does he have to get it closed?” ...

                      See, the anti-regulation types are right. A Consumer Financial Protection Agency might stifle valuable innovation like this and prevent these companies from giving consumers the value that they pay for.

                      I might have that backwards.

                        Posted by on Monday, July 20, 2009 at 12:24 AM in Economics, Financial System, Regulation | Permalink  Comments (36) 

                        links for 2009-07-20

                          Posted by on Monday, July 20, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (29) 

                          Sunday, July 19, 2009

                          "Why Toxic Assets Are So Hard to Clean Up"

                          John Taylor and Kenneth Scott argue that "sheer complexity" is at the heart of the financial crisis:

                          Why Toxic Assets Are So Hard to Clean Up, by Kenneth Scott and John Taylor, Commentary, WSJ: Despite trillions of dollars of new government programs, one of the original causes of the financial crisis -- the toxic assets on bank balance sheets -- still persists and remains a serious impediment to economic recovery. Why are these toxic assets so difficult to deal with? We believe their sheer complexity is the core problem and that only increased transparency will unleash the market mechanisms needed to clean them up.
                          The bulk of toxic assets are based on residential mortgage-backed securities (RMBS), in which thousands of mortgages were gathered into mortgage pools. The returns on these pools were then sliced into a hierarchy of "tranches" that were sold to investors as separate classes of securities. ...
                          But the process didn't stop there. Some of the tranches from one mortgage pool were combined with tranches from other mortgage pools, resulting in Collateralized Mortgage Obligations (CMO). Other tranches were combined with tranches from completely different types of pools, based on commercial mortgages, auto loans, student loans, credit card receivables, small business loans, and even corporate loans that had been combined into Collateralized Loan Obligations (CLO). The result was a highly heterogeneous mixture of debt securities called Collateralized Debt Obligations (CDO). The tranches of the CDOs could then be combined with other CDOs, resulting in CDO2.
                          Each time these tranches were mixed together with other tranches in a new pool, the securities became more complex. Assume a hypothetical CDO2 held 100 CLOs, each holding 250 corporate loans -- then we would need information on 25,000 underlying loans to determine the value of the security. But assume the CDO2 held 100 CDOs each holding 100 RMBS comprising a mere 2,000 mortgages -- the number now rises to 20 million!
                          Complexity is not the only problem. Many of the underlying mortgages were highly risky, involving little or no down payments and initial rates so low they could never amortize the loan. ...
                          With so much complexity, and uncertainty about future performance, it is not surprising that the securities are difficult to price and that trading dried up. Without market prices, valuation on the books of banks is suspect and counterparties are reluctant to deal with each other. ...
                          The latest disposal scheme is the Public-Private Investment Program (PPIP). ... But the pricing difficulty remains and this program too may amount to little. The fundamental problem has remained untouched: insufficient information to permit estimated prices that both buyers and sellers find credible. Why is the information so hard to obtain? ... CDOs were sold in private placements with confidentiality agreements. ...
                          This account makes it clear why transparency is so important. To deal with the problem, issuers of asset-backed securities should provide extensive detail in a uniform format about the composition of the original pools and their subsequent structure and performance, whether they were sold as SEC-registered offerings or private placements. By creating a centralized database with this information, the pricing process for the toxic assets becomes possible. Making such a database a reality will restart private securitization markets and will do more for the recovery of the economy than yet another redesign of administrative agency structures. ...

                          I am becoming convinced, after reading articles like this and from other research on this issue, that forcing these transactions through organized exchanges that monitor and mitigate counterparty risk is a good idea. Here's a discussion of the issues:

                          On the derivatives side, the administration had already indicated that it would push for all standardized derivatives to be traded through an organized exchange or cleared through a clearing house. ... Exchanges bring a real benefit from transparency about the pricing and volume of trades, as well as making it easier for regulators to track trading positions of major parties. In contrast, much of the trading volume in derivatives now takes place “over the counter,” between two counterparties who are not generally required to report details of the trade and who take each other’s credit risk in regard to the transaction. This credit risk is often mitigated by requiring collateral, but it is clear in retrospect that this process was not well-managed in many cases, leaving a large number of institutions very exposed to the credit risk of AIG, for example.

                          The major exchanges dealing in derivatives use central clearing houses that act as the counterparty to both sides. ...

                          It should be noted that using a clearing house does not eliminate counterparty risk altogether. The clearing house could become insolvent itself if enough of its counterparties fail to meet their obligations. This should still represent a diminution of the total credit risk in the system, since clearing houses are well-capitalized and operate in a clearly defined business..., but there could be extreme circumstances where a government rescue would be required.

                          The big controversy with derivatives is what to do about customized derivatives. The use of derivatives to manage risk by sophisticated corporations is pervasive. Sometimes those derivatives are significantly cheaper or more effective if they cover the exact risk rather than using one or more standard derivatives to approximate the desired protection. It would be a great shame to lose those efficiencies altogether by banishing customized derivatives, but there is also a fear that financial firms will deliberately sell slightly non-standard derivatives in order to avoid the tougher rules on standardized ones.

                          This is another area where the devil is in the details. The trick will be to provide incentives or requirements to use standard derivatives where possible, while leaving the ability to use customized ones where they serve a genuine need. The administration’s proposal attempts to strike this balance. It will be interesting to see what comes out the other end of the legislative process...

                          One solution is to subject transactions for customized derivatives (which have their uses) that cannot go through organized exchanges or clearinghouses to discouragingly strict margin and capital requirements.

                            Posted by on Sunday, July 19, 2009 at 08:01 PM in Economics, Financial System, Regulation | Permalink  Comments (16) 

                            "The Most Misunderstood Man in America"

                            Michael Hirsh wonders why the Obama administration hasn't consulted Joe Stiglitz more often on economic policy issues, and suggests the answer is an ongoing feud with Larry Summers:

                            The Most Misunderstood Man in America, by Michael Hirsh, Newsweek: ...Even in the contentious world of economics, [Joe Stiglitz] is considered somewhat prickly. And while he may be a Nobel laureate, in Washington he's seen as just another economic critic—and not always a welcome one. Few Americans recognize his name... Yet Stiglitz's work is cited by more economists than anyone else's in the world... And when he goes abroad—to Europe, Asia, and Latin America—he is received like a superstar, a modern-day oracle. ...

                            Stiglitz is perhaps best known for his unrelenting assault on an idea that has dominated the global landscape since Ronald Reagan: that markets work well on their own and governments should stay out of the way. ... The subprime-mortgage disaster was almost tailor-made evidence that financial markets often fail without rigorous government supervision, Stiglitz and his allies say.

                            The work that won Stiglitz the Nobel in 2001 showed how "imperfect" information that is unequally shared by participants in a transaction can make markets go haywire, giving unfair advantage to one party. The subprime scandal was all about people who knew a lot—like mortgage lenders and Wall Street derivatives traders—exploiting people who had less information... As Stiglitz puts it: "Globalization opened up opportunities to find new people to exploit their ignorance. And we found them." ... The solution, Stiglitz says, is to ... develop a balance between market-driven economies—which he favors—and government oversight.

                            Stiglitz has warned for years that pro-market zeal would cause a global financial meltdown very much like the one that gripped the world last year. ... Since at least 1990, Stiglitz has talked about the risks of securitizing mortgages, questioning whether markets and authorities would grow careless "about the importance of screening loan applicants." ...

                            To his critics—and there are many—Stiglitz is a self-aggrandizing rock-thrower. ... Stiglitz's defenders say one possible explanation for his outsider status in Washington is his ongoing rivalry with Summers. ... Since the early '90s, when Summers was a senior Treasury official and Stiglitz was on the Council of Economic Advisers, the two have engaged in fierce policy debates. The first fight was over the Clinton administration's efforts to pry open emerging financial markets, such as South Korea's. Stiglitz argued there wasn't good evidence that liberalizing poorly regulated Third World markets would make any one more prosperous; Summers wanted them open to U.S. firms.

                            The differences between them grew bitter in the late 1990s, when Stiglitz was chief economist for the World Bank and took issue with the way Treasury Secretary Robert Rubin, and Summers, who was then deputy secretary, were handling the Asian "contagion" financial collapse. After World Bank president James Wolfensohn declined to reappoint him in 1999, Stiglitz became convinced that Summers was behind the slight. Summers denies this...

                            Despite the Obama team's occasional efforts to reach out to him, Stiglitz remains deeply unhappy about the administration's approach to the financial crisis. Rather than breaking up or restructuring the big banks that failed, "the Obama administration has actually expanded the notion of 'too big to fail,' " he says. ...

                            Today, settled as a professor at Columbia, Stiglitz occasionally finds himself welcomed in the nation's capital, though usually at the other end of Pennsylvania Avenue, to testify before Congress. While he had no great desire to go back into government, friends say he was deeply disappointed when an offer didn't come from Obama last fall. Not surprisingly, Stiglitz believes his old rival was behind it, though Summers denies this. ... Stiglitz may a prophet without much honor in Washington, but he seems to be determined to keep the prophecies coming.

                            This isn't the first time Michael Hirsh has written about this. Though the question has changed from "why didn't Obama appoint Stiglitz to a key position within the administration" to "why doesn't the administration consult Stiglitz more often on economic policy issues," last December he made most of the same points:

                            OK, enough with the Obamamania already. I have a major bone to pick with our all-praised president-elect. Where, Mr. Obama, is Joseph Stiglitz? Most pundits have pretty much gone ga-ga over your economic team: The brilliant Larry Summers... The judicious Tim Geithner... The august Paul Volcker... But lost amid the cascades of ticker tape is the fact that, astonishingly, you didn't hire the one expert who's been right about the financial crisis all along—and whose Nobel Prize-winning ideas will probably be most central to fixing the global economy.

                            This is not speculation. A source close to Stiglitz told me Thursday that the Columbia University economist has been left out in the cold, even though he was expecting at least an offer. ...

                            Stiglitz, more than anyone on the Washington scene, was the biggest fly in the ointment of "free-market fundamentalism" pressed on the world in the '90s by Summers, Geithner and their mentor, former Treasury secretary Robert Rubin—advice that has now contributed to the worst financial crisis since the Great Depression. ... Sure, I know the rap on Stiglitz:... he's too often "off the reservation," won't stay on the message, and doesn't play well with others—especially Summers. (Summers is said to have pressured former World Bank president Jim Wolfensohn to fire Stiglitz in the '90s...) Unquestionably, Stiglitz has occasionally gone overboard in his criticisms... But Obama has made a point of declaring that he wants dissonant voices in his administration. So why not Joe Stiglitz?

                            I can understand not offering Stiglitz a key position within the administration, he might not always stay on message and that scares the political managers (though the fact that they accepted Summers undercuts the argument that they wanted to avoid people who are potentially politically explosive, though perhaps they'd agree to one, but not two, and Summers was the one). But in the first article Stiglitz is quoted as saying that "We've talked one or two times," and it's harder to understand why the administration hasn't consulted him more often on economic policy issues.

                            Update: Paul Krugman:

                            Morning Joe: I think this Michael Hirsch piece on Joe Stiglitz somewhat misses the point.

                            Yes, Joe should be playing a bigger role — he’s an insanely great economist, in ways you can’t really appreciate unless you’re deep into the field. I’d say that he’s more his generation’s Paul Samuelson than its John Maynard Keynes: as with Great Paul, almost every time you dig into some sub-field of economics — finance, imperfect competition, health care — you find that much of the work rests on a seminal Stiglitz paper.

                            But the larger story is the absence of a progressive-economist wing. A lot of people supported Obama over Clinton in the primaries because they thought Clinton would bring back the Rubin team; and what Obama has done is … bring back the Rubin team. Even the advisory council, which is supposed to bring in skeptical views, does so by bringing in, um, Marty Feldstein.

                            The point is that even if you think the leftish wing of economics doesn’t have all the answers, you’d expect some people from that wing to be at the table. Yet I don’t see Larry Mishel, or Jamie Galbraith … Jared Bernstein is it.

                            Joe Stiglitz stands out because in addition to being on the progressive wing, he’s also, as I said, a giant among academic economists. But I think the real story is more about excluded points of view than excluded people.

                              Posted by on Sunday, July 19, 2009 at 01:44 AM in Economics, Policy, Politics | Permalink  Comments (58) 

                              links for 2009-07-19

                                Posted by on Sunday, July 19, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (2) 

                                Saturday, July 18, 2009

                                "Financial Invention vs. Consumer Protection"

                                Robert Shiller says that while a Consumer Financial Protection Agency is a good idea, it wouldn't have prevented the housing bubble:

                                Financial Invention vs. Consumer Protection, by Robert J. Shiller, Commentary, NY Times: James Watt, who invented the first practical steam engine in 1765, worried that high-pressure steam could lead to major explosions. So he avoided high pressure and ended up with an inefficient engine. It wasn’t until 1799 that Richard Trevithick ... created a high-pressure engine that opened a new age of steam-powered factories, railways and ships.

                                That is how innovation often proceeds — by learning from errors and hazards and gradually conquering problems through devices of increasing complexity...

                                Our financial system has essentially exploded... We need to invent our way out..., and, eventually, we will. That invention will proceed mostly in the private sector. Yet government must play a role, because civil society demands that people’s lives and welfare be ... protected from overzealous innovators who might disregard public safety and take improper advantage of nascent technology.

                                The Obama administration has proposed a ... Consumer Financial Protection Agency, which would be charged with safeguarding consumers against things like abusive mortgage, auto loan or credit card contracts. The new agency is to encourage “plain vanilla” products that are simpler and easier to understand. But representatives of the financial services industry have criticized the proposal as a threat to innovation...

                                If a consumer agency had been set up 20 years ago, would the subprime mortgage crisis have been prevented? We don’t know, but it seems improbable. Such an agency would most likely have slowed some abusive practices... That ... would have reduced the severity of the crisis, and that is no small thing.

                                On the other hand, unless these regulators were extremely vanilla in approach and just said no to any innovation, or unless they had an unusually deep understanding of speculative bubbles, I think they would have allowed most of those subprime mortgages. And they probably wouldn’t have had the detailed knowledge they would have needed to halt the decline of lending standards on prime mortgages in a timely way. In all likelihood, we would still be in this financial crisis.

                                In short, the new agency seems a good idea, and, if it is created, it should ... support innovation and ...be staffed by people who know finance..., including some who appreciate that human behavior must be understood and factored into financial design.

                                But that leaves us with the deeper quandary: Our society needs financial innovation, and still seems vulnerable to ... speculative bubbles that create truly big problems. Even if they can be mitigated, periodic crises may not be preventable, at least not by banning abusive credit cards or even by throwing the bad guys in jail. ...

                                The effectiveness of our free enterprise system depends on allowing business people to manage the myriad risks — including the risk of asset bubbles — that impinge on their operations in the long term. And this process needs constant change and improvement.

                                Complexity is not in itself a bad thing. ... A laptop computer is an immensely complex instrument... Yet it can be designed well so that it seems plain vanilla to the ultimate user.

                                And as for steam engines, the modern turbine high-pressure versions are not plain vanilla in any sense. They are sophisticated triumphs of engineering. They help generate most of our electric power with very few accidents.

                                I'm not sure his example works. If a modern turbine engine fails, it doesn't threaten the broader economy. If the engines were interconnected, so interconnected that the failure of one could bring them all down (beyond a single set at a given geographical location), then they might threaten the entire economy and be more like financial innovation.

                                The point is, because the costs of a steam or turbine engine blowing up are mostly localized, we can allow innovation to occur with very little regulation within the private sector without too much concern. Of course, we need to make sure that, say, a steam engine blowing up in a garage doesn't harm the neighbors, or harm any employees who might be there, and we also want to protect the inventors from themselves to some extent, but since the threat from an explosion is localized, we can allow innovation to proceed in the private sector under relatively light regulation without incurring great risks.

                                Suppose, however, that the turbine engines were interconnected and the failure of a single engine anywhere in the system could bring the whole system down, and not just for a day or two, but for months and months, and that the loss of so much power for so long would wreck the economy. In such a case, how much trust would you be willing to place in an unregulated private sector development of a new engine type for the grid? How much complexity would you be comfortable with? How much testing would you want the engines to undergo before being allowed in use? Would the fact that they have "very few accidents" as Shiller notes be of comfort?

                                When the dangers are great, we need to be careful. The financial grid is interconnected in just this way, and we need to do all that we can to ensure that new innovations do not become engines of destruction yet again.

                                  Posted by on Saturday, July 18, 2009 at 04:23 PM in Economics, Financial System, Regulation | Permalink  Comments (24) 

                                  "Let The Good Times Roll Again?"

                                  The question of how to interpret Goldman Sachs' unexpectedly large earnings has been addressed here and here (with an addendum at the bottom of the second post). One lesson appears to be that the bad incentives underlying executive compensation are still be present. However, exactly why that is the case - other than the sheer size of the profits - has not been fully addressed. This argument from Lucian Bebchuk takes a step in that direction by noting that the Goldman Sachs' bonuses are a reward for short-term gains, when we ought to be tying compensation to long-run performance. Thus, the problematic incentive to take on large amounts of risk in pursuit of immediate profits is still present. (Though it's not included below, he also argues that compensation should be based upon the long-run value of a broad basket of securities, not just common shares as has been typical in the past, to avoid distorting incentives in a way that gives executives another reason to take on too much risk):

                                  Let the good times roll again?, by Lucian Bebchuk, Commentary, Project Syndicate: Goldman Sachs announced this month plans to provide bonuses at record levels, and there are widespread expectations that bonuses and pay in many other firms will rise substantially this year. Should the good times start rolling again so soon?

                                  Not without reform. Indeed, one key lesson of the financial crisis is that an overhaul of executive compensation must be high on the policy agenda.

                                  Indeed, pay arrangements were a major contributing factor to the excessive risk-taking by financial institutions that helped bring about the financial crisis. By rewarding executives for risky behaviour, and by insulating them from some of the adverse consequences of that behaviour, pay arrangements for financial-sector bosses produced perverse incentives, encouraging them to gamble.

                                  One major factor that induced excessive risk-taking is that firms’ standard pay arrangements reward executives for short-term gains, even when those gains are subsequently reversed. Although the financial sector lost more than half of its stock-market value during the last five years, executives were still able to cash out, prior to the stock market implosion, large amounts of equity compensation and bonus compensation.

                                  Such pay structures gave executives excessive incentives to seek short-term gains ... even when doing so would increase the risks of an implosion later on. ...

                                  Following the crisis, this problem has become widely recognised... But it still needs to be effectively addressed: Goldman’s recent decision to provide record bonuses as a reward for performance in the last two quarters, for example, is a step in the wrong direction.

                                  To avoid rewards for short-term performance and focus on long-term results, pay structures need to be re-designed. As far as equity-based compensation is concerned, executives should not be allowed to cash out options and shares given to them for a period of, say, five years after the time of “vesting”...

                                  Similarly, bonus compensation should be redesigned to reward long-term performance. For starters, the use of bonuses based on one-year results should be discouraged. Furthermore, bonuses should not be paid immediately, but rather placed in a company account for several years and adjusted downward if the company subsequently learns that the reason for awarding a bonus no longer holds up. ...

                                  A thorough overhaul of compensation structures must be an important element of the new financial order.

                                  The latest I'm aware of on this topic is draft legislation Barney Frank circulated today:

                                  All publicly traded U.S. companies, and particularly financial firms, would face new executive-compensation requirements under draft legislation circulated Friday by a top lawmaker in the U.S. House of Representatives.

                                  The measure proposed by Rep. Barney Frank, D-Mass., would give shareholders a greater ability to weigh in on compensation packages, require compensation consultants to satisfy independence criteria established by the government and would ensure that compensation committees are made up of independent directors. ...

                                  Banks, broker-dealers, investment advisers and all other financial firms would be required to disclose any incentive-based compensation structures, while federal regulators would be able to limit "inappropriate or imprudently risky" pay practices.

                                  The panel is expected to take up some form of the legislation next week.

                                  This legislation would give regulators the power to limit executive pay structures that they believe are excessively risky, but exactly what types of compensation structures would be allowed or required under this legislation is a bit vague. It doesn't sound like it will be as restrictive as Lucian Bebchuk would like, but we shall see.

                                  There are two related issues here. First, was the compensation fair in terms of being a reward for productive activities such as directing capital where it was most needed, or distributing and reducing risk? Before the crash, some people tried to make that argument, but for financial executives, it seems clear that the compensation was based upon bubble rather than fundamental values, and that this lead to inflated rewards relative to the value that was actually created. But even for non-financial executives, it's hard to believe that the generous compensation high-level managers and executives received in recent years is due entirely to their superior productivity. The "say on pay" part of the proposed legislation tries to give shareholders a greater voice in setting compensation levels, and is directed at this problem.

                                  The second issue is whether the compensation structures that have been used in the past lead to incentives to accumulate more risk than is optimal. It appears that they did, and the second part of the proposal is an attempt to overcome this problem by giving regulators the ability to limit systemically risky practices.

                                  There are two types of excessive risk to be worried about, but only one is a systemic risk, i.e. a risk to the overall economy. First, a particular executive compensation structure may give an executive the incentive to take on too much risk - more than shareholders desire - but there is no danger to the overall financial system. This type of excessive risk taking needs to be prevented, but it is not a danger to the overall economy, and regulators are generally concerned with microeconomics questions concerning optimal incentive structures. Second, there is excessive risk that endangers the entire financial system and the broader economy. This is systemic risk that is the target of the proposed legislation, the kind of risk regulators such as the Fed are concerned with, and the kind we must do our best to eliminate if we want to avoid a repeat of the present crisis.

                                  To me, both elements of the proposed legislation - the part that gives shareholders the power to limit compensation levels and the part that gives regulators the power to limit risky compensation schemes - seem vague and rather weak. I hope that changes as the legislation develops.

                                    Posted by on Saturday, July 18, 2009 at 12:24 AM in Economics, Financial System, Market Failure, Regulation | Permalink  Comments (39) 

                                    links for 2009-07-18

                                      Posted by on Saturday, July 18, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (33) 

                                      Friday, July 17, 2009

                                      FRBSF: The Current Economy and the Economic Outlook

                                      Mary Daly of the Federal Reserve Bank of San Francisco gives her views on the current economy and the outlook. There are two issues revealed in the graphs below that I wish I had time to discuss further. First, the graph labeled "Gaps are typical in downturns" shows what happens to state finances in recessions, and how severe the current recession is in that regard. The budget problems of the states in downturns is a key factor working against recovery -- many states have little choice but to reduce spending or increase taxes when the economy goes into recession -- and we need to find a way to fix that problem so that this recovery impeding mechanism doesn't get in the way the next time we face the problem of reviving a stalled economy. Second, the last graph shows the relationship, or rather the lack of a relationship, between budget deficits and inflation. This is a counterpoint to the objection to using fiscal policy based upon the claim that it will have undesirable inflationary consequences. It is also noteworthy, as shown in the second to last graph, that inflationary expectations remain well anchored:

                                      FedViews, by Mary Daly, FRBSF [Charts]: Financial markets are improving, and the crisis mode that has characterized the past year is subsiding. The adverse feedback loop, in which losses by banks and other lenders lead to tighter credit availability, which then leads to lower spending by households and businesses, has begun to slow. As such, investors’ appetite for risk is returning, and some of the barriers to credit that have been constraining businesses and households are diminishing.

                                      Continue reading "FRBSF: The Current Economy and the Economic Outlook" »

                                        Posted by on Friday, July 17, 2009 at 02:04 PM in Economics | Permalink  Comments (11) 

                                        Paul Krugman: The Joy of Sachs

                                        What can we learn from the fact that Goldman Sachs earned record profits despite the stagnation in the broader economy?:

                                        The Joy of Sachs, by Paul Krugman, Commentary, NY Times: The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits — and it’s preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?

                                        First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America.

                                        Second, it shows that Wall Street’s bad habits — above all, the system of compensation that helped cause the financial crisis — have not gone away.

                                        Third, it shows that by rescuing the financial system without reforming it, Washington has ... made another crisis more likely.

                                        Let’s start by talking about how Goldman makes money.

                                        Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared...

                                        Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? ...

                                        Goldman’s role in the financialization of America was similar to that of other players, except for one thing: Goldman didn’t believe its own hype. ... Goldman, famously, made a lot of money selling securities backed by subprime mortgages — then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.

                                        And Wall Streeters have every incentive to keep playing that kind of game.

                                        The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. ... You have every reason, then, to steer investors into taking risks they don’t understand.

                                        And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong. ... Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.

                                        You can argue that such rescues are necessary if we’re to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system’s liabilities are now backed by an implicit government guarantee.

                                        Now, the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didn’t abuse their privileges. This time, new regulations are still in the drawing-board stage — and the finance lobby is already fighting against even the most basic protections for consumers.

                                        If these lobbying efforts succeed, we’ll have set the stage for an even bigger financial disaster a few years down the road. The next crisis could look something like the savings-and-loan mess of the 1980s, in which deregulated banks gambled with, or in some cases stole, taxpayers’ money — except that it would involve the financial industry as a whole.

                                        The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.

                                        The other reason we are more vulnerable is, as this story points out, is that "two giants" are emerging from the financial crisis, and they are "starting to tower over the handful of financial titans that used to dominate the industry." Thus, if other competitors cannot recover similarly, and if the government does not use regulation and other means to level the playing field, the banking industry could end up even more concentrated and vulnerable than it was before (a point I wish I'd made here).

                                          Posted by on Friday, July 17, 2009 at 12:42 AM in Economics, Financial System, Regulation | Permalink  Comments (88) 

                                          Fed Watch: FOMC Forecasts - Reality or Fantasy?

                                          Tim Duy analyzes the economic projections in the minutes from the June FOMC meeting:

                                          FOMC Forecasts - Reality or Fantasy?, by Tim Duy: It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.

                                          The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":

                                          In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.

                                          Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.

                                          Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then accelerate further in subsequent years. Is such optimism justified? Yes and no.

                                          I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle. Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007. Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:



                                          See also consumption data:

                                          Continue reading "Fed Watch: FOMC Forecasts - Reality or Fantasy?" »

                                            Posted by on Friday, July 17, 2009 at 12:18 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (13) 

                                            links for 2009-07-17

                                              Posted by on Friday, July 17, 2009 at 12:04 AM Permalink  Comments (13) 

                                              Thursday, July 16, 2009

                                              "Congress Must not Touch the Federal Reserve"

                                              Mark Gertler says the Fed's independence should not be compromised:

                                              Congress must not touch the Federal Reserve, by Mark Gertler: The economy was experiencing the worst recession since the war. In Congress, members were beginning to wonder whether the Federal Reserve’s intervention strategy was extracting too great a toll on the economy. Some started to suggest publicly that it may be time to rein in the central bank’s independence.

                                              Sound familiar? Though they bear a strong resemblance to ... today, the events I refer to in fact happened in the early 1980s, in the midst of what was then the most serious economic crisis since the Depression. The head of the institution under threat of losing its independence was none other than Paul Volcker.

                                              Of course, Mr Volcker would go on to be recognised as one of the great central bankers of modern times. He would do so by standing firm against political pressures. By continuing on the course he set out, the economy recovered and a new era of price and output stability began. ... In the Volcker era, the political outcry occurred in the midst of the economic contraction that the Fed had engineered to tame inflation. The costs of the policy were plain to see, but the long-term benefits that would eventually emerge were difficult for many to imagine at the time.

                                              The Fed’s role has been different this time round. Rather than trying to slow the economy, it has been acting to contain the damage brought on by the most complex financial crisis of modern history. By the accounts of many, the Fed has acted masterfully under difficult circumstances. ...

                                              Given that hard times remain, nonetheless, it is natural that Congress is questioning the Fed, just as it did in the early 1980s. ... Unfortunately, the Fed cannot demonstrate what would have happened to the economy if it had not intervened in the way it did. Many observers agree that the situation would be far worse than it is today. Yet discussions of reining in central bank powers proceed as if the financial system would have stabilised itself without any Fed intervention.

                                              The Fed well understands the lesson from the Volcker era that it can be effective only when it resists political attempts to influence its decisions. One can only hope that sober voices in Congress who appreciate the importance of central bank independence will help keep Capitol Hill from taking any measures that do permanent damage to the Fed.

                                              A more constructive route for Congress would be to proceed with regulatory reform that would prevent a repeat of the current situation. At the core of the crisis is an antiquated regulatory system that permitted large financial institutions to take excessive risks. By giving the Fed the ability to monitor risk-taking by these institutions, Congress would diminish greatly the likelihood the central bank would again need to intervene directly in private credit markets.

                                              The Fed may not have been perfect in its response to this or previous crises, but that doesn't mean that a less independent Fed would have done better. Taking away Fed independence - including subjecting the Fed to audits by the GAO - would be a mistake. In addition, if we are going to strengthen regulatory authority so that we can better monitor and reduce systemic risk that threatens the financial system - and we should - that authority needs to be in the hands of an independent entity, and the Fed is the natural place for this. Finally, its role in regulating system-wide risk is complementary to many of its other activities. For example, its role as a systemic risk regulator would involve monitoring risk within large institutions. Should a bank get into trouble, that would be helpful in assessing whether the bank should be granted access to the discount window in its capacity as lender of last resort.

                                              We need to maintain an independent Fed, to give the Fed the powers it needs to monitor and regulate the level of overall risk, and to give the Fed the authority it now lacks to put banks through an orderly bankruptcy process so it can avoid bailing out financial institutions that are in trouble and a threat to overall the financial system.

                                              Update: See Willem Buiter for a longer, more detailed version of many of the same points, e.g.:

                                              Probably the single most damaging  failure of the US Treasury, the US Congress and the US financial regulators was there inability/unwillingness to create a special resolution regime (SRR) with structured early intervention and prompt corrective action for all systemically important financial institutions (those too big, too complex, to interconnected, too international or too politically connected to fail in the ordinary Chapter 11 or Chapter 7 way).  ...

                                              But however weak its past performance and credentials, they are rock-solid compared to those of the other candidate institutions. ...

                                              Only the Fed can fulfill the macro-prudential regulator-supervisor role.  That is because it has the short-term deep pockets.  It is the source of the ultimate, unquestioned liquidity in the economy, through its monopoly of the issuance of base money.  Without the short-term deep pockets, a macro-prudential regulator/supervisor cannot act as lender of last resort, market maker of last resort or provider of enhanced credit support.  It would be ... toothless...

                                              He also makes this point:

                                              The problem with this solution of the macro-prudential regulator/supervisor problem is that it is incompatible with central bank operational independence as interpreted since 1989 or thereabouts. ... When the central bank plays a quasi-fiscal role, as the Fed has been doing on an unprecedented scale in the current crisis, the fullest possible degree of accountability to the Congress, the tax payer and the citizens is essential.  The Fed has no mandate to engage in quasi-fiscal operations, even when it is for a good cause.  ...

                                              If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution.  Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury.

                                              You pick.

                                              Okay. As much as possible, monetary policy should be kept out of the hands of politicians.

                                              Update: Jim Hamilton (I also signed the petition a day or two ago):

                                              I joined many of my colleagues in urging Congress and the President to remember just how valuable an independent central bank is for the ordinary citizens of this country. You may not pay much attention to central bank independence. But you'll miss it when it's gone.

                                                Posted by on Thursday, July 16, 2009 at 06:01 PM in Economics, Financial System, Monetary Policy, Regulation | Permalink  Comments (36) 

                                                Why is the Recovery of Modern Labor Markets So Slow?

                                                Arnold Kling is puzzled by current macroeconomic developments, particularly that banks are doing better than expected, and labor doing worse. I want focus on the second:

                                                Relative to what a consensus forecast might have predicted last October, it appears that:

                                                Two Puzzles of Current Macroeconomic Condition, Econlog: ...[E]mployment has fallen more than expected. ... Why is the severity of the recession so much greater in the labor market than in the goods market? ...

                                                My answer ... is that we are superimposing a heterogeneous labor force on top of a trend of rapid productivity growth. In some sense, we are seeing an amplified version of what took place from 2001 through 2003. This was dubbed a "jobless recovery," but I called it a "productivity-cushioned recession." That is, growth in trend productivity of 2 to 3 percent per year is maintaining output higher than it would be if the trend were less than 2 percent. (Trend productivity growth is productivity growth measured over periods of five years or more, to iron out short-term fluctuations.)

                                                The heterogeneous labor force means that it is very hard to reallocate labor from sectors that decline. Forty years ago, there were lots of industries that employed men with only a high school education. Today, there are fewer such industries, so that when the construction sector and the automobile sector shrink, the job losers have almost nowhere to go. These guys aren't going to turn into school teachers or nurses next month--or ever. It would be nice if the stimulus were actually creating construction jobs, but the reality is that the net increase in state construction projects is probably infinitesimal, as the states wind up juggling their budgets to keep Medicaid going. ...

                                                There may be another factor as well. I think part of the problem - and the statistics support this interpretation - is that the economy is not creating jobs that pay as well as the jobs people are losing. Being unwilling to take a cut in pay, unemployed workers resist for awhile and keep looking, as long as they can anyway, and it isn't until they begin to exhaust the resources supporting the search and to accept the reality of a new job market that they finally lower their aspirations and take a cut in pay (or exit the labor force altogether). So it's not just that workers can't be retrained fast enough for the new, good jobs that are available, it's also that the availability of the jobs is not sufficient to reemploy workers at their previous rates of compensation.

                                                But there is a factor that works against a long, drawn out search for a job that is a good fit with skills. If unemployment compensation is low, or does not last very long, then a worker may not be able to take the time needed to find a good employment match (though for workers with more personal assets to rely upon, i.e. higher paid workers generally, or another source of income such as an employed spouse that can help to tide them through, searches could still be relatively extended):

                                                US Unemployment Benefits in International Context, by Mathew Yglesias: Gary Burtless has an interesting paper reviewing the social safety net measures in the American Recovery and Reinvestment Act. If you read the paper you’ll see that even though these elements of ARRA have gotten less discussion than the state aid and infrastructure elements, boosts in safety net spending are actually the largest segment of ARRA spending. For blogging purposes, though, I really just wanted to reproduce this chart showing how relatively stingy unemployment benefits are in the United States:


                                                In addition to being relatively stingy, unemployment insurance in many ways fails to protect people from the most salient economic risks. Older workers tend to earn more money than younger workers, in part because over the years they’ve acquired sector- and firm-specific skills that their younger colleagues lack. When they get laid off, however, these skills become devalued and even when recovery comes it’s often difficult to get a new job that’s as remunerative as the old one. This, in turn, encourages the political system to focus a lot of preservation of the status quo which winds up reducing long-run growth potential. Gene Sperling’s idea of comprehensive wage insurance would help solve this issue and do a lot of good.

                                                  Posted by on Thursday, July 16, 2009 at 10:52 AM in Economics, Unemployment | Permalink  Comments (73) 

                                                  "Ideas and Rules for the World in the Aftermath of the Storm"

                                                  This is a summary of the "causes and nature" of the financial crisis. I've added a few comments along the way:

                                                  Lessons for the future: Ideas and rules for the world in the aftermath of the storm, Part I, by Guido Tabellini, Vox EU: Almost two years after the beginning of the financial crisis that has overwhelmed the world economy, it may be time to draw some conclusions and outline the main lessons for the future. Is it really a turning point for market economies, a systemic crisis that will radically change the division of tasks between state and market? Or will everything be back to normal once a number of important technical problems concerning financial regulation are solved?

                                                  Market failure

                                                  Let us start with the market failure. There is no doubt that the crisis has revealed a serious failure in one of the most sophisticated markets in the world – modern finance. One of the crucial tasks of financial markets is allocating risk. They have failed stunningly. Risk has been underestimated, and many intermediaries took excessive risks. The reasons for this failure and the implications for economic policy, however, are less clear.

                                                  One possible explanation is that it was just due to poor judgement. Financial innovation has been so fast that even sophisticated operators were not always able to fully understand the degree of risk of the financial instruments that were constructed. The systemic implications of those instruments were even less clear. As a consequence, many investors overestimated global financial markets’ capacities, overlooking the systemic risk and the illiquidity risk that proved crucial in this crisis. This mistake can partly be explained by the difficulty of correctly evaluating the probability of rare or infrequent events. If this were all, there would be no need to worry. This crisis will not be forgotten, and it will certainly leave a mark on risk management practices and organisation models of financial intermediaries.

                                                  There is also a less benevolent explanation for the failure of financial markets, however, that highlights a systematic distortion of individual incentives rather than a mistake. First of all, the “originate and distribute” model, which separates the concession of the loan from the financial investment decision, entails obvious moral hazard problems. Secondly, rating agencies, paid by those issuing the very assets being rated, experience an obvious conflict of interest. Third, managers’ remuneration schemes encourage myopic behaviour and excessive risk taking – if the bonus depends on short-term performance indicators, each individual manager is induced to take risks that are large but rare. If this is true, it means that we cannot trust the ability of markets to learn. Distorted incentives must also be redressed, through new, stricter regulation, even at the cost of significantly slowing down financial innovation or giving up some of its beneficial effects.

                                                  It's worth pointing out that there are distinct market failures here because the best policy to overcome the market failure depends upon the type of market failure it addresses. I would have also highlighted the asymmetric information problem in these markets since the desire for reliable information on risks is what drives the need for the ratings agencies, and I would have also noted that the mal incentives extended beyond just the "originate and distribute" model, homeowners (with no recourse loans), real estate agents (who want to sell as many houses as they can for as much as they can to increase commissions), appraisers (who share some of the conflicts that ratings agencies have and also exist to solve an information problem), and so on. So it wasn't just banks and brokers responding to the bad incentives of the originate and distribute model, just about every link in the chain had bad incentives that distorted outcomes in ways that encouraged the build up of excessive risk.

                                                  Also, these two explanations are not mutually exclusive. The market failures can lead to excessive risk accumulation, and the extent of this risk could be misperceived. I think it was the interaction of the market failures and the misperception, not predominantly one or the other. If the market failures do not allow dangerous risk levels to accumulate, misperceiving it is not nearly so dangerous.

                                                  Regulatory failure

                                                  Mistakes in risk management cannot be only attributed to private operators. Supervisors have made major mistakes as well, allowing banks to accumulate off-balance-sheet liabilities and tolerating an excessive growth of leverage (i.e. the ratio of total assets to shareholders' equity) and indebtedness. This could be due to capture of supervisors by banks, arbitrage and international competition among supervising agencies, or implementation deficiencies. But more importantly, there has been a fundamental conceptual mistake –monitoring each financial institution solely on an individual basis, considering as the value at risk of the individual intermediary without taking systemic risk into any consideration. This is the same mistake that the individual intermediaries made.

                                                  I agree with the conceptual mistake noted here, but there was another one too. Everyone thought it was a good idea to get risk off of the traditional banking systems balance sheet. Somehow the notion was present that this would - through worldwide distribution of risks - reduce the chances of a meltdown to nearly zero, i.e. to reduce systemic risk. This, of course, turned out to be wrong since risk did, in fact, get concentrated in dangerous ways.

                                                  A crisis of these proportions cannot have stemmed exclusively from mistakes in risk management. The reason is that high-risk investments were relatively small compared to the overall dimension of global financial markets (Calomiris 2007). Many observers expected that the American real estate bubble would burst. But few imagined that that would overwhelm financial markets all over the world. If this has happened, it must be that the shocks hit important amplifying mechanisms. This amplification can largely be attributed to financial regulation. In other words, even more than a market failure, the crisis was triggered by a failure of regulation (see the eleventh ICMB-Geneva Report, summarised by Wyplosz 2009).

                                                  Not so much that regulation was too lenient, or that deregulation had gone too far – rather, the very founding principles of regulation have amplified the effects of a shock that in reality was not that large. Subprime mortgages, the financial products whose insolvency has originated the current crisis, amount to about one trillion dollars. It is a large number in absolute terms, but small with respect to the total of about 80 trillion dollars of financial assets of the world banking system. As a comparison, consider that the losses originally estimated in 1990 during the savings and loans crisis were about 600-800 millions of dollars, less than the total of subprime mortgages, but the total amount of financial assets was much smaller then. Yet, that crisis was quickly overcome without major upheavals. Why has it been so different this time?

                                                  There are two aspects of regulation that have amplified the effects of the initial shock: (i) the procyclicality of leverage, induced by constraints on banks’ equity, and (ii) accounting principles that require assets to be evaluated according to their market value. In case of a loss on investments, which erodes the capital of financial intermediaries, capital adequacy constraints under the Basel accord require reduced leverage and thus force banks to sell assets to obtain liquidity. The problem is thus exacerbated: forced sales reduce the market price of assets, worsening the balance sheets of other investors and inducing further forced sales of assets, in a vicious circle. Exactly the opposite happens during a boom: capital gains on portfolio assets allow intermediaries to expand leverage, which means taking on more debt in order to acquire new assets, in such a way that the price of assets is pushed up and other intermediaries become indebted chasing increasingly high prices. In sum, banking regulation has created a mechanism that amplifies the effects of shocks and accentuates cyclic fluctuations in the indebtedness of financial intermediaries.

                                                  I am coming around on the need to regulate leverage, and it does appear to have important cyclical variations. As to the mark to model versus mark to market debate, I still don't like the bad incentives and the possibility for error that exists with the mark to model framework. But the general question of how to best value the assets on a balance sheet during a time like this is an area where I still have some uncertainty.

                                                  One of the main lessons to be drawn from this crisis is that we need to deeply reconsider financial regulation and ask ourselves what its ultimate objective is – correcting distorted incentives of agents, creating buffers that reduce procyclicality of leverage, or reducing risks, and, if so, which risks? A sound regulatory system should address two concerns:

                                                  1. Correct distorted incentives of individual intermediaries or financial operators;
                                                  2. Reduce negative externalities and systemic risk, bearing in mind that evaluating risk management practices within individual intermediaries is not sufficient.

                                                  Finally, inevitably, this will have to translate into rules that reduce the size of leverage in absolute terms and its procyclicality.

                                                  And just to amplify a point from above, since a variety of problems caused the crisis, no single solution can fix them all. It will take a variety of fixes to shore up the system going forward.

                                                  Mistakes in managing the crisis

                                                  It is widely held that the current situation is mostly the result of economic policy mistakes (in regulation, in supervision and, according to some, monetary policy) made before the outbreak of the crisis. The corollary of this thesis is that it is sufficient to correct these mistakes in order to avoid the next crisis. But the truth is that many serious mistakes have been made during the management of the crisis and have significantly contributed to worsening the situation.

                                                  The unclear causes of the crisis have resulted in its management being improvised from step one without a clear path in mind. Bear Stearns was saved, Lehman Brothers failed, AIG was saved. Each decision was improvised, guided by neither pre-established criteria nor a sound and consistent strategy. The result is that, rather than boosting confidence, economic policy interventions have contributed to increasing confusion, panic, and fear.

                                                  I have made this point many times as well, and believe it created a lot of additional uncertainty. The handling of Lehman was a costly misstep.

                                                  Loss of confidence is always at the heart of any financial crisis. Expectations concerning the behaviour of authorities and other operators play a fundamental role in determining whether there will be contagion or whether the shock will be absorbed. But in order to influence expectations and restore confidence, policymakers must act according to procedures and criteria that are agreed upon and well understood, identifying the ultimate objectives and the policy tools to reach them. There has never been such clarity in this crisis, and that is an important lesson. To avoid repeating similar mistakes, it will be necessary to elaborate new and detailed procedures for managing complex phenomena such as the bankruptcy of large banks and more general policies aimed at preventing the worsening of systemic crises.

                                                  I agree, but how do we make these plans credible? We cannot bind future policymakers - they can do as they please - so how do credibly commit to these plans? When the next crisis hits and we have bankruptcy plans for a too big to fail institution, will we actually carry through or will we worry that it might not work out so well after all and step in as we did this time? Still, I think it's important that we try, and if the plans are good ones, we at least have a chance.

                                                  Given that large banks with systemic implications are typically multinational, these procedures will need to be coordinated at the international level. This is not easy, since, after all, only the state, and hence taxpayers, can cover systemic risk. Taxpayers must take on the burden of failing institutions’ debts, at least temporarily. But which state, which taxpayers, when the institution is a large multinational bank?

                                                  Although difficult, this problem is not new. Financial crises in developing countries, which occurred almost yearly in the 1990s, have now become less frequent and less devastating thanks to the procedures of crisis management elaborated within the International Monetary Fund. It is now time to learn from those experiences, adapting them to the specific problems of large multinational banks.

                                                  Yes, we need an institution that can serve as a global and modern version of a lender of last resort.

                                                  In my next column, I will outline where we might go from here.

                                                  One final comment. I think there are dangers when political power becomes concentrated in too interconnected to fail financial institutions, and this potential contributor to the crisis deserves more emphasis.


                                                  Brunnermeier, Markus K, Andrew Crockett, Charles A Goodhart, Avinash Persaud, and Hyun Song Shin (2009). The Fundamental Principles of Financial Regulation. Centre for Economic Policy Research and International Center for Monetary and Banking Studies.
                                                  Calomiris, Charles (2007). “Not (Yet) a ‘Minsky Moment’” VoxEU.org, 23 November.
                                                  Wyplosz, Charles (2009). “The ICMB-CEPR Geneva Report: ‘The Future of Financial Regulation’” VoxEU.org, 27 January.

                                                  This article may be reproduced with appropriate attribution.

                                                    Posted by on Thursday, July 16, 2009 at 12:15 AM in Economics, Financial System, Regulation | Permalink  Comments (47) 

                                                    Enough Punishment for One Day

                                                    When you are teaching a course, imposing rigorous standards and giving lots of homework can be of great benefit to your students: 

                                                    The rigors of the USC Masters in Real Estate Development Program, by Richard Green: A student of ours emails:

                                                    I just wanted you to know that this assignment got me out of a traffic ticket this morning.

                                                    La Cienega was shutdown to due an accident and I was trapped. So, I made a u-turn which included driving over a curbed median. A motorcycle cop pulled me over and gave me a lecture about how this isn't Texas (I have texas plates) and "cowboy driving" is not acceptable....whatever that means. So I told him that I had to get to campus for the mid- term and I had a limited amount of time to complete the homework assignment. I pulled out assignment #3 to make my story credible and he took it with him when he went back to his motorcycle.

                                                    When he came back he told me that it seemed like the assignment was going to be enough punishment and he let me go.

                                                      Posted by on Thursday, July 16, 2009 at 12:08 AM in Economics | Permalink  Comments (2) 

                                                      links for 2009-07-16

                                                        Posted by on Thursday, July 16, 2009 at 12:02 AM in Economics, Links | Permalink  Comments (23) 

                                                        Wednesday, July 15, 2009

                                                        "Tax the Wealthy to Keep US Healthy"

                                                        Robin-Hood Reich is happy:

                                                        The House: Tax the Wealthy to Keep Everyone Healthy, by Robert Reich: It's the most blatant form of Robin-Hood economics ever proposed. The universal health care bill reported by the House yesterday pays for the health insurance of the 20 percent of Americans who need help affording it with a surtax on the richest 1 percent.

                                                        I don't recall the last time Congress came up with such a direct redistribution. Occasionally Congress closes a few tax loopholes at the top and offers a refundable tax credit to workers at the bottom, or it creates a poor people's program like Medicaid, paid for out of general revenues from a progressive income tax. But to say out loud, as the House has just done, that those in our society who can most readily afford it should pay for the health insurance of those who cannot is, well, audacious.

                                                        There's another word for it: fair. According to the most recent data (for 2007), the best-off 1 percent of American households take home about 20 percent of total income -- the highest percentage since 1928. Yes, I know: Critics will charge that these are the very people who invest, innovate, and hire, and thereby keep the economy going. So raising their taxes will burden the economy and thereby hurt everyone, including those who are supposed to be helped.

                                                        But there's no reason to suppose that taking a tiny sliver of the incomes of the top 1 percent will reduce all that much of their ardor to invest, innovate, and hire in the future. Yet if this tiny sliver means affordable health care for a far larger number of Americans, who will be able to get regular checkups and thereby stay healthy and productive, the positive effect on the American economy is likely to be far greater.

                                                        Don't believe critics who say the surtax will harm small business. According to the Center for Tax Justice, it would hit only five percent of small business owners... Besides, only the profits of a small business would be taxed. ... So, for example, a couple whose income comes entirely from a small business would have to earn more than $350,000 in business profits -- after paying all their expenses, including salaries -- before the surcharge would affect them... And if they earned more, the surcharge wouldn't reduce their incentive to hire more employees because they pay employees with pre-tax income. And not even purchases of equipment ... would be affected because most small business owners can write off up to $250,000 of the costs of such equipment immediately.

                                                        A surtax is easy to administer. And the whole idea is easy to understand. Tax the wealthy to keep everyone healthy. Not even a bad bumper sticker.

                                                        I'll be very surprised if the Senate goes along with this.

                                                          Posted by on Wednesday, July 15, 2009 at 02:14 PM in Economics, Health Care, Taxes | Permalink  Comments (113) 

                                                          Thomas Schelling on Climate Change

                                                          Conor Clarke interviews Thomas Schelling on the implementation of climate change policy (the excerpts run across several questions):

                                                          An Interview With Thomas Schelling, Part Two, by Conor Clarke: This is the second part of my interview with Nobel Prize-winning economist Thomas Schelling. Part one is here. In this part we talk very generally about climate change...

                                                          ...It's not obvious that averting global climate change is in the rational self-interest of anyone ... alive today. The serious consequences probably won't occur until 2080 or 2100 or thereafter..., [and] those consequences are going to be distributed in a radically uneven way. The northwest of the United States might actually benefit. So how does a negotiation process work? How does a generation today negotiate on behalf of future generations? And how do we negotiate when the costs are distributed so unevenly?

                                                          Well I do think that one of the difficulties is that most of the beneficiaries aren't yet born. More than that: Most of the beneficiaries will be born in ... the developing world. By 2080 or 2100 five-sixths of the population, at least, will be in places like China, India, Indonesia, Africa and so forth. And what I don't know is whether Americans are really willing to understand that and do anything for the benefit of the unborn Chinese.

                                                          It's a tough sell. And probably you have to find ways to exaggerate the threat. And you can in fact find ways to make the threat serious. I think there's a significant likelihood of a kind of a runaway release of carbon and methane ... that will create a huge multiplier effect, and it could become very serious. ...

                                                          If I were to come clean to the American public I would say that, except for a very low probability of a very bad result -- which is the disintegration of the West Antarctic ice sheet, which would put Washington DC under water -- we are probably going to outgrow any vulnerability we have to climate change. ... You know, very little of the US economy is susceptible to climate. All of agriculture is less than 3% of our gross product. Forestry may be endangered. Fisheries may be endangered. But recreation might actually benefit!

                                                          So if we can double our GDP in the next 70 or 80 years,... -- even if we lose 10% of our GDP from climate change -- we're still ahead so much that the effect of climate change wouldn't be noticed. But it would be pretty disastrous in a lot of the less developed parts of the world. And that's why I think it's crucially important not to demand anything of China, India and so forth that will significantly impede their economic progress. ...

                                                          [I]f the developed countries ... are really serious, they'll tell India and China and Brazil, "we're going to provide enormous assistance to help reduce your dependence on fossil fuels. And we don't expect you to pay for it yourselves. We will pay for it because we're rich and you're not." ...

                                                          But while people talk about this..., nobody that I know of is thinking about how in the world you organize so that the rich countries can agree what you do with the poor. You need to know who divides the money, and who the monitors is. We're going to need a whole new set of institutions...

                                                          It's very hard to get Americans to engage in what they think will be suffering not just for the polar bears but for the poor around the world who will indeed suffer if they can't outgrow their vulnerability to climate change. ...

                                                          I think you have to realize that most people have very strong moral feelings. I think in a lot of cases they're misdirected. I wish moral feelings about a two-month old fetus were attached to hungry children in Africa. But I think people have very strong moral feelings. In fact, I'm always amazed by the number of people who at least pretend they're worried about the polar bears.

                                                          And one thing that I think ought to help but doesn't is that -- and my impression is that maybe this is slightly changing -- the organized churches in America don't take seriously preserving the heritage that God gave us. ... I get no impression that Protestants and Catholics are sermonizing on the importance of preserving the bounty of the earth, the richness of the species, or preserving the planet as we would like to know it. ... I think the churches don't realize that they could have a potent effect in not letting so much of gods legacy -- in terms of flora and fauna -- be destroyed by climate change.

                                                          But I tend to be rather pessimistic. I sometimes wish that we could have, over the next five or ten years, a lot of horrid things happening -- you know, like tornadoes in the Midwest and so forth -- that would get people very concerned about climate change. But I don't think that's going to happen.

                                                          Exaggerating the threat won't help. When people find out that you are doing that -- and they will at some point -- you lose credibility and end up further behind than when you started. Also, though this is a bit picky -- this qualification is often omitted to simplify the discussion -- the costs are not fully captured by the loss of GDP. If, for example, some species become extinct due to climate change, that is only included in the costs to the extent that it lowers the output of goods and services. But our concerns are broader than that. Finally, I don't think we should, even just sometimes, wish that horrid things would happen to people no matter how much good might come of it. There are better ways to get there.

                                                            Posted by on Wednesday, July 15, 2009 at 12:44 AM in Development, Economics, Environment, Policy, Regulation | Permalink  Comments (63) 

                                                            Loonie Network Effects

                                                            Nick Rowe use California's IOUs and Canadian Tire money to illustrate possible outcomes when two currencies circulate side by side:

                                                            The State(s) Theory of Money: California and Canadian Tire, by Nick Rowe: I learn via [this] that there is a distinct chance that California will allow taxes to be paid in the new scrip it issued when it ran out of funds. I have no idea whether this will happen, or whether the Federal government will stop it. Let me just assume that it does happen, and that the Federal government does not stop it. I'm (almost) hoping that it does happen, and that the Fed doesn't stop it, because it would be such a fascinating experiment in monetary theory.

                                                            Assuming this experiment does go ahead, what are the chances that California scrip will circulate as a medium of exchange, and be generally acceptable, not just at banks, but in exchange for all or most goods and services?

                                                            Another way to ask this question: what's the difference between California and Canadian Tire?

                                                            For non-Canadian readers let me explain that Canadian Tire corporation is a large chain of stores selling a wide range of automotive supplies, hardware, sports and camping equipment, gasoline, etc., that has many outlets across Canada. And it issues Canadian Tire "Money". CT money consists of small paper notes, about the same size as US dollar bills, in denominations ranging from a few cents up to a couple of dollars. When you buy something at Canadian Tire, you get CT money with a face value of a couple of percent of the purchase price. Canadian Tire money is redeemable for merchandise, at par with Canadian dollars, at all Canadian Tire stores.

                                                            That last sentence is crucial. If the State of California accepts California scrip for payment of taxes, at par with US dollars, it is just like Canadian Tire. Sure, you have to pay taxes, and you don't have to shop at Canadian Tire, but most Canadians do shop at Canadian Tire, and do so more times a year than most Californians pay taxes (if we are talking about annual income taxes, at least). So the frequency with which Canadian Tire money can be redeemed at its issuer will exceed that of California scrip.

                                                            But Canadian Tire "Money" does not normally circulate as a generally accepted medium of exchange. In special circumstances, someone (other than Canadian Tire) might accept Canadian Tire money in payment for goods, but only as a favour if you have run out of "real" money, or at a discount. It is not generally used outside of Canadian Tire stores. People generally redeem it as soon as they next visit a Canadian Tire store (or just leave it stashed away until they remember to do so).

                                                            And we can understand why Canadian Tire money does not circulate as a medium of exchange. This is a case where, contrary to Gresham's Law, good money drives out bad. (Gresham's Law does not apply because there is no legal tender law saying that merchants have to accept Canadian Tire money at par, and only Canadian Tire does so).

                                                            We have known since Carl Menger that money, like language, has network effects. If the people with whom you interact are already speaking a particular language, or using a particular medium of exchange, that increases your incentive to adopt that same language or medium of exchange. Conventions can arise spontaneously, and have the force of custom. Canadian Tire money would have to be, not just as good as, but significantly better than the Loonie, in order to compete with the Loonie as a medium of exchange. It isn't. You can redeem Canadian Tire money at par in Canadian Tire stores, and below par elsewhere, so everybody just redeems it at Canadian Tire stores. It doesn't circulate.

                                                            So California scrip would end up like Canadian Tire money - being kept in the glove box until your next visit to the issuing store - except for one thing: California scrip pays 3.5% interest; Canadian Tire money pays none. In that one respect at least, California scrip is better than US dollars.

                                                            Suppose California scrip does end up circulating as a medium of exchange, being generally acceptable at par to US dollars. Is that possible? I don't think it is, because then Gresham's Law would kick in. If I hold both in my pocket, and merchants will accept both, at par, I would pay with US dollars, and hoard the California scrip, to collect the interest.

                                                            It's hard to model a stable equilibrium in which two different monies could circulate side-by-side. If one money gains any slight advantage over the other, and becomes more widely accepted, that makes people even more willing to use it, and less willing to use the other, until one money dominates. And that's what we normally see, except in "bilingual" border zones.

                                                            And I just find it hard to imagine that California scrip could ever displace the US dollar as the preferred medium of exchange, even in California. The 3.5% interest might offset any risk of default or depreciation, but the sheer force of custom should outweigh both.

                                                              Posted by on Wednesday, July 15, 2009 at 12:31 AM in Economics, Financial System, Taxes | Permalink  Comments (7) 

                                                              How Should We Interpret Goldman Sach's Unexpectedly Large Earnings?

                                                              The NY Times Room for Debate is discussing how we should interpret Goldman Sach's compensation pool, which will be an $11.36 billion set aside for the first half of 2009. Here's the unedited version of my entry (you may like the shorter, edited version better):  

                                                              Returning to High-Risk Strategies, Room for Debate, NY Times, by Mark Thoma: What does the size of Goldman's compensation pool tell us? It signals several things. First, it gives some indication that the financial sector is improving, and that is good news. There's no guarantee, however, that the overall economy will follow anytime soon. Even with improvements in the financial sector, the recovery of the broader economy is likely to be a slow process.

                                                              One of the reasons I expect the recovery to be slow despite improvements in the financial sector is that the economy cannot go back to where it was before the crisis hit. The financial and housing sectors need to shrink, too many economic resources were used unproductively in support of these activities, and the automobile sector is also in transition.

                                                              And it's not just that the financial sector needs to get smaller so that resources can be used productively elsewhere, the financial sector also needs to change its ways so that risk accumulations do not threaten the financial system and the broader economy. As Robert Reich notes today, Goldman's chief financial officer tells Bloomberg News that "Our model really never changed, we’ve said very consistently that our business model remained the same." Thus, a second signal from Goldman's unexpectedly large earnings is that firms such as Goldman Sachs are returning to the same high-risk strategies backed by too big to fail government guarantees that got us into trouble in the first place, and that aspect of Goldman's success is worrisome. It's a signal that the excesses that led to the high incomes of financial executives have not ended.

                                                              Why aren't the profits and the bonuses paid to executives justifiable? Don't they signal the superior talents of Goldman employees, and don't those talents deserve to be rewarded by the marketplace? I think we can legitimately question whether this is a reward for superior talent. Goldman was helped by bailout funds -- there's some debate about whether it actually needed a direct infusion of funds -- but it's certainly true that Goldman benefitted when its counterparties such as AIG were bailed out. Goldman is also benefitting from its early escape from government constraints that still inhibit the ability of other firms to compete on equal - though perhaps overly slippery and risky - footing.

                                                               So Goldman's earnings are not simply the product of the superior talent of Goldman's executives, there is more to the story. In addition, the bad incentives that executive compensation structures provide was one of the factors that caused the crisis, and the size of the compensation pool tells us there is work yet to be done to fix this problem.

                                                              Other entries from William K. Black, Yves Smith, Charles Geisst, David Merkel, and Jeffrey Miron.

                                                                Posted by on Wednesday, July 15, 2009 at 12:18 AM in Economics, Financial System, Media | Permalink  Comments (64) 

                                                                links for 2009-07-15

                                                                  Posted by on Wednesday, July 15, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (28) 

                                                                  Tuesday, July 14, 2009

                                                                  Enough to Help, not Enough to Cure

                                                                  If the first pill doesn't cure the patient, does that mean the prescription didn't work?

                                                                    Posted by on Tuesday, July 14, 2009 at 10:02 AM in Economics, Video | Permalink  Comments (9) 

                                                                    Consumer Protection Elitists? Hardly

                                                                    Richard Green takes on Peter Wallison's arguments against establishing a Financial Product Safety Commission:

                                                                    Peter Wallison calls Consumer Protection Elitist: He writes:

                                                                    Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure all consumers -- of whatever level of sophistication -- could make rational decisions about the products and services they are offered. No more. If the administration's plan is adopted, many consumers will be told that they cannot have particular products or services because they are not sophisticated, educated or perhaps intelligent enough to understand what they have been offered.

                                                                    Conservatives have always argued that liberals are elitists who do not respect ordinary Americans; this legislation seems to prove it. For example, the administration's plan would allow the educated and sophisticated elites to have access to whatever financial services they want but limit the range of products available to ordinary Americans.

                                                                    This unprecedented result comes about because, under the proposed legislation, every provider of a financial service (a term that includes organizations as varied as banks, check-cashing services, leasing companies and payment services) is required to offer a "standard" product or service -- to be defined and approved by the proposed agency -- that will be simple and entail "lower risks" for consumers. These standard products are called "plain vanilla" in the white paper that the administration circulated in advance of the legislation.

                                                                    Such protection is actually not unprecedented. For example, people must be deemed to be "accredited investors" or (for more complicated products) "qualified purchasers" in order to invest in certain types of hedge funds. And stock brokers have an obligation to make sure their clients' investments are "suitable."

                                                                    But beyond the issue of precedence, there is a broader issue of safety. We reasonably forbid or require a variety of actions in the interest of safety. We require people to wear seatbelts. Be don't allow people to buy certain type of narcotics over the counter. Perhaps Mr. Wallison thinks such protections are a bad idea too, in which case he is consistent, if not also ridiculous. Mortgages can be dangerous products. Let's turn it over to Richard Thaler:

                                                                    Fast forward to 2008, and the world of mortgage shopping had become a much more complicated place. Borrowers were quoted low initial “teaser” rates that would jump later to some higher level, depending on market interest rates at the time, and there were prepayment penalties for paying off the loans early. For such mortgages, an A.P.R. was no longer an adequate measure of the loan’s cost.

                                                                    How can we help people make sense of all this?

                                                                    One extreme approach would be to ban complex mortgages entirely: we could just go back to the world of uniform fixed-rate mortgages. But the cost of simplicity is an end to innovation. ...

                                                                    A better approach is to strive for maintaining diverse options but helping consumers make smart choices and avoid the most common pitfalls. ... As the administration plan describes it, lenders could be required to offer some mortgages they call “plain vanilla,” with uniform terms. There might be one vanilla 30-year, fixed-rate mortgage and one five-year, adjustable-rate mortgage. The features of these plain mortgages would be uniform, much as in a standard lease used in most rental agreements.

                                                                    Lenders would also be free to offer other exotic mortgages — perhaps called “rocky road” mortgages? — along with the vanilla variety, but these offerings would receive more intense scrutiny from regulators.

                                                                    I am not sure what is so elitist about this, other than the fact that those who are hostile to regulations tend to like to use elitist as an epithet for their opponents. So I guess I have two questions for Mr. Wallison:

                                                                    (1) If I gave him an HP12C calculator, assumptions about an interest rate path, and the terms of an option-ARM mortgage, would he be able to tell me the payment on that mortgage in, say, month 62? Perhaps he could, but I don't know too many lawyers (and he is a lawyer) who could do that calculation. ... The point is ... to emphasize a fact--most of us do not have the equipment to make informed judgments about complex financial products.

                                                                    (2) I am curious how often Mr. Wallison hangs out with those who are not elite. Does he socialize with, say, median income people? ... Perhaps he does, in which case he is entitled to refer to "the elite" as an other. But I have my doubts.

                                                                    I would be hesitant to endorse this banks weren't "free to offer other exotic mortgages," but that's not a problem.

                                                                    Why make these products identical, i.e. why have a plain vanilla option? Have you ever tried to compare the price of mattresses at different stores? It's almost impossible - intentionally - to find matching model numbers and exactly identical products, so you are never quite sure which is the better deal. That uncertainty gives the stores pricing power. If stores were required to offer two or three identical mattresses, such comparison shopping would no longer be a problem and you'd expect competition to drive the price down its minimum level. There would still be exotic mattresses at each store, nobody would make you purchase the standard option, you would still have choices. But even if you aren't a mattress expert and hence have little idea if the exotic mattresses are worth the price, at least there would be two or three choices where you could be sure that the mattresses were priced fairly and that they adhered to particular quality and safety standards.

                                                                    Of course, since such a proposal would take away pricing power of firms selling mattresses, and they would be opposed to such a requirement. It's no different for financial firms, and Simon Johnson doesn't think the administration is being aggressive enough in countering efforts to undermine and weaken the proposed consumer protection legislation:

                                                                    Waiting For The Big Push: Selling The Consumer Protection Agency For Financial Products. by Simon Johnson: ...[T]he administration’s major remaining initiative is its version of a Financial Product Safety Commission - something that would be clearly beneficial for the public.  And the skepticism – and outright opposition – comes from the banking sector. ...

                                                                    As far as I can see, [the administration is] not pushing this new consumer protection/safety agency hard enough. Some sources claim that Secretary Geithner is fully on board with the Agency...  But there is no sign of the frenzied effort that accompanied efforts to launch the PPIP – when, for example, almost every economist in the administration seemed pressed into service to call potential critics and ask them to “give it a chance.”

                                                                    One symptom of this “effort gap” is that counter-arguments and disinformation about the proposed agency begin to gain the upper hand.  One senior executive recently told me that this agency would have unprecedented powers to determine the design of individual products – “something not even the FDA can do.”

                                                                    Of course, this is nonsense.  The new agency would be powerful – and thus it is feared by the industry – and presumably it would be able to prevent sufficiently toxic products from being sold.  Hopefully, it will also be able to require that all financial institutions also offer some vanilla products, to make consumers’ choices easier.  But the idea that an agency would design the details of all products for any sector is both implausible and a malicious rumor being spread by opponents (actually, it reminds me of the pushback from meatpackers, and others, early in the 20th century). 

                                                                    If Treasury is so supportive of this new Agency, now is the time to launch public, high profile, and clever counterattacks.  By the time the legislation is being voted on, it will be too late.

                                                                    And in this context, the administration should push hard on one of the great ironies here.  Financial sector executives like to stress the importance of “consumer confidence,” and they urge the government to take steps to restore this confidence...

                                                                    But the same people completely reject the idea that consumers will feel more confident about financial products if there is finally some serious consumer protection around those products.  Whenever people learn – or just fear – that a particular food product is unsafe, they stop buying it.  When the stock market ripped people off in the late 1920s, it took legislation with real teeth to rebuild investor confidence – take a look at, for example, the Securities Exchange Act of 1934. ...

                                                                    If Treasury and the administration really wants a Consumer Protection/Safety Agency for finance, they need to kick their support campaign into much higher gear immediately.

                                                                    Consumers have a big information disadvantage when it comes to mortgages and understanding which product fits their needs without exposing them to unnecessary risk, and in some cases they may not even be presented with the full spectrum of mortgage products that are available when they apply for a loan. And though it's better than it used to be, it's also difficult to shop around due to the transactions costs involved. The information problem combined with the difficulty in comparison shopping give brokers the opportunity to steer people toward products that are more profitable, but not as good a fit for the borrower. Having a few common options that are available across brokers makes comparison shopping easier and helps to overcome the information problem.

                                                                    Update: More at Rortybomb.

                                                                    Update: Tim Fernholz disagrees with Simon Johnson:

                                                                    Simon Johnson writes that the administration isn't supporting the proposed Consumer Financial Products Agency enough. Since I wrote a piece arguing the exact opposite last week, I thought I'd respond, though I do agree with Simon in so far as he administration could never do too much to support the creation of the agency.

                                                                      Posted by on Tuesday, July 14, 2009 at 01:20 AM in Economics, Financial System, Regulation | Permalink  Comments (33) 

                                                                      links for 2009-07-14

                                                                        Posted by on Tuesday, July 14, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (15) 

                                                                        Monday, July 13, 2009


                                                                        Dani Rodrik says "mercantilism deserves a rethink":

                                                                        Mercantilism Reconsidered, by Dani Rodrik, Commentary, Project Syndicate: A businessman walks into a government minister's office and says he needs help. What should the minister do? Invite him in for a cup of coffee and ask how the government can be of help? Or throw him out, on the principle that government should not be handing out favors to business?

                                                                        This question constitutes a Rorschach test for policymakers and economists. On one side are free-market enthusiasts and neo-classical economists, who believe in a stark separation between state and business. In their view, the government's role is to establish clear rules and regulations and then let businesses sink or swim on their own. ... This view reflects a venerable tradition that goes back to Adam Smith...

                                                                        On the other side are what we may call corporatists or neo-mercantilists, who view an alliance between government and business as critical to good economic performance and social harmony. In this model, the economy needs a state that eagerly lends an ear to business, and, when necessary, greases the wheels of commerce by providing incentives, subsidies, and other discretionary benefits. Because investment and job creation ensure economic prosperity, the objective of government policy should be to make producers happy. ... This view reflects an even older tradition that goes back to the mercantilist practices of the seventeenth century. ...

                                                                        Adam Smith and his followers decisively won the intellectual battle between these two models of capitalism. But the facts on the ground tell a more ambiguous story.

                                                                        Continue reading "Neomercantilism" »

                                                                          Posted by on Monday, July 13, 2009 at 09:30 PM in Economics, International Trade, Regulation | Permalink  Comments (52) 

                                                                          The Shadow Knows

                                                                          Awhile back there was some controversy over the role of the shadow banking system in the financial crisis. Resetting the stage:

                                                                          Much Ado About the Shadow Banking System, The Hearing: Occasionally, a blog post will flower into a wide-ranging debate in what is usually called the "economics blogosphere." Last Friday's guest post on regulation by Mark Thoma triggered just such a debate. I'll quote the controversial passage at some length:

                                                                          Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.

                                                                          The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.

                                                                          We need to bring the shadow banking system – essentially any institution that takes deposits and makes loans either directly or indirectly – under the same regulatory umbrella as the traditional banking system.

                                                                          Dr. Manhattan, an anonymous blogger at The Atlantic, focused on that middle paragraph in a post called "Sentences That Don't Compute," arguing that the crisis was due to problems at regulated financial institutions, such as AIG, not the shadow banking system.

                                                                          Brad DeLong defended Thoma, drawing the line between commercial deposit-taking banks (heavily regulated) and other institutions (lightly regulated).

                                                                          Thoma also responded on his own blog, pointing to the fact that AIG's problems, for example, were caused by the unregulated part if its business - the Financial Products derivatives-trading business.

                                                                          Arnold Kling (who usually blogs here) responded to DeLong at The Atlantic, saying that failures of regulation of commercial banks were also a problem.

                                                                          Finally, Rortybomb has a careful review of the issues, showing how different people mean different things by "shadow banking system." Ultimately he sides with Thoma on this point: money shifted into a sector of the financial system where there was no backstop against a liquidity crisis - unlike the regulated operations of the commercial banks, where deposit insurance plays that role. This is a problem that needs to be fixed.

                                                                          Mike Rorty follows up today in The Atlantic's business blog with an interview with Perry Mehrling on shadow banking and its role in the crisis. Mehrling's bottom line for regulators is a "new Bagehot Rule" for modern markets: Insure freely but at a high premium.

                                                                          Here's part of the interview:

                                                                          Continue reading "The Shadow Knows" »

                                                                            Posted by on Monday, July 13, 2009 at 12:08 PM in Economics, Financial System, Regulation | Permalink  Comments (18) 

                                                                            Money Monopoly

                                                                            Marshall Auerback says California is challenging the federal monopoly on money creation:

                                                                            Schwarznegger to Obama: Watch and Learn, by Marshall Auerback: According to the San Diego Union-Tribune, Republicans and Democrats alike embraced legislation last Friday that would make California IOUs legal tender for all taxes, fees and other payments owed to the state.

                                                                            Effectively, California is using its IOUs to create a currency. If this bill passes it would allow California to deficit spend just like the Federal Government and with the IOU's acceptable as payment of state taxes, it instantly imparts value to them. In effect, what you have is a state of the union creating a sovereign currency right under the noses of Treasury, Fed. They are stumbling their way into it... It will be viewed as a stop gap measure at first, and then could very well become entrenched as states realize they have a way to escape balanced budget requirements. ...

                                                                            The ... Federal government retains this monopoly under our existing monetary arrangements. If California is successful here in allowing its IOUs to pay tax, it has profound constitutional ramifications. ...

                                                                            It will be interesting to see what the exchange rate is between California IOU and US currency - the IOUs do offer a yield, so should be less than par by design. I wonder if NY is next.

                                                                            This is like some sort of return to the 13 colonies with all kinds of ersatz currency floating about. It's hard to believe the Rubinite wing of the Democrats will just let it be, given the threat it represents to Wall Street's prevailing economic interests, but it is an understandable response...

                                                                            There are political benefits for Obama...: If the Federal government allows this proposal of the state of California to go unchallenged, it would relieve the President of a major political quandary, which is, does he help California and then open himself to aid requests from other states?..., or, does he let California go and lose 56 electoral votes in the next election?

                                                                            By allowing them to "solve" their own problem in the manner proposed by the legislation he avoids the quandary. And ... they just might let them do it until the import is fully understood.

                                                                            It is true that this legislation represents a profound break from all federal laws. It is almost bound to incur some sort of constitutional challenge, representing as it does, a profound threat to the Federal government's currency monopoly powers. But this is another instance where Obama's inattentiveness to the ramifications of the states' respective fiscal crises has come back to haunt him. This situation would not have arisen had Obama embraced a simple revenue sharing plan with the states (so that the states' respective fiscal policies would be working in harmony with his proposals, rather than mitigating the impact of the Federal fiscal stimulus), as recommended by any number of prominent economists...

                                                                            It will be interesting to see how this plays out. As California goes, will the nation follow? ...

                                                                            Setting aside the particulars of the California case and whether or not the IOUs are actually functioning as money - that's debatable - very, very generally, the federal government has a budget constraint just like everyone else, well sort of like everyone else anyway -- most of us can't levy taxes or print money. Federal government finances must satisfy

                                                                            G - T = ΔM + ΔB,

                                                                            where Δ means "change in," G is government spending, T is taxes, M is the money supply, and B is bonds. The left-hand side is the deficit, and the right-hand is how it is financed. Thus, when G is greater than T so that there is a deficit in a given budget period, it must be financed by printing new money (ΔM) or issuing new bonds (ΔB). (If it helps, think of G as being 100 and T being 70 so that the deficit is 30. The deficit can be financed by printing 30 new dollars, by borrowing 30 dollars from the public, or some combination of the two)

                                                                            Now, for states, ΔM is zero since that would be money creation, and they are not allowed to do that. Thus, a state's budget constraint is:

                                                                            G - T = ΔB

                                                                            This must be satisfied each budget period. Because this constraint must hold each budget period, notice what happens if there is a legal or political debt limit -- in some states it is effectively B=0 -- and B is already at the limit (which means ΔB cannot be positive since that would add to the debt). If the state's budget deficit rises in a recession due to decreased tax revenue and increased spending on social services, then G must fall to eliminate the deficit, or new taxes must be levied, and the cutback in spending and/or increase in taxes makes the recession worse.

                                                                            But what if a state was suddenly granted the power to print money? Then it could pay for that year's deficit without increasing bonds (i.e. debt) any further, i.e. G - T could be financed solely by ΔM if it so chooses. That is, the state now has the constraint

                                                                            G - T = ΔM + ΔB

                                                                            If B is maxed out politically or legally so that ΔB must equal zero (or be negative), then a deficit, G - T, could still be financed with ΔM.

                                                                            Having fifty different currencies isn't necessarily bad, there are pros and cons to having a single currency across all fifty states, i.e. to forming currency union. With a currency union, individual members lose the ability to conduct independent monetary policy - there is one money and one policy so everyone in the group gets the same treatment - but that is less costly when the the economic differences among the members of the union is small and the same policy is generally applicable. There are many advantages to having a single currency (no exchange rate uncertainty and lower transactions costs to name just two), and for countries considering forming a currency union, there is a list of factors that are cited as working for or against unification. Many of these factors involve social, political, economic, and geographic factors, and generally, though not always, the more similar the countries are, the more likely it is that a currency union will be beneficial (e.g. similar levels of development, a similar mix of products, similar legal institutions, same language). In the case of the fifty states within the U.S., I believe the advantages of a single currency far outweigh the disadvantages, and states should not be allowed to create their own currencies.

                                                                              Posted by on Monday, July 13, 2009 at 01:25 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (64) 

                                                                              "Boiling the Frog"

                                                                              What are we waiting for?:

                                                                              Boiling the Frog, by Paul Krugman, Commentary, NY Times: Is America on its way to becoming a boiled frog?

                                                                              I’m referring, of course, to the proverbial frog that, placed in a pot of cold water that is gradually heated, never realizes the danger it’s in and is boiled alive. Real frogs will, in fact, jump out of the pot — but never mind. The hypothetical boiled frog is a useful metaphor for a very real problem: the difficulty of responding to disasters that creep up on you a bit at a time. ...

                                                                              I started thinking about boiled frogs recently as I watched the depressing state of debate over both economic and environmental policy. These are both areas in which ... it’s very hard to get people to do what it takes to head off a catastrophe foretold. ...

                                                                              Start with economics: ...Most economic forecasters now expect gross domestic product to start growing soon, if it hasn’t already. But all the signs point to a “jobless recovery”...

                                                                              Now, it’s bad enough to be jobless for a few weeks; it’s much worse being unemployed for months or years. Yet that’s exactly what will happen to millions of Americans if the average forecast is right — which means that many of the unemployed will lose their savings, their homes and more.

                                                                              To head off this outcome — and remember, this isn’t what economic Cassandras are saying; it’s the forecasting consensus — we’d need to get another round of fiscal stimulus under way very soon. But neither Congress nor, alas, the Obama administration is showing any inclination to act. Now that the free fall is over, all sense of urgency seems to have vanished.

                                                                              This will probably change once the reality of the jobless recovery becomes all too apparent. But by then it will be too late to avoid a slow-motion human and social disaster.

                                                                              Still, the boiled-frog problem on the economy is nothing compared with the problem of ... climate change. ... At this point, the central forecast of leading climate models — not the worst-case scenario but the most likely outcome — is utter catastrophe, a rise in temperatures that will totally disrupt life as we know it... How to head off that catastrophe should be the dominant policy issue of our time.

                                                                              But it isn’t, because climate change is a creeping threat rather than an attention-grabbing crisis. The full dimensions of the catastrophe won’t be apparent for decades, perhaps generations. ... Unfortunately, if we wait to act until the climate crisis is ... obvious, catastrophe will already have become inevitable.

                                                                              And while a major environmental bill has passed the House, which was an amazing and inspiring political achievement, the bill fell well short of what the planet really needs — and despite this faces steep odds in the Senate.

                                                                              What makes the apparent paralysis of policy especially alarming is that so little is happening when the political situation seems, on the surface, to be so favorable...

                                                                              After all, supply-siders and climate-change-deniers no longer control the White House and key Congressional committees. Democrats have a popular president to lead them, a large majority in the House of Representatives and 60 votes in the Senate. And this isn’t the old Democratic majority, which was an awkward coalition between Northern liberals and Southern conservatives; this is, by historical standards, a relatively solid progressive bloc.

                                                                              And let’s be clear: both the president and the party’s Congressional leadership understand the economic and environmental issues perfectly well. So if we can’t get action to head off disaster now, what would it take?

                                                                              I don’t know the answer. And that’s why I keep thinking about boiling frogs.

                                                                                Posted by on Monday, July 13, 2009 at 01:11 AM in Economics, Environment, Fiscal Policy, Politics | Permalink  Comments (38) 

                                                                                links for 2009-07-13

                                                                                  Posted by on Monday, July 13, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (24) 

                                                                                  Sunday, July 12, 2009

                                                                                  "The Hottest Places in Hell are Reserved for Those Who, in Times of Moral Crisis, Maintain a Neutrality"

                                                                                  Tom Bozzo says to watch this video [parts of transcript below]:

                                                                                  Bill Moyers Journal: BILL MOYERS: Wendell Potter ... worked for CIGNA 15 years and left last year. ... why are you speaking out now?

                                                                                  WENDELL POTTER: I didn't intend to, until it became really clear to me that the industry is resorting to the same tactics they've used over the years, and particularly back in the early '90s, when they were leading the effort to kill the Clinton plan. ...

                                                                                  I was beginning to question what I was doing as the industry shifted from selling primarily managed care plans, to what they refer to as consumer-driven plans. And they're really plans that have very high deductibles, meaning that they're shifting a lot of the cost off health care from employers and insurers, insurance companies, to individuals. And a lot of people can't even afford to make their co-payments when they go get care... But it really took a trip back home to Tennessee for me to see exactly what is happening to so many Americans. I ... went home, to visit relatives. And I picked up the local newspaper and I saw that a health care expedition was being held a few miles up the road, in Wise, Virginia. And I was intrigued.

                                                                                  BILL MOYERS: So you drove there?

                                                                                  WENDELL POTTER: I did. ... It was being held at a Wise County Fairground. ... It was a very cloudy, misty day, it was raining that day, and I walked through the fairground gates. And I didn't know what to expect. I just assumed that it would be, you know, like a health-- booths set up and people just getting their blood pressure checked and things like that.

                                                                                  But what I saw were doctors who were set up to provide care in animal stalls. Or they'd erected tents, to care for people. I mean, there was no privacy. In some cases-- and I've got some pictures of people being treated on gurneys, on rain-soaked pavement.

                                                                                  And I saw people lined up, standing in line or sitting in these long, long lines, waiting to get care. People drove from South Carolina and Georgia and Kentucky, Tennessee-- all over the region, because they knew that this was being done. A lot of them heard about it from word of mouth.

                                                                                  Continue reading ""The Hottest Places in Hell are Reserved for Those Who, in Times of Moral Crisis, Maintain a Neutrality"" »

                                                                                    Posted by on Sunday, July 12, 2009 at 06:32 PM in Economics, Health Care | Permalink  Comments (38) 

                                                                                    Fiscal Policy: "The Right and the Obvious Thing To Do"

                                                                                    Two things seem relatively clear. First, given the projected baseline for the economy, the previous stimulus package was too small. It was big enough to help, but it won't give anything near the boost the economy needs. Second, the original baseline was far too optimistic.

                                                                                    So I agree:

                                                                                    Fiscal Policy: The Obama Administration Is Not Making Much Sense These Days, by Brad DeLong: ...Last December the Obama administration to be decided on a fiscal stimulus package which they believed would have minor effects on the economy in the first two quarters of 2009 and major effects--would push unemployment down below what it would other wise have been by more than half a percentage point--starting in the third quarter of 2009. They believed that the economy was not that weak, and that with the fiscal stimulus package taking effect unemployment would be peaking now at a rate of 7.9%.

                                                                                    Instead, unemployment is now probably in the 9.5-9.7% range--and without the stimulus package it would right now have turned out to be above 10%:

                                                                                    The financial crisis of last fall hit the economy's levels of production, spending, and employment much harder than people thought at the time. If we had known then what we know now, it would have been prudent then to propose twice as large a fiscal stimulus program as the Obama administration in fact did propose. ...

                                                                                    All in all, it looks like the unemployment rate in 2009 is going to average 1.2 percentage points above where the administration last December thought we would be. ...

                                                                                    It is interesting and important to note that the excess unemployment now forecast over 2009 relative to last December's forecast is of the ... magnitude ... of ... a $170 billion shortfall.

                                                                                    If I were running the government, I would be trying to make up that GDP shortfall right now: I would be rushing a clean $170 billion--$500 per citizen--aid-to-states-that-maintain-effort package through the congress this week. It would seem the right and the obvious thing to do.

                                                                                    At least that much, and the sooner the better.

                                                                                      Posted by on Sunday, July 12, 2009 at 01:46 PM in Economics, Fiscal Policy | Permalink  Comments (19) 

                                                                                      The Caritas in Veritate: Justice

                                                                                      The only time I ever got an F on an exam, or even close, was in a religious studies course I took to fulfill general education requirements. You know how some of you don't get math? I felt the same way. I somehow managed to pass the course, but I had no foundation whatsoever in the topic going in, and I just didn't get it.

                                                                                      So I am going to let others comment on the Pope's Caritas in Veritate:

                                                                                      Mixing morals and money. by Christopher Caldwell, Commentary, Financial Times: To judge from his encyclical Caritas in Veritate, published this week, Pope Benedict XVI agrees with those who say that something has gone wrong with the way the world does business. ... The encyclical is not anti-global or anti-capitalist. ... Business and finance have not created new excesses. They have opened new routes for an arrogance already present in the hearts of men.

                                                                                      The Pope, in perhaps his most radical passage, laments the “hegemony of the binary model of market-plus-state”. ... Business and government have become specialised fields; each follows a logic that dispenses with the insights of religion. Globalisation can break down cultures, and with them the moral systems in light of which it can be judged. ...

                                                                                      Unfortunately, one of the lost insights concerns justice. The Pope would like us to think about justice as having three aspects. There is commutative justice (the idea of properly judging the prices of things), distributive justice and social justice. National governments, which used to address the second and third, no longer have full power to do so. The global institutions that have replaced them tend to be concerned only with commutative justice – and they do a bad job, the Pope thinks, of judging the value of labour. “If the market is governed solely by the principle of the equivalence in value of exchanged goods, it cannot produce the social cohesion that it requires,” he writes.

                                                                                      Continue reading "The Caritas in Veritate: Justice" »

                                                                                        Posted by on Sunday, July 12, 2009 at 10:45 AM in Economics, International Trade | Permalink  Comments (25) 

                                                                                        links for 2009-07-12

                                                                                          Posted by on Sunday, July 12, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (12) 

                                                                                          Saturday, July 11, 2009

                                                                                          "Trumped by Darwin?"

                                                                                          Robert Frank returns to the point he made in Alpha Markets, i.e. that Charles Darwin provides the "true intellectual foundation" for economics. Though the example this time is male elk rather than bull elephant seals, the central point - and it's one worth giving more thought to - is that "Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance." In these situations, which occur frequently in economic and social relationships, the assumption in neoclassical economic models that the maximization of self-interest is consistent with the maximization of social interest does not hold, and failure to recognize this has " undermined regulatory efforts ... causing considerable harm to us all":

                                                                                          The Invisible Hand, Trumped by Darwin?, by Robert Frank, Commentary, NY Times: If asked to identify the intellectual founder of their discipline, most economists today would probably cite Adam Smith. But that will change. ... Charles Darwin ... tracks economic reality much more closely. ...

                                                                                          Smith’s basic idea was that business owners ... have powerful incentives to introduce improved product designs and cost-saving innovations. These moves bolster innovators’ profits in the short term. But rivals respond by adopting the same innovations, and the resulting competition gradually drives down prices and profits. In the end, Smith argued, consumers reap all the gains.

                                                                                          The central theme of Darwin’s narrative was that competition favors traits and behavior according to how they affect the success of individuals, not species or other groups. As in Smith’s account, traits that enhance individual fitness sometimes promote group interests. For example, a mutation for keener eyesight in hawks benefits not only any individual hawk that bears it, but also makes hawks more likely to prosper as a species.

                                                                                          In other cases, however, traits that help individuals are harmful to larger groups. For instance, a mutation for larger antlers served the reproductive interests of an individual male elk, because it helped him prevail in battles ... for access to mates. But as this mutation spread, it started an arms race that made life more hazardous for male elk over all. The antlers of male elk can now span five feet or more. And despite their utility in battle, they often become a fatal handicap when predators pursue males into dense woods.

                                                                                          In Darwin’s framework, then,... [c]ompetition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always.

                                                                                          Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance, as in the antlers arms race. In the marketplace, such reward structures are the rule, not the exception. The income of investment managers, for example, depends mainly on the amount of money they manage, which in turn depends largely on their funds’ relative performance. Relative performance affects many other rewards in contemporary life. ...

                                                                                          In cases like these, relative incentive structures undermine the invisible hand. To make their funds more attractive to investors, money managers create complex securities that impose serious, if often well-camouflaged, risks on society. But when all managers take such steps, they are mutually offsetting. No one benefits, yet the risk of financial crises rises sharply. ...

                                                                                          It’s the same with athletes who take anabolic steroids. ...

                                                                                          If male elk could vote to scale back their antlers by half, they would have compelling reasons for doing so, because only relative antler size matters. Of course, they have no means to enact such regulations.

                                                                                          But humans can and do. ... Darwin has identified the rationale for much of the regulation we observe in modern societies — including steroid bans in sports, safety and hours regulation in the workplace, product safety standards and the myriad restrictions typically imposed on the financial sector.

                                                                                          Ideas have consequences. The uncritical celebration of the invisible hand by Smith’s disciples has undermined regulatory efforts to reconcile conflicts between individual and collective interests in recent decades, causing considerable harm to us all. ...

                                                                                          [And, again, for those who might be interested, see also Paul Krugman's: What Economists Can Learn from Evolutionary Theorists Synopsis.]

                                                                                            Posted by on Saturday, July 11, 2009 at 06:43 PM in Economics, Methodology, Regulation | Permalink  Comments (35) 

                                                                                            Average Weekly Hours


                                                                                              Posted by on Saturday, July 11, 2009 at 03:28 PM in Economics, Unemployment | Permalink  Comments (43) 

                                                                                              "Is Benefit-Cost Analysis Helpful for Environmental Regulation?"

                                                                                               Robert Stavins notes that:

                                                                                              With an exceptionally talented group of thinkers - including scientists, lawyers, and economists - now in key environmental and energy policy positions at the White House, the Environmental Protection Agency, the Department of Energy, and the Department of the Treasury, this question about the usefulness of benefit-cost analysis is of particular importance

                                                                                              Here's his (balanced) discussion. Points four, five, and eight struck me as particularly noteworthy:

                                                                                              Is Benefit-Cost Analysis Helpful for Environmental Regulation?, by Robert Stavins: ...[Does] economic analysis - in particular, the comparison of the benefits and costs of proposed policies - play ... a truly useful role in Washington, or is it little more than a distraction of attention from more important perspectives on public policy, or - worst of all - is it counter-productive, even antithetical, to the development, assessment, and implementation of sound policy in the environmental, resource, and energy realms. ...

                                                                                              For many years, there have been calls from some quarters for greater reliance on the use of economic analysis in the development and evaluation of environmental regulations. As I have noted in previous posts on this blog, most economists would argue that economic efficiency — measured as the difference between benefits and costs — ought to be one of the key criteria for evaluating proposed regulations. ... Because society has limited resources to spend on regulation, such analysis can help illuminate the trade-offs involved in making different kinds of social investments. In this sense, it would seem irresponsible not to conduct such analyses, since they can inform decisions about how scarce resources can be put to the greatest social good.

                                                                                              In principle, benefit-cost analysis can also help answer questions of how much regulation is enough. From an efficiency standpoint, the answer to this question is simple — regulate until the incremental benefits from regulation are just offset by the incremental costs. In practice, however, the problem is much more difficult, in large part because of inherent problems in measuring marginal benefits and costs. In addition, concerns about fairness and process may be very important economic and non-economic factors. Regulatory policies inevitably involve winners and losers, even when aggregate benefits exceed aggregate costs.

                                                                                              Over the years, policy makers have sent mixed signals regarding the use of benefit-cost analysis in policy evaluation. Congress has passed several statutes to protect health, safety, and the environment that effectively preclude the consideration of benefits and costs in the development of certain regulations, even though other statutes actually require the use of benefit-cost analysis. At the same time, Presidents Carter, Reagan, Bush, Clinton, and Bush all put in place formal processes for reviewing economic implications of major environmental, health, and safety regulations. Apparently the Executive Branch, charged with designing and implementing regulations, has seen a greater need than the Congress to develop a yardstick against which regulatory proposals can be assessed. Benefit-cost analysis has been the yardstick of choice.

                                                                                              It was in this context that ten years ago a group of economists from across the political spectrum jointly authored an article in Science magazine, asking whether there is role for benefit-cost analysis in environmental, health, and safety regulation. That diverse group consisted of Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and myself. That article and its findings are particularly timely, with President Obama considering putting in place a new Executive Order on Regulatory Review.

                                                                                              In the article, we suggested that benefit-cost analysis has a potentially important role to play in helping inform regulatory decision making, though it should not be the sole basis for such decision making. We offered eight principles.

                                                                                              First, benefit-cost analysis can be useful for comparing the favorable and unfavorable effects of policies, because it can help decision makers better understand the implications of decisions by identifying and, where appropriate, quantifying the favorable and unfavorable consequences of a proposed policy change. But, in some cases, there is too much uncertainty to use benefit-cost analysis to conclude that the benefits of a decision will exceed or fall short of its costs.

                                                                                              Second, decision makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Removing statutory prohibitions on the balancing of benefits and costs can help promote more efficient and effective regulation.

                                                                                              Third, benefit-cost analysis should be required for all major regulatory decisions. The scale of a benefit-cost analysis should depend on both the stakes involved and the likelihood that the resulting information will affect the ultimate decision.

                                                                                              Fourth, although agencies should be required to conduct benefit-cost analyses for major decisions,... those agencies should not be bound by strict benefit-cost tests. Factors other than aggregate economic benefits and costs may be important.

                                                                                              Fifth, benefits and costs of proposed policies should be quantified wherever possible. But not all impacts can be quantified, let alone monetized. Therefore, care should be taken to assure that quantitative factors do not dominate important qualitative factors in decision making. ...

                                                                                              Sixth, the more external review that regulatory analyses receive, the better...

                                                                                              Seventh, a consistent set of economic assumptions should be used in calculating benefits and costs. Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

                                                                                              Eighth, while benefit-cost analysis focuses primarily on the overall relationship between benefits and costs, a good analysis will also identify important distributional consequences for important subgroups of the population.

                                                                                              From these eight principles, we concluded that benefit-cost analysis can play an important role in legislative and regulatory policy debates on protecting and improving the natural environment, health, and safety. Although formal benefit-cost analysis should not be viewed as either necessary or sufficient for designing sensible public policy, it can provide an exceptionally useful framework for consistently organizing disparate information, and in this way, it can greatly improve the process and hence the outcome of policy analysis.

                                                                                              If properly done, benefit-cost analysis can be of great help...

                                                                                                Posted by on Saturday, July 11, 2009 at 10:47 AM in Economics, Environment, Regulation | Permalink  Comments (9) 

                                                                                                links for 2009-07-11

                                                                                                  Posted by on Saturday, July 11, 2009 at 12:01 AM in Economics, Links | Permalink  Comments (21) 

                                                                                                  Friday, July 10, 2009

                                                                                                  Haiku Economics

                                                                                                  Why the sudden popularity of Haiku Economics??? This is from Steve Ziliak:

                                                                                                  Dear Mark:

                                                                                                  The economic recession -- something -- is bringing increased attention to "haiku" and "Haiku Economics."

                                                                                                  The first fundamental assumption of haiku economics is: Less is more and more is better. The idea seems to be catching on with financial traders as much as with poets and political speechwriters.  The unemployed, it seems, can't resist it, and more than a few economists (heedless of Bentham) have put pens to verse.

                                                                                                  Continue reading "Haiku Economics" »

                                                                                                    Posted by on Friday, July 10, 2009 at 08:02 PM in Economics | Permalink  Comments (14) 

                                                                                                    "Are Depressions Necessary?"

                                                                                                    Chris Hayes takes up a notion I've never been very fond of, that recessions are necessary and healthy since they clear out inefficient firms, and spur the development of new innovation during the recovery phase. (Why do I think this is unnecessary? The entry and exit of firms driven by innovation and the development of new products can be part of a full employment equilibrium, that is, cycles are not needed to clear out old firms and spur innovation. Imagine an economy where a new idea allows a slightly more productive firm to enter a market and displace a less productive firm, and the workers migrate from the old to the new firm over time. If this happens at a constant rate in aggregate over time, there won't be any cycles at all, but we still manage to clear out the inefficient firms and replace them with more innovative rivals. The displaced workers from the the innovation driven structural adjustment are part of the natural rate of unemployment in such an economy):

                                                                                                    Are Depressions Necessary?, by Christopher Hayes, The American Prospect: ...Are economic contractions, like the one we're currently experiencing, a good thing? ... It would be career suicide for any elected official to suggest that the widespread stress, misery and heartache being wreaked by ... contraction were are a good thing. But scratch the surface a bit and you'll find a surprisingly vibrant school of thought, one that reaches back all the way back to the Great Depression, that holds precisely this view.

                                                                                                    Famed economist Joseph Schumpeter said that "a depression is for capitalism like a good, cold douche," one that rinses off accumulated dysfunction. Robber baron Andrew Mellon (who served as Herbert Hoover's treasury secretary) welcomed the Great Depression with these infamous words: "It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people"

                                                                                                    It's not hard to find this same view among bankers, financiers and sundry Wall Streeters today. ...

                                                                                                    The stakes for this argument are very high: if steep economic contractions are like forest fires, a necessary part of the system's self-calibration, we should more or less let them burn. If they are more like five-alarms raging through dense city neighborhoods, we should call in the fire department.

                                                                                                    Continue reading ""Are Depressions Necessary?"" »

                                                                                                      Posted by on Friday, July 10, 2009 at 01:37 PM in Economics, Macroeconomics | Permalink  Comments (59)