Should We Ban Naked CDSs?, by Brad DeLong: I say, narrowly, no--that if we can get proper clearing, transparency, and capital adequacy requirements in place banning naked CDOs would not do any good and would do a little bit of harm. But it is a close call. And if we can't get proper clearing, transparency, and capital adequacy requirements in place then we should ban them.
Let's go back to first principles. The direct benefits of having more developed, liquid, and sophisticated financial markets are threefold:
They allow people to buy insurance: people facing or holding too much of one particular risk can trade piece of it away to others, and so make a win-win deal: the buyer of insurance makes a negative expected value bet but one that, given the magnitude of the distress that would be caused if the risk became reality, they are happy to make; the sellers of insurance make a positive expected value bet.
Saving and investment: people with wealth who went to spend later can make win-win deals with people with ideas who need financing to turn those ideas into productive and profitable enterprises.
People who have done research and learned information about the structure and likely evolution of the market can bet on their knowledge: they win because they make their positive expected-value bets, and everyone else wins because after they have bet financial market asset prices better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.
The disadvantages of having more developed, liquid, and sophisticated financial markets are fourfold:
People who are excessively and irrationally averse to risks can trade those risks away at a price, and so lose wealth because they are shrinking at shadows.
People are are excessively and irrationally unconcerned about risks can trade to accept those risks, and so lose wealth because they are excited by the thrill of tossing the dice.
A more developed financial market is one in which it is easier to make money by unfairly appropriating somebody else's information through insider trading.
A more developed financial market is a more fragile market: when prices move suddenly and bankruptcies and failures to deliver emerge, it destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.
In general, you want to set up your financial markets so that they do as good a job as possible at (i) rewarding those who work hard doing research into fundamental values, (ii) matching individuals with wealth to save with entrepreneurs with ideas to try out, and (iii) enabling those who want to shed diversifiable risk to do so. And you want to set up your financial markets to minimize (i) the irrationally risk-averse's ability to throw away their money, (ii) the irrationally risk-loving's ability to throw away their money, (iii) the unfair appropriation of other people's information through insider trading, and (iv) the chance that a chain of bankruptcies and failures-to-deliver will disrupt the web of trust, cause a flight to liquidity and quality, and create a depression in the real economy.
There is an eighth consideration, however, and which way it cuts---whether it is a benefit or a disadvantage--is unclear:
- A more developed financial market increases the chance that somebody who thinks market prices are too low and wants to buy will find a counterparty who thinks that market prices are too high and wants to sell.
This eighth consideration is definitely not win-win. One of the two parties is definitely wrong--prices right now are, if they are not exactly right, either too high or too low. Both think that they are getting a good deal, but both cannot be correct. As far as the two parties are concerned, these trades are at best zero-sum and probably less than zero sum: risk is, after all, increased.
However, when all the people making too-high and too-low bets meet in the marketplace prices move until the number who think prices are too high (and are willing to put their money behind that belief) equals the number who think prices are too low (and are willing to put their money behind that belief). This reveals the balance of opinion, and so moves financial market asset prices to a place where they better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.
On the other side of the argument, somebody is holding a portfolio that is based on false beliefs about the way the world works. Such people are especially likely to fail when reality comes calling--and so encouraging these directional-bet transactions increases the chance that, when reality comes calling and when prices move suddenly, they go bankrupt or fail to deliver--and that destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.
George Soros believes that this last consideration should lead us to limit the extent to which our financial markets are friendly to directional bets. Thus he calls for the banning of "naked" credit default swaps:
George Soros Says Credit Default Swaps Need Much Stricter Regulation: AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps....
CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them toxic is that such speculation can be self-validating. Up until the crash of 2008, the prevailing view -- called the efficient market hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matter of anticipation, not knowledge....
[B]eing long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling. The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry... exerts a downward pressure on the underlying bonds.... The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect... bear raids on financial institutions can be self-validating.... AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule.... The unlimited shorting of bonds was facilitated by the CDS market.... Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies...
Tim Geithner disagrees:
Seeking Alpha: My own sense is that banning naked (CDS) volumes is not necessary and wouldn’t help fundamentally in this case. It’s too hard to hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.... [T]he absolutely essential thing is that there is more capital held against these positions so we never again face the situation where those types of judgments could imperil the system...
I call this one, narrowly, for Geithner: The key elements are clearing, transparency, and capital adequacy requirements that maximize the flow of information into market prices from the fact that people with money are willing to put it on the line to back their predictions and that minimize the chances of disruption of the web of trust.
Thursday, May 20, 2010
Rajiv Sethi discusses James Tobin's "four distinct conceptions of financial market efficiency," particularly his notion of functional efficiency"
James Tobin's Hirsch Lecture, by Rajiv Sethi: James Tobin's Fred Hirsch Memorial Lecture "On the Efficiency of the Financial System" was originally published in a 1984 issue of the Lloyds Bank Review, and republished three years later in a collection of his writings. Willem Buiter discussed the essay at some length about a year ago in a provocative post dealing with the regulation of derivatives. Both the original essay and Buiter's discussion of it remain well worth reading today as guides to the broad principles that ought to underlie financial market reform.
In his essay, Tobin considers four distinct conceptions of financial market efficiency:
Efficiency has several different meanings: first, a market is 'efficient' if it is on average impossible to gain from trading on the basis of generally available public information... Efficiency in this meaning I call information arbitrage efficiency.
A second and deeper meaning is the following: a market in a financial asset is efficient if if its valuations reflect accurately the future payments to which the asset gives title... I call this concept fundamental valuation efficiency.
Third, a system of financial markets is efficient if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies... I call efficiency in this Arrow-Debreu sense full insurance efficiency.
The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to to their more socially productive uses. I call efficiency in these respects functional efficiency.
The first two criteria correspond, respectively, to weak and strong versions of the efficient markets hypothesis. Tobin argues that the weak form is generally satisfied on the grounds that "actively managed portfolios, allowance made for transactions costs, do not beat the market." He notes, however that efficiency in the second (strong form) sense is "by no means implied" by this, and that "market speculation multiplies several fold the underlying fundamental variability of dividends and earnings."
My own view of the matter (expressed in an earlier post) is that such a neat separation of these two concepts of efficiency is too limiting: endogenous variations in the composition of trading strategies result in alternating periods of high and low volatility. Nevertheless, as an approximate view of market efficiency over long horizons, I feel that Tobin's characterization is about right.
Full insurance efficiency requires complete markets in state contingent claims. This is a theoretical ideal that is impossible to attain in practice for a variety of reasons: the real resource costs of contracting, the thinness of potential markets for exotic contingent claims, and the difficulty of dispute resolution. Nevertheless, Tobin argues for the introduction of new assets that insure against major contingencies such as inflation, and securities of this kind have indeed been introduced since his essay was published.
Finally, Tobin turns to functional efficiency, and this is where he expresses greatest concern:What is clear that very little of the work done by the securities industry, as gauged by the volume of market activity, has to do with the financing of real investment in any very direct way. Likewise, those markets have very little to do, in aggregate, with the translation of the saving of households into corporate business investment. That process occurs mainly outside the market, as retention of earnings gradually and irregularly augments the value of equity shares...
I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this 'paper economy', not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitation nth-degree speculation which is short sighted and inefficient...Arrow and Debreu did not have continuous sequential trading in mind; when that occurs, as Keynes noted, it attracts short-horizon speculators and middlemen, and distorts or dilutes the influence of fundamentals on prices. I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.
Recall that these passages were published in 1984; the financial sector has since been transformed beyond recognition. Buiter argues that Tobin's concerns about functional efficiency are more valid today than they have ever been, and is particularly concerned with derivatives contacts involving directional bets by both parties to the transaction:[Since] derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution. Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.
The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults. Defaults, insolvency and bankruptcy are key components of a market economy based on property rights. There involve more than a redistribution of property rights (both income and control rights). They also destroy real resources. The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough.The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple. The party purchasing the insurance should be able to demonstrate an insurable interest. [Credit Default Swaps] could only be bought and sold in combination with a matching amount of the underlying security.
The debate over naked credit default swaps is contentious and continues to rage. While market liquidity and stability have been central themes in this debate to date, it might be useful also to view the issue through the lens of functional efficiency. More generally, we ought to be asking whether Tobin was right to be concerned about the size of the financial sector in his day, and whether its dramatic growth over the couple of decades since then has been functional or dysfunctional on balance.
Stunning Overbuilding Fact of the Day, by Richard Green: I am listening to a presentation at the Homer Hoyt meetings on the condo meltdown in South Florida. Developers planned on building 95,000 units in the city of Miami between 2002 and 2007. In the 2000 census, the whole city had 163,000 units.
Unless the old people who move to Florida and buy these condos are partying so hard they destroy them in a few years -- maybe golf and bingo really bring out the wild side -- then that is, as noted, some "stunning overbuilding." Makes you wonder about the claim there is no way to tell if a bubble is developing until it pops.
Wednesday, May 19, 2010
Dean Baker says policymakers need to "to pick up Keynes again":
Politicians ignore Keynes at their peril, by Dean Baker: John Maynard Keynes explained the dynamics of an economy in a prolonged period of high unemployment more than 70 years ago in The General Theory. Unfortunately, it seems very few people in policymaking positions in the United States or Europe have heard of the book. Otherwise, they would be pushing economic policy in the exact opposite direction than it is currently heading.
Most wealthy countries have now made deficit reduction the primary focus of their economic policy. Even though the US and many eurozone countries are projected to be flirting with double-digit unemployment for years to come, their governments will be focused on cutting deficits rather than boosting the economy and creating jobs.
The outcome of this story is not pretty. Cutting deficits means raising taxes and/or cutting spending. In either case, it means pulling money out of the economy at a time when it is already well below full employment. This can lower deficits, but it also means lower GDP and higher unemployment.
This might be OK if we could show some benefit from lower deficits, but this is a case of pain with no gain. Ostensibly, there will be a lower interest-rate burden in future years, but even this is questionable. First, the contractionary policy being pursued by the deficit hawks will slow growth and lead to lower inflation or possibly even deflation. It is entirely possible that the debt-to-GDP ratio may actually end up higher by following their policies than by pursuing more expansionary policy.
In other words, we may end up with smaller deficits and therefore accumulate less debt, but we may slow GDP growth even more. The burden of the debt depends on the size of the economy and in the scenario where we do more to slow GDP growth than the growth of the debt, then we end up with a higher interest-rate burden, not a lower one.
The other reason why we may not end up with a lower interest rate-burden is that we need not issue debt to finance the budget deficits. Countries such as the United States and the United Kingdom that control their central banks can simply have the central banks buy up the bonds used to finance the deficits. In this story, the interest payments on the bonds are paid to the central bank, which is in turn refunded to the government. This means that there is no interest-burden created by these deficits.
If that sounds impossible, then it's necessary to pick up Keynes again. The economies of Europe and the United States are not suffering from scarcity right now. They are suffering from inadequate demand. This means that if governments run deficits, and thereby expand demand, the economy has the capacity to fill this demand. The decision of central banks to expand the money supply by buying bonds simply leads to an increase in output, not to inflation.
The idea that there is a direct link between the money supply and inflation is absurd. Do any businesses raise their prices because the Fed has put money into circulation? How many businesses even have a clue as to how much money is in circulation? In the real world, prices are set by supply and demand. If any businesses tried to raise their prices just because the Fed has put more money into circulation they would soon find themselves wiped out by the competition – at least as long as we are in this situation of having enormous excess supply.
This story should be old hat to those who have studied Keynes. In a period of high unemployment, like the present, governments can literally just print money. Not only will this put people back to work, this process can also lay the basis for stronger growth in the future by creating better infrastructure, more energy-efficient buildings, supporting research and development of clean energy and improving the education of our children.
Unfortunately, our political leaders don't give a damn about mundane issues such as unemployment and economic growth. It is far easier for them to bandy about silly cliches about fiscal responsibility and generational equity, even though the policies they are pushing are 180 degrees at odds with anything that will help our children or grandchildren. Their main concern is pushing policies that keep the financial industry happy. And 10 million unemployed never bothered anyone at Goldman Sachs, just as Fabulous Fabio.
What is the likely shape of the recovery for this year and next?:
The Shape of Things to Come, by Justin Weidner and John C. Williams, FRBSF Economic Letter: Economic recoveries from the past two recessions have been much more gradual than the rapid V-shaped recoveries typical of earlier downturns. Analysis of the factors that determine economic growth rates indicates that recovery from the most recent recession is likely to be faster than from the two previous recessions, but slower than earlier V-shaped recoveries.
By many measures, the most recent recession has been the worst in the United States since the Great Depression. Will the recovery now under way be rapid, as it was following most postwar recessions through the mid-1980s? Or will growth be more modest, as it was following the two most recent recessions? This question is often rephrased in terms of the shape of the recovery. That is, will economic activity turn up sharply, tracing out the upward sweep of the letter V? Or will it be more gradual, like the lower part of the letter U? This Economic Letter examines the key factors that determined the shape of past recoveries and assesses how they are influencing the pace of recovery this time.
Basic macroeconomic theory identifies three major factors that affect growth of real gross domestic product (GDP): the degree of slack in the economy, the stance of monetary policy, and the trend growth rate of potential GDP. Using the model of the U.S. economy presented in Laubach and Williams (2003), which incorporates these factors, we quantify how much each contributed to previous economic recoveries. Real GDP growth tends to be faster than usual in the early stages of a recovery, reflecting the effects of inventory rebuilding and pent-up consumer and business demand. Deep recessions with lots of economic slack tend to generate more pent-up demand and a quicker bounce-back. The Laubach and Williams model measures slack in terms of the output gap, or the percent deviation of real GDP from potential output, which is defined as the level of real GDP consistent with no upward or downward pressure on inflation, all else being equal (see Weidner and Williams 2009).
GDP growth also depends on the stance of monetary policy, which can be characterized by the difference between the real federal funds rate and the natural rate of interest. The natural rate of interest measures the combined effects of persistent influences on economic activity beyond the real interest rate, such as fiscal policy, the rate of productivity growth, and financial conditions (see Williams 2003). When monetary policy is accommodative, that is, the real funds rate is less than the natural rate of interest, real GDP grows at a higher rate than it otherwise would.
Finally, the real GDP growth rate depends on the growth rate of potential output, which in turn depends on the growth rates of productivity, that is, output produced per worker, and the labor force. The level of potential output, its growth rate, and the natural rate of interest can all vary over time. Unlike real GDP and interest rates, they are not directly measurable or observable. However, they can be estimated using statistical and economic models, such as that of Laubach and Williams.
The past is prologue
Real GDP growth including August 2009 forecasts
Note: LW refers to Laubach and Williams (2003).
In the postwar period until the 1990s, the U.S. economy tended to bounce back relatively briskly from downturns. As shown in Figure 1, the growth rate of real GDP over the eight quarters immediately following the business cycle low point tended to be very rapid, averaging about 5½%. We drop the 1980 recession from this analysis because the recovery was interrupted by the 1981–82 recession. This rapid GDP growth during the early part of a recovery is the defining characteristic of a V-shaped recovery.
All three factors—a large degree of slack, accommodative monetary policy, and high trend growth—contributed to the pattern of V-shaped recoveries through the 1980s.The first column of Table 1 estimates how much the three factors contributed to growth during recoveries from the 1960s through the 1980s, based on the Laubach and Williams model. During this period, the output gap averaged about 4% at business cycle troughs. The pent-up demand from this large amount of slack contributed about 1 percentage point to growth during the first two years of recovery. Monetary policy tended to be quite accommodative, contributing an additional 1 percentage point to growth. Finally, potential output growth was a relatively rapid 3.6%. These three factors combined predict about 5½% growth during the first two years of recoveries, almost exactly what was recorded.
Contributions to real GDP growth (at an annual rate)
Real GDP growth after the recessions of 1990–91 and 2001 was far less robust, reflecting smaller contributions from all three factors. Real GDP growth averaged only 2.9% in the first two years of these recoveries. The second column of Table 1 reports the three factors’ contributions to real GDP growth following these two recessions. The average output gap at the recession troughs was only 1.4%, about one-third as large as in the recessions of the earlier period, so the effect of pent-up demand was correspondingly lower. Monetary policy was less accommodative, contributing only 0.6 percentage point to growth. Finally, the estimated growth rate of potential output was 2.5%, well below the pace of the earlier period. The combined contribution to growth from these factors was 3.4%, 2.1 percentage points lower than in the earlier recoveries. Note that the actual pace of recovery was even somewhat slower than what the model predicts.
The estimated contributions of the three factors to past recoveries are similar when alternative estimates of the output gap and trend GDP growth are used. Replacing estimates from the Laubach and Williams model with calculations from the Congressional Budget Office (CBO 2010) yields quite similar GDP growth estimates.
At the turning point
Turning to the current recovery, we start by examining forecasts from last summer when the economy first returned to growth. Private forecasters predicted a very gradual recovery, similar to the pattern following the two most recent recessions. Although the National Bureau of Economic Research’s Business Cycle Dating Committee has not yet decided when the trough of the most recent recession occurred, we assume that it happened in June 2009, when real GDP is estimated to have reached its lowest value of this downturn. Figure 1 shows the Blue Chip Economic Indicators August 2009 consensus forecast. The forecast called for about 2.6% growth in the first two years of recovery, a projection that subsequent Blue Chip economic forecasts have echoed. Why have forecasters consistently rejected evidence from earlier V-shaped recoveries and predicted such a slow rebound?
Among the reasons for anticipating a slow recovery, economists point to the aftereffects of the banking and financial crisis, including debt hanging over U.S. households, and limitations on monetary stimulus owing to the fact that the Federal Reserve’s policy interest rate is effectively at its zero lower bound. We quantify these effects the same way that we examined recoveries from past recessions, using August 2009 Blue Chip real interest rate forecasts and data available in August 2009 to construct real-time Laubach and Williams model forecasts.
At the recession trough, the Laubach and Williams model predicted growth of about 3½% over the first two years of recovery. As seen in Figure 1 and Table 1, this is nearly one percentage point faster than the contemporaneous Blue Chip forecast, but still well below V-shaped recoveries of the past.
The model’s prediction of growth a little over 3½% reflected its assessment of a moderate output gap and considerable monetary stimulus, but relatively slow growth in potential output. First, the Laubach and Williams model output gap estimates during the latest recession have been considerably smaller than other estimates (see Weidner and Williams 2009). The model estimates an output gap of 2.3% for the second quarter of 2009, larger than in the prior two recessions, but well short of the average for recessions of the 1960s through the 1980s.
Second, the model’s estimate of the natural rate of interest was a historically low 1%, which likely reflected heightened uncertainty and a weakened financial system following the mortgage meltdown and financial panic. This very low value of the natural interest rate measures the “headwinds” that are holding back the economy. The effect is similar to, but much more severe than, the experience of the mid-1990s, when the banking sector was suffering large losses following the savings and loan crisis (see Greenspan 2004). In the recent downturn, the Fed cut nominal rates to near zero, bringing the real federal funds rate to about –1½%. This stimulated growth, but not as much as would have occurred if the natural interest rate had not declined. Also, the zero lower bound on nominal interest rates limited the ability of the Fed and other central banks to increase traditional monetary stimulus (see Williams 2009). Finally, the Laubach and Williams model estimate of the growth rate of potential output was a very low 2.1%, likely reflecting the low prevailing rate of labor force growth.
Through the first three quarters of the recovery, the Laubach and Williams model forecast from last August has proven to be reasonably accurate. During that period, real GDP has increased at a 3.7% annual rate, a touch faster than the model forecast. In contrast, the August 2009 Blue Chip forecast underpredicted the pace of recovery by more than one percentage point.
Real GDP growth including May 2010 forecasts
Note: LW refers to Laubach and Williams (2003).
What is the likely shape of the recovery for this year and next? Figure 2 compares the most recent Blue Chip consensus forecast for real GDP growth with the Laubach and Williams model forecast updated using data through the first quarter of 2010. The Blue Chip forecast remains relatively pessimistic, calling for approximately 3% growth this year as well as next, about the same rate experienced during the prior two recoveries.
By contrast, the Laubach and Williams model currently calls for nearly 4% growth this year and about 3½% next year. This is quite similar to the model’s August 2009 forecast, reflecting the same three factors: a moderate bounce-back from a moderate output gap, considerable monetary stimulus fighting strong headwinds, and sluggish growth of potential output. Of course, all three factors are measured with considerable uncertainty and could change. For example, if the CBO’s 1.6% estimate of potential output growth this year and next is accurate, then the Laubach and Williams forecast would be close to that of Blue Chip. Or, if financial conditions improve markedly, the natural rate of interest may rise from its current low value, implying faster real GDP growth ahead. Similarly, if the output gap were larger than the model estimates, then, all else equal, the predicted growth rate could exceed 4½% this year and next.
In the past, large output gaps, rapid growth of potential output, and real interest rates well below the natural interest rate have contributed to rapid V-shaped recoveries. These factors were much more muted in the recessions of 1990–91 and 2001, leading to U-shaped recoveries. Now they point to a moderate pace for the current recovery, somewhere between the U and V shapes of the past.
Congressional Budget Office. 2010. “The Budget and Economic Outlook: Fiscal Years 2010 to 2020.” January.
Greenspan, Alan. 2004. “Risk and Uncertainty in Monetary Policy.” Remarks at the meetings of the American Economic Association, January 3.
Laubach, Thomas, and John C. Williams. 2003. “Measuring the Natural Rate of Interest.” Review of Economics and Statistics 85 (4, November), pp. 1063–1070.
Weidner, Justin, and John C. Williams. 2009. “How Big Is the Output Gap?” FRBSF Economic Letter 2009-19 (June 12).
Williams, John C. 2003. “The Natural Rate of Interest.” FRBSF Economic Letter 2003-32, October 31.
Williams, John C. 2009. “Heeding Daedalus: Optimal Inflation and the Zero Lower Bound.” Brookings Papers on Economic Activity 2009(2), pp. 1-37.
In standard economic models, individuals maximize their self-interest. In the identity economics model described below by George Akerlof ond Rachel Kranton, identities and norms are basic motivations. They claim that " Identity Economics provides the broader, better vision that we need":
Identity Economics, by George Akerlof and Rachel Kranton, Commentary, Project Syndicate: A great strength of economics is its ability to examine how decisions are made from the point of view of decision makers. For example, economics can explain in this way why consumers buy what they do. It also offers a perspective on why employees work for some employers and not others, why they work as hard as they do, and, indeed, why they go to work at all.
But in most economic analysis, the decision makers’ point of view is quite narrow. It starts with what people like and don’t like. People may have a taste for oranges or bananas, or a preference for enjoying life today instead of saving for the future. They then decide what to buy or how much to save, given prevailing prices, interest rates, and their own income. Economists have included in such analysis that people interact with others, but they have largely treated such social interactions in a mechanical fashion, as if they were commodities. ...[continue reading]...
Tuesday, May 18, 2010
David Andolfatto reacts to Ron Paul's worries that the Fed can create money "out of thin air":
On Ron Paul and the Fed, by David Andolfatto: ...The Fed has the ability to create money "out of thin air!" Whenever I hear this expression, I chuckle. We all have the power to create debt out of "thin air." When Microsoft creates shares to finance an acquisition, it creates the shares "out of thin air." If you bum a beer from a friend and promise to repay him next week, you create a debt obligation "out of thin air." Ooooo..."out of thin air!" ...
I am traveling to China today (Beijing) to talk at a conference about US fiscal policy during the crisis, and have no idea about my ability to connect here once I arrive. I assume it won't be a problem, but just in case -- and because I won't have as much time as usual -- I have things set to post automatically until I get back.
Update: Finally here. Here are the slides for my presentation today.
Google is different here, but if I log onto the VPN at school I can get to the regular version. Sometimes my blog won't come up if I'm not logged in to the VPN, but not always, so not sure what's up. Blogs hosted by Google on blogger seem to be missing, and other blogs on TypePad don't always load either (though they do show up on Google unlike the blogs on blogger). With VPN though, no troubles. Anyone know the current state of blog access here?
Tim Duy argues that the European crisis may do more to help the US recovery than hurt it:
Is the European Crisis a Net Positive for the US?, by Tim Duy: How will the European crisis feed into the US outlook? I clearly recall JP Morgan making a recession call in the wake of the Asian Financial crisis, predicting a US recession on the back of a drop in net exports. While a drop in net exports did occur, domestic growth more than absorbed the impact. The US recession was delayed until the impact of tighter monetary policy, higher energy prices, and the popping of the tech bubble all came home.
I can see a similar pattern of events evolving now.
First off, I think it unlikely that an export demand shock alone is sufficient to push the US economy back into recession. Menzie Chinn tackled this issue back in 2007, arguing at the time it was unlikely a rise in exports would stave off a recession. The reverse logic holds as well; US recessions look to be driven by sharp declines in domestic absorption, not exports.
That is not to say that slowing exports would not crimp US growth. The rising Dollar not only stresses US exports to Europe, but China as well. As Calculated Risk notes, European exporters are now more competitive in China compared to their US counterparts. Moreover, the falling Euro may delay any eventual loosening of Chinese currency policy, as policymakers fret about the effects of one falling currency, let alone two.
Now, it is perfectly reasonable to be concerned about the implications of falling net exports for growth given the supposed fragility of the US recovery. The Wall Street Journal reports the Goldman Sachs analysis:
Estimates of how much the government’s spending is actually stimulating growth vary wildly — some economists contend it has no net effect at all. But if you believe the economists at Goldman Sachs, who have spent a lot of time poring over the details, the effect is quite significant: about two percentage points of annualized growth in both this quarter and the last. Indeed, if one subtracts that stimulus effect and the boost from changing inventories — also a temporary factor — there’s been no recovery at all. Growth in the first and second quarters of 2010 would be zero.
One can contrast this with a more optimistic assessment from Justin Weidner and John Williams at the San Francisco Federal Reserve Bank:
In the past, large output gaps, rapid growth of potential output, and real interest rates well below the natural interest rate have contributed to rapid V-shaped recoveries. These factors were much more muted in the recessions of 1990–91 and 2001, leading to U-shaped recoveries. Now they point to a moderate pace for the current recovery, somewhere between the U and V shapes of the past.
Yes, per usual, two economists, three opinions. In any event, one would have to consider the positive impact of the Greek crisis against any trade drag. And yes, there are positive implications. First, the weaker Euro has taken a bite out of oil prices, which fell back below $70 today. Make no mistake - keeping a lid on oil prices offers continued support for US consumers. And while we can all dream of a more balanced economy less dependent on household spending, for now it remains the best game in town. Although Phil Izzo at the Wall Street Journal tried to throw some cold water on the details, the overall trend in retail sales continue to look solid:
Consumers have a wind at their backs, unbelievably, and further job growth will only speed them further. Likewise, the rush to Treasuries is keeping a lid on US interest rates. And this is coming on the back of already surging demand for US assets. From Bloomberg:
Global demand for long-term U.S. financial assets strengthened in March to a record as investors from China to the U.K. purchased the most Treasuries since November, a Treasury Department report said.
Net buying of equities, notes and bonds totaled $140.5 billion in March, more than double economists’ projections, after net buying of $47.1 billion in February, the report released today in Washington showed. Including short-term securities such as stock swaps, investors abroad purchased a net $10.5 billion, compared with net buying of $9.7 billion the previous month.
Signs of a sustained economic recovery, including a rebound in earnings and stock prices, may increase demand for U.S. investments as concerns mount about the sustainability of government debt in Europe, economists said. The world’s largest economy has expanded for three consecutive quarters and added 573,000 jobs in the first four months of the year.
Add a lid on interest rates via a steady surge of capital flows to sustained job growth, and the odds of sustainable recovery look better every day. Moreover, we are still in a sweet spot with regards to monetary policy. The Fed was not inclined to tighten policy this year, expecting continued downward pressure on inflation via a persistent unemployment gap. The European crisis only adds to the willingness of monetary policymakers to hold tight. No, in the near term, the Fed is not likely to derail the recovery.
Of course, the European financial crisis remains a bogeyman via the possibility of financial contagion. Will the US banking system once again come under assault? On this point I think we can pull out the "too big too fail" card - images of the most recent crisis remain vivid in policymakers' minds. They would likely swamp the financial system with cash if the crisis threatened to spread to the US, quickly pulling out all the tools they just put back on the shelf. And note that the inflows of capital helped the US whether the Asian Financial Crisis despite a few harrowing days on Wall Street (like that little thing called LTCM).
Bottom Line: The European crisis, by keeping US interest rates in check and oil prices low, may do more to help the US recovery than hurt it. In the process, however, we would expect the flip side of the resulting capital inflows into the US to emerge - namely, a rising external imbalance. Arguably, this simply shifts the ultimate adjustment to sometime in the future. Again.
Martin Feldstein argues that the eurozone should commit to strict budget rules
For a solution to the euro crisis, look to the states, by Martin Feldstein, Commentary, Washington Post: The Greek budget crisis has made it clear that something must be done to limit fiscal deficits in eurozone countries. The attempt to do so with the group's Stability and Growth Pact has failed. ...
There is now political consensus in Europe that new rules are needed to prevent large deficits, but there is no agreement on what should be done. The European Commission ... proposed last week that the national budgets of each country be examined by the others before they are approved. ...
It would clearly be anathema to the German government to have its spending and tax policies approved by France, let alone by Greece and Portugal. The problem ... is therefore to find a way to prevent excessive deficits while leaving member states free to shape their own spending and tax policies.
Here there may be something to learn from United States. Although the 50 states share a currency and each sets its own spending and tax policies, state deficits remain very low. Even California has a deficit of only about 1 percent of the state's GDP and total general obligation debt of less than 4 percent of state GDP. The basic reason for these small deficits is that each state's constitution prohibits borrowing for operating purposes. ...
In some states, these self-imposed restrictions go back to the 19th century, a time when excessive borrowing led to state defaults. Those states wanted to assure potential lenders that such excess borrowing would not happen again. Over time, all states adopted such rules to help make the bonds they issued for capital expenditures attractive to investors. ... If the EMU governments were to adopt similar constitutional rules, the interest rates on their bonds would fall.
Of course, important differences exist between EMU members and the U.S. states. Because Europe lacks a central fiscal authority, some provision must be made for temporary deficits when economic conditions warrant. European nations also have national security responsibilities that may require surges in defense spending. But if the budget rules are well articulated, the effectiveness of the fiscal discipline will remain.
Germany recently adopted such a constitutional amendment. Germany's central government must reduce its deficit to 0.35 percent of GDP by 2016 unless a decline in GDP causes a larger deficit. ... Other EMU nations could follow Germany's example ... because doing so would bring down their interest rates. The European Central Bank could accelerate this process by restricting collateral to bonds issued by governments with satisfactory constitutional limits on their deficits. ...
The combination of national self-interest in achieving lower interest rates and an ECB rule on allowable collateral would create a powerful restriction on deficits. ... It would also leave member governments free to determine the structure and levels of their taxes and spending, as long as their decisions did not violate their self-imposed constitutional limits.
Does this still hold if we allocate the national debt to the states? Much of the debt at the national level is for activities that the states would have to do on their own if the federal government did not provide these goods to them (this is also true for stabilization policies during recessions, though in the present case the states didn't get as much help as they need). Thus, shouldn't the debt that is incurred at the national level be included in the comparisons with European countries? Does that change the picture? If countries in Europe could do the same thing -- allow a federal government to accumulate large amounts of debt that is, in essence, on their behalf -- would it change the outcome for individual countries?
Family as insurance:
The parental home as unemployment insurance, Economic Logic ...Greg Kaplan is documenting ... that many of those who do not attend college return home during unemployment spells, much like college students return home over the Summer. This analysis is very nicely done with an estimated structural model that features a repeated game between children and altruistic parents. In particular, this allows to understand why the savings rate of young people is so low. As they have the option of returning to their parents, they see no need to build up any precautionary savings. This means also that programs like unemployment insurance have little impact for them.
Just thinking of all things parents do to provide the insurance, yet minimize the moral hazard problem. The last place I would have wanted to live at that age was with my parents, and I'm pretty sure the feeling was mutual.
Monday, May 17, 2010
Why is right-wing extremism suddenly in the news?:
http://www.nytimes.com/2010/05/17/opinion/17krugman.html: Utah Republicans have denied Robert Bennett, a very conservative three-term senator, a place on the ballot, because he’s not conservative enough. In Maine, party activists have pushed through a platform calling for, among other things, abolishing both the Federal Reserve and the Department of Education. And it’s becoming ever more apparent that real power within the G.O.P. rests with the ranting talk-show hosts.
News organizations have taken notice: suddenly, the takeover of the Republican Party by right-wing extremists has become a story...
But why is this happening?... The right’s answer, of course, is that it’s about outrage over President Obama’s “socialist” policies... Many on the left argue, instead, that it’s about race... — and there’s surely something to that.
But I’d like to offer two alternative hypotheses: First, Republican extremism was there all along — what’s changed is the willingness of the news media to acknowledge it. Second, to the extent that the power of the party’s extremists really is on the rise, it’s the economy, stupid.
On the first point: when I read ... journalists who are shocked, shocked at the craziness of Maine’s Republicans, I wonder where they’ve been... Indeed, the new Maine platform is if anything a bit milder than the Texas Republican platform of 2000, which called not just for eliminating the Federal Reserve but also for returning to the gold standard, for killing not just the Department of Education but also the Environmental Protection Agency, and more.
Somehow..., the radicalism of Texas Republicans wasn’t a story in 2000, an election year in which George W. Bush of Texas, soon to become president, was widely portrayed as a moderate.
Or consider those talk-show hosts. Rush Limbaugh hasn’t changed... What’s changed is his respectability: news organizations are no longer as eager to downplay Mr. Limbaugh’s extremism...
So why has the reporting shifted? Maybe it was just deference to power: as long as America was widely perceived as being on the way to a permanent Republican majority, few were willing to call right-wing extremism by its proper name. Maybe it took a Democrat in the White House to give some observers the courage to say the obvious.
To be fair, however, it’s not all ... perception. Right-wing extremism ... clearly has more adherents now than ... a couple of years ago. Why? It may have a lot to do with a troubled economy. ...
When the economy plunged into crisis, many observers — myself included — expected a political shift to the left. After all, the crisis made nonsense of the right’s markets-know-best, regulation-is-always-bad dogma. In retrospect,... this was naïve:... in bad times, the gut reaction of many voters is to move right.
That’s the message of a recent paper by ... Markus Brückner and Hans Peter Grüner, who find ... periods of low economic growth tend to be associated with a rising vote for right-wing and nationalist political parties. The rise of the Tea Party, in other words, was exactly what we should have expected in the wake of the economic crisis.
So where does our political system go from here? Over the near term, a lot will depend on economic recovery. If the economy continues to add jobs, we can expect some of the air to go out of the Tea Party movement.
But don’t expect extremists to lose their grip on the G.O.P. anytime soon. What we’re seeing in places like Utah and Maine isn’t really a change in the party’s character: it has been dominated by extremists for a long time. The only thing that’s different now is that the rest of the country has finally noticed.
Since you had so much fun with the last comparison, here's another one from Yves Smith:
German Households Owe More Than Greece’s Do, by Yves Smith: Be careful about your cultural stereotypes! From Bloomberg, via Marshall and Andrew:
Nouriel Roubini is becoming increasingly hawkish about public debt:
Return to the Abyss, by Nouriel Roubini, Commentary, Project Syndicate: ...History ... suggests that financial crises tend to morph over time. Crises like those we have recently endured were initially driven by excessive debt and leverage among private-sector agents... This eventually led to a re-leveraging of the public sector as fiscal stimulus and socialization of private losses – bail-out programs – caused a dangerous rise in budget deficits and the stock of public debt.
While such fiscal stimulus and bailouts may have been necessary to prevent the Great Recession from turning into Great Depression II, piling public debt on top of private debt carries a high cost. Eventually those large deficits and debts need to be reduced through higher taxes and lower spending, and such austerity – necessary to avoid a fiscal crisis – tends to slow economic recovery in the short run. If fiscal imbalances are not addressed through spending cuts and revenue increases, only two options remain: inflation for countries that borrow in their own currency and can monetize their deficits; or default for countries that borrow in a foreign currency or can’t print their own.
Thus, the recent ... global financial crisis is not over; it has, instead, reached a new and more dangerous stage. ... The progression is clear: first came rescue of private firms, and now comes the rescue of the rescuers – i.e., governments.
The scale of these bailouts is mushrooming. During the Asian financial crisis of 1997-1998, South Korea ... received ... $10 billion. But, after the rescues of Bear Sterns ($40 billion), Fannie Mae and Freddie Mac ($200 billion), AIG (up to $250 billion), the Troubled Asset Relief Program for banks ($700 billion), we now have the mother of all bailouts: the $1 trillion European Union-International Monetary Fund rescue of troubled eurozone members. A billion dollars used to be a lot of money...
Governments that bailed out private firms now are in need of bailouts themselves. But what happens when the political willingness of Germany and other disciplined creditors – many now in emerging markets – to fund such bailouts fizzles? Who will then bail out governments that bailed out private banks...? Our global debt mechanics are looking increasingly like a Ponzi scheme.
While the right medicine needed to avoid fiscal train wrecks is well known, the main constraint ... is that weak governments ... lack the political power and willingness to implement austerity. Political gridlock in Washington ... demonstrates the absence of the bipartisanship needed to address America’s fiscal issues. In the United Kingdom, a “hung” parliament has resulted in a coalition government that will have a hard time implementing fiscal discipline.
In Germany, Chancellor Angela Merkel lost a key state election after the rescue of Greece, and Japan has a weak and ineffectual government that seems in denial of the scale of the problem that it faces. In Greece itself, there are riots in the streets and strikes in the factories; in the rest of the PIIGS (Portugal, Ireland, Italy, and Spain),... political constraints may prevent fiscal austerity and structural reforms from being implemented.
As a result, “crisis economics” is likely to be with us for a long time. Indeed, the recent financial crisis is not over, and, worse, the medicine used to treat may have been partly toxic. It seems to have made the patient weaker and more addicted to dangerous drugs, as well as more susceptible to new strains of the virus that may, in some cases, eventually prove fatal.
When we are around six months until the economy returns full employment, it will be time to begin tightening both monetary and fiscal policy, but anything before that risks unduly slowing the recovery or even sending the economy back into recession. It's fine to plan what to do when the time comes, and we should begin doing that, but we need to avoid being overly anxious to begin reversing stimulative policy. The other thing is, since the main problem is rising health care costs -- the rest of the budget can be managed without much trouble -- it's not clear how we solve that problem right away in any case. There are certainly things we can do on the revenue side, and measures on the spending side such as ending wars would help as well. But the biggest part of the problem by far it the growth in health care costs, and that will take time -- and considerable political battling -- to resolve.
I'm not saying there's nothing to worry about, though things have been a bit better lately the political environment is generally fairly toxic, and it's not clear politicians are up to addressing the long-run health care challenge. But that doesn't mean we should begin pulling back on stimulus programs before the economy is ready. It wouldn't help much at all with the long-run problem, but it could cause considerable trouble in the short-run.
Sunday, May 16, 2010
This is a list of my posts at CBS MoneyWatch:
- What Economic Policies Should Government Pursue During the Recovery? 2010/05/14
- Congress and the Fed: Why the Bark is Worse Than the Bite 2010/05/11
- The Employment Report 2010/05/07
- Initial Claims for Unemployment Insurance Fall Slightly 2010/05/06
- GDP Grows by 3.2 Percent 2010/04/30
- A Loss of Faith in Government 2010/04/28
- Is the Six Percent Rise in Producer Prices a Signal that Inflation is Coming? 2010/04/22
- What’s Missing from the Dodd Proposal for Financial Reform? 2010/04/20
- Unemployment Insurance has Little Effect on the Unemployment Rate 2010/04/19
- The SEC Accuses Goldman Sachs of Fraud 2010/04/16
- How Mathematics Might Have Caused the Financial Crisis 2010/04/15
- Is a Falling Deficit Good News? 2010/04/13
- Federal Reserve Bank of New York President Dudley Calls for the Fed to Take Action Against Bubbles 2010/04/07
- Unemployment Rate Holds Steady at 9.7% 2010/04/02
- ADP Report: Private Sector Lost Jobs Last Month 2010/03/31
- Initial Claims for Unemployment Insurance Decrease Slightly 2010/03/25
- Be Prepared: Tax Increases Are Inevitable 2010/03/22
- Who Benefits from Health Care Reform? 2010/03/22
- FOMC Meeting: Rates Steady for an Extended Period, Asset Purchase Programs to End 2010/03/16
- Is This the Best Congress Can Do for the Unemployed? 2010/03/11
- Why Do Federal Reserve Board Seats Remain Unfilled? 2010/03/10
- Monetary Policy and Unemployment: Should the Fed have Done More? 2010/03/09
- Unemployment Unchanged 2010/03/05
- New Claims for Unemployment Insurance Fall Slightly 2010/03/04
- Unemployment Compensation has Broad Based Benefits 2010/03/02
- Initial Weekly Claims for Unemployment Insurance Increase to 496,000 2010/02/25
- Health Care Reform: What Needs to Come Next 2010/02/24
- Health Care is Important, But Don’t Forget the Unemployed 2010/02/21
- Europe’s Sovereign Debt Problem: Causes and Solutions 2010/02/18
- What the World’s Leaders Did on their Winter Vacation: Nothing 2010/02/12
- The Fed’s Exit Strategy 2010/02/10
- What Changes Are Needed in the U.S. Financial System? 2010/02/08
- Both Employment and Unemployment Fall 2010/02/05
- Bank Size and the Severity of Financial Shocks 2010/01/31
- GDP Grows at an Estimated 5.7 Percent Annual Rate in the 4th Quarter of 2009 2010/01/29
- Ben Bernanke Reconfirmed: Will He Get the Message? 2010/01/28
- The Importance of Automatic Stabilizers to the Economy2010/01/25
- Obama Talks Tough to Banks 2010/01/21
- The Unemployment Gap 2010/01/18
- Will the Administration’s Proposed Bank Tax Create a Moral Hazard Problem? 2010/01/15
- What Caused the Fed’s Record $45 Billion in Earnings for 2009? 2010/01/12
- The Economy Continues to Lose Jobs 2010/01/08
- Did the Fed Cause the Recession? 2010/01/04
- Will Economists Ever Learn? 2009/12/30
- Policymakers Need Better and More Timely Economic Data 2009/12/22
- Is Criticism of the Bernanke Fed Justified? 2009/12/21
- The Fed Can Help, But Fiscal Policy Is The Key To Job Creation 2009/12/18
- Producer Prices Rise 1.8 Percent; Should the Fed Be Worried About Inflation? 2009/12/15
- Why It May Take Almost Seven Years for Unemployment to Reach Five Percent 2009/12/11
- The Administration’s Job Creation Proposal is Inadequate 2009/12/09
- The Relationship Between Budget Deficits, Fed Independence, and Inflation 2009/12/08
- Employment Report Shows Small Decline in Unemployment 2009/12/04
- What Types of Employment Policies Should be Discussed at the Jobs Forum? 2009/12/02
- A Lost Decade for Private Sector Jobs 2009/12/01
- Will Consumption Growth Return to Its Pre-Recession Level? 2009/11/30
- Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes 2009/11/25
- Existing Home Sales Rise 10.1 Percent 2009/11/23
- What Causes Employment to Lag Output in Recoveries? 2009/11/20
- What’s Wrong With the Dodd Proposal to Restructure the Fed 2009/11/20
- Housing Starts Fall 2009/11/18
- Data on Production and Producer Prices Will Not Change Fed Policy 2009/11/17
- Ben Bernanke’s Outlook for the Economy 2009/11/16
- How To Prevent the Next Financial Crisis 2009/11/16
- Why We Need an Individual Mandate for Health Insurance 2009/11/13
- Today’s Unemployment Report: Both Good and Bad News 2009/11/12
- Why The Federal Reserve Needs To Be Independent 2009/11/12
- Will There Be a ‘New Normal’ For Unemployment? 2009/11/11
- Why Employment Might Not Fully Recover Until 2013 2009/11/10
[This is just so I have them all in one place (though it won't hurt my feelings if you decide to read one of them). I started a MoneyWatch category for posts not too long ago to make the posts easier to find later, and this is faster than going back and trying to add the tag to all the references to MoneyWatch posts that appeared here.]
Economics of Contempt argues that statutes that ban on proprietary trading at banks and bank holding companies must leave considerable discretionary power to regulators, attempts to be more specific end up creating more loopholes than they close:
Merkley-Levin Is a Joke, by Economics of Contempt: The Merkley-Levin Amendment (SA 3931) is a version of the Volcker Rule. The Volcker Rule, if you'll recall, is a ban on proprietary trading at banks and bank holding companies (BHCs). If you ask Merkley and Levin's offices, they'd no doubt tell you that their amendment significantly strengthens the existing Volcker Rule language in the Dodd bill (Section 619 of S.3712). Don't be fooled — it does nothing of the sort. I spent the majority of my career as a lawyer for a big investment bank, and my first thought after reading Merkley-Levin was: "Wow, this would be cake to get around." Wall Street is scared of the Volcker Rule, but believe me, they're not scared of Merkley-Levin....So essentially, section (G) allows BHCs to continue their prop trading through their London offices, provided they find non-US counterparties (shouldn't be too difficult), and the trading isn't being controlled by someone in New York (fine, just send all your prop traders to London). And this is in addition to all the prop trading the banks could do out of their New York offices under the ridiculously broad "permitted activities" in sections (d)(1)(B) and (C). Seriously, this would be like taking candy from a baby for the dealer banks. ...
This requires a bit of explanation. To ban prop trading at BHCs, the law must distinguish between market-making trades and propietary trades. Market-makers stand ready and willing to buy or sell securities for their own account, at firm bid and offer prices. If an investor is looking to sell a security, the market-maker will buy the security using its own capital, and hold it in inventory until an investor who's looking to buy the security surfaces. Holding many inventories of securities (i.e., bonds, stocks, derivatives) exposes market-makers to all manner of short-term market risk, interest rate risk, foreign exchange risk, etc. This requires market-makers to do quite a bit of hedging in order to safely carry these inventories. We don't want to prevent banks from hedging the inventories they hold as market-makers, but we do want to prevent banks from entering into trades that aren't intended to hedge a risk associated with its market-making activities — that is, purely speculative prop trades. This is a difficult and complicated task, but it can be done (I've seen it done from the inside).
Ideally, what the financial reform bill would do is just say, "Proprietary trades are banned; market-making trades are allowed," and then let the regulators work out how to define "market-making trades" and "proprietary trades." This is something that simply can't be done at the statutory level; it has to be done at the regulatory level. Unfortunately, these days it's fashionable for people to bash any sort of regulatory discretion as tantamount to letting Wall Street win. This is where Merkley-Levin comes in, because it's clearly a response to this "anti-regulatory discretion" meme. ...
Merkley-Levin prohibits "proprietary trading," which it defines very broadly, and then creates 9 categories of "permitted activities" (listed in section (d)(1) of the amendment). The categories of "permitted activities," which function like exceptions to the definition of "proprietary trading," are so ridiculously broad that they completely swallow the amendment's prop trading ban. ...[goes on to lists several exceptions and then explains why they are problematic, for example]...
People often ask why I say that complicated financial regulations can't be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.
I think specific rules are best, where they can be applied, but strict dividing lines aren't always possible and regulators will generally have at least some discretionary power in enforcing the rules. In addition, even with very specific rules, it still comes down to the will of regulators to enforce the statutes on the books. Strict rules don't do much good if the people enforcing them simply look the other way when they are violated. But I don't know enough about this particular issue to say whether strict rules on proprietary trading are as difficult to write as described above. The argument sounds convincing, but an experienced lawyer ought to be able to make a convincing case. Anyone want to argue the other side?
One other note. If discretionary authority for regulators cannot be avoided, and it can't, and if it sometimes involves very important, but complicated issues, as it does, then we need qualified, dedicated regulators. We are seeing the consequences of poor regulation in the gulf right now, and those problems, together with the problems that poor regulation caused related to the financial crisis, show that the consequences of lax regulation, regulatory error, or poorly structured rules and regulations can be very, very large.
We have been through a period where the people in charge of regulation were not chosen with much care. The attitude toward government in the previous administration led to these positions being used as rewards for political support or to further the administration's ideological agenda much more so than before, and this administration has not moved as fast as it should have to clean up the mess. I hope that recent events lead people to better understand the importance of filling the agencies in charge of regulation with dedicated, capable people, and that politicians and administrations that do not take this mission seriously will be held accountable. But I hope for lots of things, it certainly doesn't mean they'll happen. However, I am encouraged by recent indications concerning financial reform regulation. It's not as strong as I'd like, but it's looking to be much stronger than I thought it would be, so perhaps there's hope that we are beginning to take these issues more seriously than we have for some time now.
The OECD’s growth prospects and political extremism, by Markus Brückner and Hans Peter Grüner, Vox EU: Will the global crisis lead to a rise in political extremism just as during the Great Depression? ... Is political extremism always likely to be marginal in rich economies? Will changes in growth promote support for right-wing or left-wing parties, or both?
Benjamin Friedman has argued that GDP per capita growth is a key factor for the development of a political system (Friedman 2005). His analysis ... points out that only a continuous improvement of individual living standards provides the ground for the development of what he calls a more “open” society. Accordingly, it is not so much the level of GDP that determines the way in which a democracy develops but the growth rate. ...
In our recent CEPR Discussion Paper (Brückner and Grüner 2010), we examine the question of how GDP per capita growth is linked to the support for extreme policy platforms for a panel of 16 OECD countries. ...
Our main finding is that higher per capita GDP growth is significantly negatively linked to the support for extreme political positions. While estimates vary between specifications, we find that roughly a one percentage point decline in growth translates into a one percentage point higher vote share of right-wing or nationalist parties. Moreover, we find that the amount of income inequality in a country affects the role that growth plays. Highly unequal countries display a lower growth effect than more equal countries. For countries with a more equal distribution of income, a one percentage point drop in the growth rate may increase the vote share of far right parties by up to two percentage points. ...
Our results lend support to Benjamin Friedman’s view that economic growth determines the direction in which a democracy develops. ...
If you believe the price of a good you consume regularly is going to go up in the future, the best thing to do is to stock up now. If everyone else shares that belief, that will drive the price up, just as you thought. Thus, even if the expectation of an increase in the price was driven by nothing more than speculation and rumor, the expected change in the price will be self-fulfilling. Beliefs about the future will be validated by observable events, and this will tend to reinforce the beliefs (this is one way a bubble could get started, but the point here is simply that expectations can be self-fulfilling).
Robert Shiller says there is a growing belief that the economy will have a double-dip recession, and that this belief may cause the outcome people are worried about:
Fear of a Double Dip Could Cause One, by By Robert J. Shiller, Commentary, NY Times: The risk of a double-dip recession hasn’t abated..., the danger stems from the weakness and vulnerability of confidence — whose decline could bring markets down, further stress balance sheets and cause cuts in consumption, investment and local government expenditures.
Ultimately, the risk resides largely in social psychology. It is the fear of fear itself, of which Franklin D. Roosevelt famously spoke.
From 2007 to 2009, there was widespread concern about the risk of an economic depression, but that scare has been abating. Since mid-2009, it has been replaced by the milder worry of a double-dip recession... And with that depression scare still fresh in our minds, sensitivity to the possibility of another downturn remains high.
To be sure, many economists doubt that a double-dip recession is in store. ... And there have been encouraging factors... But forecasters ... may be missing the real worry that many people harbor about the economy.
I use a definition of a double-dip recession that doesn’t emphasize the short term. Instead, I see it as ... a recession in which unemployment rises to a high level and then falls at a disappointingly slow rate. Before employment returns to normal, there is a second recession. As long as economic recovery isn’t complete, that’s a double-dip recession, even if there are years between the declines.
Under that definition, there has been only one serious double-dip recession in the last century — and it was serious indeed. It started with the 1929-33 recession, which was followed by a recession in 1937-38. Between those declines, the unemployment rate never moved below 12.2 percent. Those two recessions, four years apart, are now typically lumped together as one event, the Great Depression.
Many negative factors persisted between those dips. High among them was a widespread sense then that something was amiss with the economy. There was a feeling of uncertainty that discouraged entrepreneurship, lending and spending, and most important, hiring.
We have to deal with a similar — though less extreme — problem today. Many of us are unsettled by images that are preventing a return to normal confidence — images of rioting in Athens, or of baffled American traders during the nearly 10 percent drop in the stock market on May 6. And if the BP oil spill ... eventually wreaks havoc on the gulf economy, we may need to add it to the list, too. ...
Fostered by mass psychology,... aftershocks could occur in the next year or two. This ... could be ... severe. ... We need to look at short-run events, like the market reaction to the Greek bailout, as no more than side effects. Slowly moving changes in our animal spirits represent the real risk of a double-dip recession.I think the more likely trigger is further economic trouble. We could be hit by big shocks that we are vaguely aware might be a problem but do not yet fully anticipate, or it could be something else unexpected -- another big oil shock for political or other reasons would be hard for the recovering economy to absorb. Even more likely is an outbreak of extreme hawkishness causing us to pull back too fast on fiscal stimulus, and to raise interest rates too fast. That is, I think it's more likely that economic events will drive fear rather than the other way around. That's not to say that fear doesn't provide an important negative feedback mechanism, I think it does, but I'm not convinced that psychology is the prime causal mover.
Saturday, May 15, 2010
Via Brad DeLong, Elena Kagan's Undergraduate Thesis:
From the introduction:
Ever since Werner Sombart first posed the question in 1905, countless historians have tried to explain why there is no socialism in America. For the most part, this work has focused on external factors--on features of American society rather than of American socialist movements. Socialists and non-socialists alike have discussed the importance of the frontier... the fluidity of class lines... the American labor force's peculiarly heterogeneous character, which made concerted class action more difficult than it might otherwise have been. In short, most historians have looked everywhere but to the American socialist movement itself for explanations of U.S. socialism's failure. Such external explanations are not unimportant but neither do they tell the full story. They ignore or overlook one supremely important fact: Socialism has indeed existed in the United States.... The Socialist Party increased its membership from a scanty 10,000 in 1902 to a respectable 109,000 in the early months of 1919... a party press that included over three hundred publications with an aggregate circulation of approximately two million....
The success of the socialists in establishing a viable--if minor--political party in the early twentieth century suggests that historians must examine not only external but also internal factors if they hope to explain the absence of socialism from contemporary American politics. The effects of the frontier, of class mobility, of an ethnically divided working class may explicate why the Socialist Party did not gain an immediate mass following; they cannot explain why the growing and confident American socialist movement collapsed....
We are, then, left with three ultimately inadequate explanations of the sudden demise of a growing socialist movement. The otherworldliness of the socialists, the expulsion of Haywood in 1912, the Russian Revolution of 1917--none will satisfactorily explain the death of social- ism in America. What, then, was responsible? In attempting to answer this question, this thesis will focus almost exclusively on the history of the New York City local of the Socialist Party....
The collapse of New York socialism, although sudden, had deep roots indeed. From its first days, the New York SF was both divided within itself and estranged from many of its trade-union followers. Among the party's members, a right-left cleavage arose early--a cleavage based not on the minutiae of dogma but on the very fundamentals of socialism itself. What was the proper class composition of a socialist party? What trade-union and electoral policies should the party follow? What attitude should the party take toward distinctly non-radical reform measures?... At the end of 1918, old disputes quickly reappeared, but this time in even fiercer form. For years, large numbers of the SP's members and large blocs of its trade-union support had expressed deep dissatisfaction with socialist leadership. Now, the Russian Revolution set the spark... and the Socialist Party burst into flames. In 1919, the SP split into two.... Intra-party sectarianism had previously weakened the socialist movement; inter-party sectarianism now finished the job...
And from the conclusion:
In our own times, a coherent socialist movement is nowhere to be found in the United States. Americans are more likely to speak of a golden past than of a golden future, of capitalism's glories rather than of socialisms greatness. Conformity overrides dissent; the desire to conserve has overwhelmed the urge to alter. Such a state of affairs cries out for explanation. Why, in a society by no means perfect, has a radical party never attained the status of a major political force? Why, in particular did the socialist movement never become an alternative to the nation's established parties?
In answering this question, historians have often called attention to various charcteristics of American society... an ethnically-divided working class, a relatively fluid class structure, an economy which allowed at least some workers to enjoy what Sombart termed "reefs of roast beef and apple pie"--prevented the early twentieth century socialists from attracting an immediate mass following. Such conditions did not, however, completely checkmate American socialism.... Yet in the years after World War I, this expanding and confident movement almost entirely collapsed.... [T]he experience of New York.... From the New York socialist movement's birth, sectarianism and dissension ate away at its core. Substantial numbers of SP members expressed deep and abiding dissatisfaction with the brand of reform socialism advocated by the party's leadership. To these left-wingers, constructive socialism seemed to stress insignificant reforms at the expense of ultimate goals. How, these revolutionaries angrily demanded, could the SP hope to attract workers if it did not distinguish itself from the many progressive parties, if it did not proffer an enduring and radiant ideal? How, the constructivists angrily replied, could the SP hope to attract workers if it did not promise them immediate benefits, if it did not concern itself with their present burdens?...
Through its own internal feuding, then, the SP exhausted itself. forever.... The story is a sad but also a chastening one for those who, more than half a century after socialism's decline, still wish to change America. Radicals have often succumbed to the devastating bane of sectarianism; it is easier, after all, to fight one's fellows than it is to battle an entrenched and powerful foe. Yet if 'the history of Local New York shows anything, it is that American radicals cannot afford to become their own worst enemies. In unity lies their only hope. ---- Download Elena-kagan-thesis
Barry Eichengreen on the euro:
Europe’s Historic Gamble, by Barry Eichengreen, Commentary, Project Syndicate: The last few weeks have been the most amazing – and important – period of the euro’s 11-year existence. First came the Greek crisis, followed by the Greek bailout. When the crisis spread to Portugal and Spain, there was the $1 trillion rescue. Finally, there were unprecedented purchases of Spanish, Portuguese, Greek, and Irish bonds by the European Central Bank. All of this was unimaginable a month ago.
Europe’s fortnight mirabilis was also marked by amazing – and erroneous – predictions. Greece would be booted out of the monetary union. The eurozone would be divided into a Northern European union and a Southern European union. Or the euro – and even the European Union – would disintegrate as Germany turned its back on the project.
But, rather than folding their cards, European leaders doubled down. They understand that their gamble will be immensely costly if it proves wrong. They understand that their political careers now ride on their massive bet. But they also understand that they already have too many chips in the pot to fold....[continue reading]...
Friday, May 14, 2010
Help me complete a list of policies that the government should pursue during the recovery period:
Even though things are looking better, the government's job is far from done.
Right now, scare stories about the national debt are "everywhere you look":
We’re Not Greece, by Paul Krugman, Commentary, NY Times: It’s an ill wind that blows nobody good, and the crisis in Greece is making some people — people who opposed health care reform and are itching for an excuse to dismantle Social Security — very, very happy. Everywhere you look there are editorials and commentaries, some posing as objective reporting, asserting that Greece today will be America tomorrow unless we abandon all that nonsense about taking care of those in need.
The truth, however, is that America isn’t Greece — and, in any case, the message from Greece isn’t what these people would have you believe.
So, how do America and Greece compare? Both nations have lately been running large budget deficits, roughly comparable as a percentage of G.D.P. Markets, however, treat them very differently: The interest rate on Greek government bonds is more than twice the rate on U.S. bonds, because investors see a high risk that Greece will eventually default on its debt, while seeing virtually no risk that America will... Why?
One answer is that we have a much lower level of debt — the amount we already owe, as opposed to new borrowing — relative to G.D.P. ... Even more important, however, is the fact that we have a clear path to economic recovery, while Greece doesn’t.
The U.S. economy has been growing since last summer, thanks to fiscal stimulus and expansionary policies by the Federal Reserve. I wish that growth were faster; still, it’s ... showing up in revenues. ...Congressional Budget Office projections ... imply a sharp fall in the budget deficit over the next few years.
Greece, on the other hand, ... faces years of grinding deflation and low or zero economic growth. So the only way to reduce deficits is through savage budget cuts, and investors are skeptical about whether those cuts will actually happen.
It’s worth noting ... that Britain — which is in worse fiscal shape than we are,... remains able to borrow at fairly low interest rates. Having your own currency, it seems, makes a big difference.
In short, we’re not Greece..., our fiscal outlook ... is vastly better.
That said, we do have a long-run budget problem. But what’s the root of that problem? ... Bear in mind that the drive to cut taxes largely benefited a small minority of Americans... And bear in mind, also, that taxes have lagged behind spending partly thanks to ... “starve the beast”: conservatives have deliberately deprived the government of revenue in an attempt to force the spending cuts they now insist are necessary.
Meanwhile, when you look under the hood of those troubling long-run budget projections, you discover that they’re not driven by some generalized problem of overspending. Instead, they largely reflect just one thing: the assumption that health care costs will rise in the future as they have in the past. This tells us that the key to our fiscal future is improving the efficiency of our health care system — which is, you may recall, something the Obama administration has been trying to do, even as many of the same people now warning about the evils of deficits cried “Death panels!”
So here’s the reality: America’s fiscal outlook over the next few years isn’t bad. We do have a serious long-run budget problem, which will have to be resolved with a combination of health care reform and other measures, probably including a moderate rise in taxes. But we should ignore those who pretend to be concerned with fiscal responsibility, but whose real goal is to dismantle the welfare state — and are trying to use crises elsewhere to frighten us into giving them what they want.
It looks like the oil spill in the gulf is much larger than we've been led to believe. BP deserves it's share -- a large share -- of the criticism for what has happened, but has the administration done everything it could do to help with the oil spill problem. Has it mobilized all possible resources, taken control of the response, etc.? Or has it left too much of the task to BP, and, as convenient, accepted lowball estimates of the magnitude of the problem hoping somehow it would go away? Are you satisfied with the administration's response? I'm not:
Size of Oil Spill Underestimated, Scientists Say, by Justin Gillis, NY Times: Two weeks ago, the government put out a round estimate of the size of the oil leak in the Gulf of Mexico: 5,000 barrels a day. Repeated endlessly in news reports, it has become conventional wisdom.
But scientists and environmental groups are raising sharp questions about that estimate, declaring that the leak must be far larger. They also criticize BP for refusing to use well-known scientific techniques that would give a more precise figure.
The criticism escalated on Thursday, a day after the release of a video that showed a huge black plume of oil gushing from the broken well at a seemingly high rate. ...
The figure of 5,000 barrels a day was hastily produced by government scientists in Seattle. It appears to have been calculated using a method that is specifically not recommended for major oil spills.
Ian R. MacDonald, an oceanographer at Florida State University who is an expert in the analysis of oil slicks, said he had made his own rough calculations using satellite imagery. They suggested that the leak could “easily be four or five times” the government estimate, he said. ...
BP has repeatedly said that its highest priority is stopping the leak, not measuring it. “There’s just no way to measure it,” Kent Wells, a BP senior vice president, said in a recent briefing.
Yet for decades, specialists have used a technique that is almost tailor-made for the problem. With undersea gear that resembles the ultrasound machines in medical offices, they measure the flow rate from hot-water vents on the ocean floor. ...
Richard Camilli and Andy Bowen, of the Woods Hole Oceanographic Institution in Massachusetts, who have routinely made such measurements, spoke extensively to BP last week... They were poised to fly to the gulf to conduct volume measurements.
But they were contacted late in the week and told not to come, at around the time BP decided to lower a large metal container to try to capture the leak. That maneuver failed. They have not been invited again. ...
The issue of how fast the well is leaking has been murky from the beginning. For several days after the April 20 explosion of the Deepwater Horizon rig, the government and BP claimed that the well on the ocean floor was leaking about 1,000 barrels a day.
A small organization called SkyTruth, which uses satellite images to monitor environmental problems, published an estimate on April 27 suggesting that the flow rate had to be at least 5,000 barrels a day, and probably several times that.
The following day, the government — over public objections from BP — raised its estimate to 5,000 barrels a day. ...
BP later acknowledged to Congress that the worst case, if the leak accelerated, would be 60,000 barrels a day, a flow rate that would dump a plume the size of the Exxon Valdez spill into the gulf every four days. BP’s chief executive, Tony Hayward, has estimated that the reservoir tapped by the out-of-control well holds at least 50 million barrels of oil. ...
About That Mediterranean Work Ethic, Twenty Cent Paradigms: According to many accounts of the financial crisis in Europe, one reason intervention has been slow is that it is hard to convince Germans, widely seen by themselves and others as hard-working, thrifty and virtuous, to "bail out" those lazy, spendthrift Greeks.
This bit of OECD data on hours worked per worker (via Economix) runs contrary to the stereotypes:
That is, according to the OECD, the average Greek worker logs 2120 hours per year - 690 more than a German worker.
Thursday, May 13, 2010
Chemical and biological engineers are hoping to be able to do intelligent design within the next few decades, but for now, for the most part, they'll have to let evolution do the work:
Directed Evolution, by Anne Trafton, MIT News Office: In nature, evolution takes place over eons... But evolution can also happen on a small and fast scale in the laboratory.
The approach is called “directed evolution,” and scientists are using it to generate proteins that do not occur in nature — for example, cancer drugs, new microbial enzymes for converting agricultural waste to fuel, or imaging agents for magnetic resonance imaging (MRI).
Most protein structures are so complex that it’s nearly impossible to predict how altering their structure will affect their function. So the trial-and-error approach of directed evolution is usually the fastest way to come up with a new protein with desirable traits, says Dane Wittrup, an MIT professor of chemical and biological engineering...
Such experiments often yield proteins that researchers never would have come up with on their own. ...For example, let’s say you want to create an antibody that will bind to a certain protein found on tumor cells. You start with a test tube full of hundreds of millions of yeast cells, engineered to express a variety of mammalian antibodies on their surfaces. Then you add probes containing the molecule you want your new protein to target, allowing you to pick out the proteins that bind to it.
Next, you take the proteins that bind the best and mutate them, in hopes of generating something even better. This can be done by irradiating the cells, or by forcing them to replicate their DNA in a way that is prone to mistakes. Those new proteins are screened the same way, and each time, the best candidates are used to create more proteins. “At the end, you have proteins that bind very tightly and specifically,” says Wittrup. “In the lab, it’s the same rules as natural evolution, but we get to set the criteria for who survives.”
Wittrup and his students recently created a new antibody that binds tightly to tumor cells and to a radioactive compound used for chemotherapy, potentially allowing for very precise targeting of the cancer treatment.
First developed about 15 years ago, directed evolution has become ... easy enough that a first-year graduate student can produce a suitable protein in a couple of months, Wittrup says.
He and others at MIT ... have also tried to design proteins ... using computer models to predict how changes in a protein’s sequence will affect its structure and function. In 2007, their simulation successfully produced a new version of the cancer drug cetuximab that binds to its target with 10 times greater affinity than the original. However, this approach is very expensive and only works when researchers start with a great deal of information about the protein interactions being modeled.
“In a limited way, we could do rational design,” says Wittrup. “Fifty years from now, maybe everyone will be doing that.
In an examination reminiscent of Dani Rodrik's "Political Trilemma," Tomas David-Barrett exams the international economy using Joseph Nye's "three-dimensional, three-layered box":
The Three-Layered Chess Box, by Tomas David-Barrett: A central question of global economics concerns the architecture of policy institutions. If you regard the global socio-economic system as a single unit -- a not entirely unreasonable assumption, perhaps -- then it is strikingly obvious that the system's optimal management would call for much stronger global governance functions than exist today. Global economics calls for efficient global monetary and fiscal policy, global financial regulation, enforceable global solutions to the global climatic issues, the rapid loss of biodiversity, overfishing, and so on. This just does not happen. The 2007-2009 crisis of the global economy was perhaps the best chance so far to create on overarching economic policy umbrella for the world economy, an opportunity left unused despite the multitude of summits ending with the Great Leaders' press conferences, which in turn were followed by uniformly unilateral action. The failure of Copenhagen ... speaks of similar ineptitude when it comes to managing the climate.
Why is this? Why are sovereign states so reluctant to coordinate policy, let alone give up power for the protection of the shared economic and ecological commons?
Tuesday I got to meet an international relations thinker, Joseph Nye. He, as an extension of his earlier innovation smart power, suggests that the traditional two-dimensional chess board of the power game among states should be replaced by a three-dimensional, three-layered box, in which the traditional hard power layer is accompanied by one where the dynamics among economies take place, and another one where transnational sociopolitical processes dominate.
From a global economics point of view this model is strikingly state-centered. If the main focus of the analysis is military power, compared to which other forms of inter-state persuasion can be softer or alternative, then the natural unit of analysis is of where the military is: the sovereign state. Yet, there seems to be something wrong with this picture.
The economy layer of Joseph Nye’s analysis has changed tremendously in the past hundred years. While even a few decades ago each national economy more or less corresponded to a state, we are hard-pressed to find truly local economic processes today. Finance is global wherever you go. Manufacturing systems that used to be local, then became regional, are now predominantly global. The pharmaceutical market is global. Raw materials are global. The transportation system is global. Even the ultimate local product, that of farming, has gone global. Therefore, perhaps it can be argued that there is no layer that is formed by national economies. Although it’s tempting to talk about the Chinese economy, the Indian economy, the American economy, or even the European economy, these are increasingly useless categories. Their borders became fuzzy. Integration into one large economic system, the emergence of a truly global economy seems to be a more appealing model.
The trouble is that the rise of the new, global organizational level has not been accompanied by governance institutions with the same scope. We are trying to manage what is essentially a global process using national level economic policy institutions.
The transnationals, that is, the third layer that Joseph Nye suggests as a building block of the three-dimensional global power structure, has similar problems. For what a decade ago might have been somewhat negligible side phenomena, such as NGO efforts in international reaction of the Haitian earthquake, or the anti-malaria activities of the Gates foundation, or the PR exercises of Greenpeace, is now giving way to a global movement. The trigger, it seems to be increasingly obvious, is a major ecological catastrophe that is to dominate the coming decades. The rapidly changing climate, and the collapsing biodiversity is creating a strong demand for collective global action. Just as in the case of the global economy, we are trying to meet this demand using state-level governance tools, and hence are predictably falling short.
And thus one might turn the logic around, and ask if it is the location of the hard power, the fact that it is anchored to the bureaucracy of the sovereign state which stops the formation of the global governance institutions. In other words, is it possible that the failure of Copenhagen, the never-emergence of a global financial regulatory system, or the we-have-not-even-got-done-to-tackle-it overlogging and overfishing problems stay unresolved because of states that mistake their hard power for global omnipotence. ... Or, perhaps, could there be a general link between the hard power of a state and its unwillingness to to hand over governance functions to transnational institutions? ...
[The post goes on to try to find empirical support for the hypothesis in the last sentence.]
Robert Shiller hopes that regulatory reform will include the requirement that financial products have "a standardized disclosure label analogous to the nutritional labels on foods":
How Nutritious Are Your Investments?, by Robert J. Shiller, Commentary, Project Syndicate: Those labels that you see on packaged foods listing their ingredients and nutritional values had their beginnings in an international scandal and in the efforts by governments to deal constructively with the public outrage that followed.
The scandal erupted with the publication in 1906 of Upton Sinclair’s novel The Jungle... The public response to the book’s description of unsanitary conditions in the industry was so strong that the United States Congress enacted the Pure Food and Drug Act – the first law to require labeling of contents on food packages – the very same year. ...
These labels are undoubtedly useful to consumers, but it is unlikely that many manufacturers, if given the choice, would have introduced them on their own.
That is how regulatory progress is often made. The history of legislative reform is ... long periods of time during which public apathy prevents any progress, interrupted by scandals that suddenly make progress possible. Entrenched interests ... resist change with all of their lobbying efforts, but public outrage is too strong for them to win.
We have to hope that the same kind of outcome will emerge from the financial scandals that have produced public outrage analogous to that directed at the food industries in Upton Sinclair’s day. As was the case then, public outrage today is at a level that might well overwhelm the lobbying efforts of entrenched interests. ...
For today we need laws that will require purveyors of financial products to provide the essential information that consumers need. ...[I]nvestment products like mutual funds should include a standardized disclosure label analogous to the nutritional labels on foods. The structure of the label should be developed by a committee of academics, regulators, and industry executives with the objective of promoting informed comparison among consumers of investment products. ...
The ... standardized disclosure should give the consumer an understandable measure of long-term risk. ... Not all investors will be able to interpret even ... simple measures of the outlook for an investment. But neither are all consumers of food able to interpret the quantities of nutrients that are shown on nutritional labels. These facts should be there to allow those people who will look at them to do so, and to encourage them to spread the information...
The standardized disclosure label should not, however, include past returns on investments. This is because most investors overreact to past returns... Moreover,... when an advertisement for an investment product does report a prior average return, it should also include a statement of the uncertainty associated with that return. ...
Including such information on financial products would give an enormous boost to the efficiency and efficacy of our financial products in serving customers’ needs. The only reason that such labeling has not yet been required is the same reason that nutritional labels were not required long ago on foods. Public outcry at a time of scandal forced progressive change then; we should hope that it does so now.
I don't think it's on the financial reform agenda, though there was talk of providing "plain vanilla" options for some financial products awhile back to help with this problem. But that got dropped due to opposition from the financial industry.
Is there a good reason not to do this? I couldn't think of one. There is a small cost to the banks to develop the labels, but if it's a standard form that shouldn't be too costly, particularly relative to the potential benefit to consumers from overcoming the informational market failure.
Barry Ritholtz takes on the crowd trying to blame the financial and subsequent economic crises on the government:
Get Me ReWrite!, by Barry Ritholtz: My approach to everything I have written, studied and analyzed in this space is pretty straight forward: Start with the data and evidence and go forward from there ... in order to make intelligent investing decisions for myself and my clients.
There are others who do not share this objective. Their goals are either political (winning the next election) or ideological (having their belief system become dominant). Truth is irrelevant to these people.
Not surprisingly, these folks — many of whom contributed to the crisis in a mighty way — are desperately trying to duck responsibility for what happened. Those who helped cause the crisis are engaged in an ongoing effort to rewrite its history.
Their goal? Exonerate their own bad behavior, throw off any responsibility to the collapse, blame anything but their own ideology and horrific decision making. They want to keep pushing their tired political agendas, despite the damage they may have caused.
When writing ... I blamed Democrats and Republicans — not equally, but in proportion to their what they did. Unsupported theories, tenuous connection, loose affiliations were not part of the analysis. ...
You will note that the CRA is not ... a cause or even a minor factor. If they were, the housing bubbles would not have been in California or S. Florida or Los Vegas or Arizona — Harlem and South Philly and parts of Chicago and Washington DC would have been the focus.
Nor do I blame Fannie and Freddie. Now understand, there is no love lost between myself and the GSEs. For years, I have called them “Phoney and Fraudy.” Since George Bush and Hank Paulson nationalized them, I have accused the government of using these two as a backdoor bailout for banks — a hidden PPIP/TARP used to buy all the garbage mortgages that banks are desperate to get off their balance sheets. Longtime readers will recall we very publicly shorted Fannie based upon their fraudulent practices and horrific balance sheet.
But even I cannot reconcile the movement to place all of the world’s troubles at the feet of the GSEs. Not, at least, according to the data.
That lack of evidence, however, doesn’t stop ideologues from making the attempt. Consider this attempt at rewriting the causes of the credit crisis by Kevin Hassett:
“The worst financial crisis in generations was set off by a massive government effort, led by the two mortgage giants, to make loans to homebuyers no matter whether they could make the payments. Lenders were willing to lend money to just about all comers, no matter how low their income. Why? Because the lenders knew Fannie and Freddie would purchase the loans from them for a high price before bundling them into securities to sell to investors.”
Now, this makes for a fascinating narrative that plays into a number of different ideological beliefs. It exonerates the radical free market deregulators, it ignores what the private sector did, and it somehow ignores the fact that Congress was controlled by a very conservative GOP from 1994 to 2006 — the prime period of time covered leading up to and including the beginning of the crisis.
But worse than all of that, the data supporting Hassett’s position simply isn’t there.
Over the past 2 years, I have repeatedly asked the people who push this narrative to provide some evidence for their positions. I have offered a $100,000 if they could prove their case.
Specifically, I have requested some data or evidence that DISPROVED the following facts:
-The origination of subprime loans came primarily from non bank lenders not covered by the CRA;
-The majority of the underwriting, at leats fro the first few years of the boom, were by these same non-bank lenders
-When the big banks began chasing subprime, it was due to the profit motive, not any mandate from the President (a Republican) or the the Congress (Republican controlled) or the GSEs they oversaw.
-Prior to 2005, nearly all of these sub-prime loans were bought by Wall Street — NOT Fannie & Freddie
-In fact, prior to 2005, the GSEs were not permitted to purchase non-conforming mortgages.
-After 2005, Fannie & Freddie changed their own rules to start buying these non-conforming mortgages — in order to maintain market share and compete with Wall Street for profits.
-The change in FNM/FRE conforming mortgage purchases in 2005 was not due to any legislation or marching orders from the President (a Republican) or the the Congress (Republican controlled). It was the profit motive that led them to this action.
These are data supported fact...
Of course, folks like Hassett hate this factual history, as it conflicts with their goals and politics. Rather than produce evidence, they create story lines unsupported by facts. ...
I demand evidence, data and facts. The blame Fannie & Freddie crowd have managed to remain blissfully data free. They have steadfastly ignored all calls for proof.
Its way past the time to call out their intellectual dishonesty. If you cannot show any data, if you cannot prove what you are alleging with actual facts, you need to be called out for what it is you actually are: Proponents of a failed philosophy.
[Update: Russ Roberts responds.]
Things are heating up for the banks:
Wall Street Probe Widens, by Susan Pulliam, Kara Scannell, Aaron Lucchetti, and Serena Ng,WSJ: Federal prosecutors, working with securities regulators, are conducting a preliminary criminal probe into whether several major Wall Street banks misled investors about their roles in mortgage-bond deals, according to a person familiar with the matter.
The banks under early-stage criminal scrutiny—J.P. Morgan Chase & Co., Citigroup Inc., Deutsche Bank AG and UBS AG—have also received civil subpoenas from the Securities and Exchange Commission as part of a sweeping investigation of banks' selling and trading of mortgage-related deals... Under similar preliminary criminal scrutiny are Goldman Sachs Group Inc. and Morgan Stanley, as previously reported by The Wall Street Journal. ...
At issue is whether the Wall Street firms made proper representations to investors in marketing, selling and trading pools of mortgage bonds called collateralized debt obligations, or CDOs. ...
Prosecutors so far are simply gathering evidence. ... It's possible the probe could end with no charges being brought against any of the firms. ...
Prosecutors Ask if 8 Banks Duped Rating Agencies, by Louise Story, NY Times: The New York attorney general has started an investigation of eight banks to determine whether they provided misleading information to rating agencies in order to inflate the grades of certain mortgage securities...
The investigation parallels federal inquiries into ... interactions between the banks and their clients who bought mortgage securities, this one expands the scope of scrutiny to the interplay between banks and the agencies that rate their securities. ... The inquiry ... suggests that ... the agencies may have been duped by one or more of ... Goldman Sachs, Morgan Stanley, UBS, Citigroup, Credit Suisse, Deutsche Bank, Crédit Agricole and Merrill Lynch...
The companies that rated the mortgage deals are Standard & Poor’s, Fitch Ratings and Moody’s Investors Service. ... Mr. Cuomo’s investigation follows an article in The New York Times that described some of the techniques bankers used to get more positive evaluations from the rating agencies.
Mr. Cuomo is ... interested in the revolving door of employees of the rating agencies who were hired by bank mortgage desks to help create mortgage deals that got better ratings than they deserved... His ... focus is on information the investment banks provided to the rating agencies and whether the bankers knew the ratings were overly positive...
Edmund Andrews says financial reform legislation is not yet a done deal, and could still be watered down to appease banking interests:
Financial overhaul, perils ahead, by Edmund L. Andrews: It’s tempting to think that financial regulatory reform is already a done deal in Congress... Don’t be fooled. It’s true that the Senate is likely to pass some kind of bill. Unfortunately, the legislation is still at risk of death by a thousand cuts: scores of seemingly anodyne amendments that, if passed, turn the bill into a cynical joke.
You know the drill..., some people – on Wall Street, or at the banks -- want to spare us from “unintended consequences.”
Today, Senate Democrats managed to vote down a major Republican push to gut portions of the bill to regulate derivatives, like the credit-default swaps that blew apart AIG. ...
Tomorrow, Republican Sam Brownback will push an amendment to exclude car dealers from oversight by the new Consumer Financial Protection Bureau. ...
But I would like to focus on a third imminent that seems drier than derivatives or car loans but is at least as important: federal pre-emption of state financial regulations. And this time, it's moderate Dems who are carrying water for the banks.
In the run-up to the mortgage meltdown, federal bank regulators fought hard to pre-empt any state efforts to crack down on shady bank practices. A number of states, like North Carolina and New York, were trying to crack down on abusive mortgage practices by subprime lenders. But many of the lenders were subsidiaries of national banks, and the Office of the Comptroller of the Currency declared that states had no right to touch them whatsoever. ...
The amendment to watch out for in the days ahead actually comes from a Democrat: Tom Carper of Delaware. Carper’s amendment would forbid state attorney generals from prosecuting banks that violate national consumer laws, much as the fed’s blocked Elliott Spitzer and Andrew Cuomo of New York from investigating racial and ethnic targeting by subprime lenders. It would also allow the Feds to override state consumer laws...
Don’t let it happen.
The bill needs to be made stronger, not weaker, so let's hope that amendments to water down the bill's impact continue to lack the necessary support.
On a broader note, there seems to be a shift in the narrative about what caused the crisis. Fraud, deception, and other questionable if not illegal behaviors are beginning to take on a larger role in the story of what happened to bring about the problems in the financial sector. The turning point was, of course, the investigation of Goldman, and the investigations have been growing more numerous ever since.
The shift in attitude has probably helped to stave off challenges designed to weaken the legislation, and if a smoking gun turns up in one of the investigations like those described above, that would likely make it even harder for banks get the political support needed to water down the legislation. But I'm not counting on that happening, and as noted above, the deal isn't done yet. It's still possible for the legislation to be weakened, and as pointed out above there's no shortage of attempts to do just that.
Wednesday, May 12, 2010
Will this pass? If it does pass, will it meet the goals described below? I see the chances of it passing as about 50-50 right now, and a lower chance that the legislation will reduce greenhouse gas emissions as much as hoped:
Senate Climate Bill Makes Its Debut, by John Broder: Senators John F. Kerry ... and Joseph I. Lieberman ... presented their long-delayed proposal to address global warming and energy Wednesday afternoon. They are calling it the American Power Act.
The nearly 1,000-page plan provides something for every major player – loan guarantees for nuclear plant operators, incentives for use of natural gas in transportation, exemptions from emissions caps for heavy industry, free pollution permits for utilities, modest carbon dioxide limits for oil refiners and expansion of offshore drilling for those states willing to accept the risks.
The bill’s overall goal is to reduce greenhouse gas emissions by 17 percent from 2005 levels by 2020 and 83 percent by 2050. The targets match those in a House bill passed last year and the Obama administration’s announced policy goal.
It is impossible to know now whether all the concessions will add up to the 60 votes needed to thwart an attempt to filibuster the bill.
But Senator Kerry said he was confident he had found a winning formula for a comprehensive approach to climate change and energy independence. ...
The full text of the bill can be found at www.kerry.senate.gov.
Grist's David Roberts says "Chances for passage are quite slim, but not as slim as generally perceived, and ironically, the path to passage now involves the bill getting stronger, not weaker."
Linda Beale says Congress should allow the estate tax should to revert to 2001 levels as scheduled under existing legislation:
Estate Tax: leave it alone, by Linda Beale: We are almost halfway through 2010, the weirding time under the GOP's estate tax plan when there is no estate tax and the step-up in basis is gone. They had, of course, intended to eliminate the estate tax for good, but knew that it would cause huge deficits and so didn't want to pass that along with the rest of their 2001 tax cuts that already amounted to more than a trillion dollars. So they left it for later.
Repeal was a bad idea to start with. Most of the mythology around the estate tax is just that--sob stories ginned up by the coalition of wealthy families who want to shirk their responsibility to the country for taxes. This is where the President and the Democratic Party should use the bully pulpit to inform people about how the estate tax works. It is relevant for only the largest estates. It doesn't cause family farms to be lost, no matter how many times the wealthy families' coalition spokespersons claim that it does.
We are at a turning point in this country, where our inability to think long term and our need for immediate gratification mean that we are spending ridiculous amounts on a military budget, too little on infrastructure, and incapable of passing a single payer health care system like every other developed economy has. The Bush regime cut taxes over and over again--mostly aiding the wealthy but also costing us in terms of long-term deficits... The economic theory on which the tax cuts were based has been proven wrong again and again...: tax cuts don't generate more revenues, wealthy people who are not taxed on their capital gains don't turn overnight into entrepreneurs.
So now we need to stop the drain of revenues from the federal fisc. Stop excessive military spending--we can't sustain ongoing wars in Iraq and Afghanistan for another decade any better than the USSR could do. ...
That means that the estate tax is an ideal tax. The tax comes at the point when wealth from one generation is being passed to the heirs in the next generation who have done nothing to merit having it. The extraordinarily wealthy that bear the tax already have the lion's share of the wealth of the country, and some method of evening the odds is needed, else we will be a country of the gated rich and the multitudinous poor. The estate tax can be easier to enforce than other taxes (and would be even fairer if only Congress would act to make the various estate planning techniques using trusts and family partnerships unlawful). So Congress should just let the Bush tax change lapse according to the sunset provision that the GOP built into the law. That would mean that in 2011 we would revert to the law before the 2001 tax change.
There is no huge constituency worried about the estate tax--just the wealthy few whose estates might be subject to some taxation. But apparently Sens. Kyl, Baucus, Grassley and Lincoln are working to include a "bipartisan" proposal in the small business tax bill that they hope to put through Congress. Odds are it will cut the estate tax rate and increase the exemption amount, making the wealthy even less likely to pay any estate tax. ...
Will somebody tell me how these Senators can justify another huge tax break for the wealthy when this country has the highest deficits its ever recorded and little prospect of recouping that ... without adding tax increases ... to the mix? ...
We are not Greece, that's clear, but there is a similarity. It's not excessive government spending like you may have been led to believe by deficit hawks, see this comparison chart. The similarity is the (successful) attempt by those with power and influence to avoid paying their fair share of the nation's bills.
Martin Feldstein says we shouldn't allow Bush tax cuts to expire for high income households as the administration is proposing, we should keep them in place for another two years:
Extend the Bush Tax Cuts—For Now, by Martin Feldstein, Commentary, WSJ: This is not the time for a tax increase. But unless Congress acts, under current law the existing income tax rates will rise sharply at the beginning of next year. Congress should vote now to extend all of the current tax rates for two years, including the tax rates on dividends, interest and capital gains. Limiting the resulting tax-rate cuts to two years would reduce the projected future fiscal deficits. The sooner Congress acts, the stronger our prospects for continued economic recovery.
A tax increase next year could easily derail the current fragile expansion. ... A 2011 tax increase that reduces economic incentives and household spending would raise the risk of a new economic downturn.
President Obama proposes to increase tax rates on high-income households while making the existing tax rates permanent for taxpayers below the top tax brackets. While the increase would hit only a relatively small fraction of all households, that group represents a large share of total taxes and of private spending. Raising their tax rates would be a substantial blow to overall spending and therefore to GDP growth. ...
Although it is important to avoid increasing the current tax rates until the recovery is well established, the enormous budget deficits that are now projected for the rest of the decade must not be allowed to persist. ...
It would be wrong therefore to commit to the permanent reduction in tax rates for all taxpayers below the top brackets that is called for in the Obama budget. ...
Such a limit on the future tax cuts should be combined with policies to slow the growth of spending. ... If Congress cares about future deficits, it will prevent that unprecedented rise in government spending. It will also do more to deal with the spending programs that are hidden in the tax law like the health-insurance subsidy, the child-care credits, and the deductibility of local property taxes.
Failure to cut future deficits would mean a weaker recovery and slower long-term growth. ...
The fragility of the economic recovery means that it would be dangerous to allow any taxes to rise in 2011. The inherent uncertainty about the out-year deficits means that it would be unwise to enact tax cuts that stretch beyond the next two years. Congress should move quickly to reassure taxpayers and financial markets that the current tax rates will be preserved for two years but that further tax cuts will depend on the future fiscal outlook.
We could always shift the tax burden, i.e. allow the tax cuts to expire at the upper end of the distribution and replace them with cuts at the lower end (for the two year period or even beyond). That would make the overall distribution of taxes more progressive, something that's needed, and it would get money into the hands of people who need it. Shifting the tax cuts to people who are more likely to spend the extra money rather than put it into savings would provide an even larger boost to the economy.
It's also worth noting that if the worry is about the effect on the economy and the deficit, it would also be possible to allow the tax cuts to expire and then replace the missing demand with additional temporary government spending, say for two years. Since the spending is temporary -- it only lasts for two years just like the tax cuts -- the long-run impact on the deficit would be the similar. The point isn't that we should do this, or that we shouldn't, it's that there's no necessity in keeping the tax cuts in place at the upper end of the distribution to preserve aggregate demand. A tax increase can always be offset by tax cuts in other places or by additional government spending. One argument is that any policy that involves increasing taxes on the wealthy is inherently inefficient, e.g. that it lowers productivity, but I don't find the empirical evidence for that argument to be very compelling (and even if some categories of taxes are inefficient, that doesn't meant that, say, a capital gains tax can't be replaced with some other type of tax with more desirable properties).
Tuesday, May 11, 2010
Dani Rodrik uses his idea of a political trilemma (e.g. see this from 2007), i.e. that "economic globalization, political democracy, and the nation-state are mutually irreconcilable," to analyze recent events in Europe:
Greek Lessons for the World Economy, by Dani Rodrik, Commentary, Project Syndicate: The $140 billion support package that the Greek government has finally received from its European Union partners and the International Monetary Fund gives it the breathing space needed to undertake the difficult job of putting its finances in order. The package may or may not prevent Spain and Portugal from becoming undone in a similar fashion, or indeed even head off an eventual Greek default. Whatever the outcome, it is clear that the Greek debacle has given the EU a black eye.
Deep down, the crisis is yet another manifestation of what I call “the political trilemma of the world economy”: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance.
The history of the world economy shows the trilemma at work. ...[gives examples]...
[One way around] the trilemma is to do away with national sovereignty altogether. In this case, economic integration can be married with democracy through political union among states. ... Think of this as a global version of federalism. The United States, for example, created a unified national market once its federal government wrested sufficient political control from individual states. ...
The crisis has revealed how demanding globalization’s political prerequisites are. It shows how much European institutions must still evolve to underpin a healthy single market. The choice that the EU faces is the same in other parts of the world: either integrate politically, or ease up on economic unification.
Before the crisis, Europe looked like the most likely candidate to make a successful transition to the first equilibrium – greater political unification. Now its economic project lies in tatters while the leadership needed to rekindle political integration is nowhere to be seen.
The best that can be said is that Europe will no longer be able to delay making the choice that the Greek affair has laid bare. If you are an optimist, you might even conclude that Europe will therefore ultimately emerge stronger.
New post at MoneyWatch in reaction to today's 96-0 vote in the Senate to audit the Fed:
I argue that Congress should try to look like it is being very tough on the Fed, but it's not in Congress' interest to take a big bite out of the Fed's authority.
Dean Baker takes on the "banks not lending" explanation for the persistence of the downturn and sluggish movement toward recovery:
Banks failing to lend is not the problem, by Dean Baker: One of the big myths of the current downturn is that the reason the slump persists is that banks are refusing to lend. The story goes that because the banks have taken such big hits to their capital as a result of the collapse of the housing bubble and record default rates, they no longer have the money to lend to small- and mid-sized businesses.
We then get the story about how small businesses are the engine of job creation, responsible for most new jobs. Therefore, if they can't get capital, we can't expect to see robust job growth.
This story of banks not lending is used to justify all sorts of special policies to help out small businesses and banks. In fact, the Obama administration has plans to make a special $30bn slush fund available to banks if they promise to lend it out to small businesses.
In reality, every part of this argument is completely wrong. First, small businesses are not special engines of job growth. Small businesses do create most new jobs, but they also lose most new jobs. Half of new businesses go under within four years after being started. Jobs do get created when the businesses start, but jobs are lost when the businesses fail.
The reality is that businesses of all sizes create jobs. There is no special reason to favor small businesses in promoting job creation. We should favor businesses that create good paying jobs with good benefits and conditions, regardless of their size.
The other parts of this story make even less sense. Let's hypothesize that many banks are crippled in their ability to lend because of the large hits to their balance sheets from bad mortgage debt. Well, not all banks got themselves over their heads with bad mortgages. There are banks with relatively clean balance sheets.
If it were the case that a substantial portion of banks are now unable to issue many new loans because of their inadequate capital, we would expect to see the healthy banks rushing in to fill the lending gap. There should be accounts of dynamic banks that are taking advantage of this once-in-a-lifetime opportunity and rapidly gaining market share.
While this may be happening, there certainly have not been many accounts in the media of banks that fit this description. In other words, it does not appear to be the view among banks, including those with plenty of capital, that there are many good potential customers who are unable to borrow money.
The other missing part of the story has to do with the nature of competition between small firms and their larger competitors. We know that large firms have no difficulty attracting capital at present. They can issue bonds at near record-low interest rates. They can also borrow short-term money at extraordinarily low interest rates in the commercial paper market.
If small and mid-sized companies were being prevented from expanding due to their inability to raise capital then we should be seeing larger companies rushing in to take market share. Retail stores should be opening up new outlets everywhere. Factories should be rapidly increasing output and transportation companies should be rushing into new markets.
Of course, we don't see any of this happening. If anything, most large businesses are expanding at a slower rate than they did before the crisis. If their competitors have been hamstrung due to a lack of credit, no one seems to have told Wal-Mart, Starbucks and the rest. They have both slowed the rate at which they are adding new stores, not sped it up as the credit-shortage story would imply.
There is truth to the credit-squeeze story, but it goes in the other direction. Stores that have seen their business plummet as a result of the downturn are, in fact, worse credit risks from the standpoint of banks. Many businesses that were profitable in 2006 and 2007 are now highly unprofitable and may not be able to stay in business. As a result, the banks that were happy to lend money just a few years ago are no longer willing to lend money to the same business. This drying up of credit happens in every downturn. It is just more serious this time because of the severity of the downturn.
The moral of this story is that we should not think that "fixing" the banks will get us out of the downturn. The problem is that we have to generate demand, which means having the government spend more money to stimulate the economy. Unfortunately, the politicians in Washington are scared to talk about larger deficits, so more spending seems off the table at the moment – therefore we get this nonsense about insufficient bank lending.
But hey, at the rate we created jobs in April, we should be back at full employment in seven years anyhow. Who could ask for anything more?
This is not a supply problem, banks are sitting on mountains of excess reserves (some of which are serving as insurance against unexpected contingencies, but even so the excess reserves in the system are voluminous). But the ample supply of loans available to be loaned out at the right terms does not automatically create a demand for them.
I think the problem is on both sides. Supply has tightened up due to poor economic conditions -- as noted above banks are unwilling to loan to firms who look shaky during the downturn, firms that might have looked very solid and worthy not all that long ago. But the demand for loans has fallen as well since firms have little reason to invest in such bad economic conditions. So if the goal is to generate more investment, the solution is twofold. First, the demand for loans must be present. Additional government spending as called for above can help, but so can measures such as an investment tax credit or other financial incentives for firms that undertake to new investment. Second, banks must have the money to lend and be willing to do so at reasonable terms. Available reserves are not the problem, it's the fear of losses due to poor economic conditions that is making banks hesitate. One way over this hurdle is for the government to share in losses that banks realize on these loans. With lower expected losses through the loss sharing arrangement, the banks would be more willing to part with funds.
But the big question for me is the desirability of promoting investments that the private sector does not think are a good idea. If the result of this intervention is a bunch of failed investments and wasted resources, then this is not the best way to stimulate the economy. If there's some sort of market failure that is preventing firms and banks from entering into productive deals, then there is clearly a role for government to step in and fix the problem. One could make an argument that, say, risk is artificially elevated (disconnected from its "fundamental" value) and hence some sort of intervention is needed to restore the market, and I think there's some merit to the market failure arguments. Still, rather than helping firms in this way, I'd prefer to have more help for those households suffering the most from the downturn, i.e. additional government spending, transfers, and job creation -- that means a far bigger stimulus program than we got -- and then let firms respond to the additional demand as they see fit.
Finally, this is a bit different -- it involves investment in basic research rather than investment by firms -- but some types of government intervention appear to be productive:
Federal investment in basic research yields outsized dividends -- innovation, companies, jobs, EurekAlert: How can the United States foster long-term economic growth? A new report suggests that one of the best ways is through investment in the basic research that leads to innovation and job creation. ...
"There is no question that the public benefit gained from funding basic research is exponentially greater than the initial investment," said Susan Desmond-Hellmann, Chancellor of University of California San Francisco. "The success stories highlighted in this report demonstrate that fact and are a reminder that the continued scientific and technological leadership of the United States – and our economic well-being – depends on consistent, strong funding for research." ...
These success stories include global industry leaders like Google, Genentech, Cisco Systems, SAS and iRobot, as well as relative newcomers such as advanced battery manufacturer A123 Systems; network security company Arbor Networks; AIDS vaccine developer GeoVax Labs; and Sharklet Technologies, which has developed a novel surface technology based on the qualities of shark skin to combat hospital-acquired infections.
The report illustrates the substantial economic benefits the U.S. reaps when companies are created as a result of discoveries in federally funded university laboratories. One example of this return on investment is TomoTherapy Incorporated, based in Madison, Wisconsin. A $250,000 grant from the National Institutes of Health's National Cancer Institute to two researchers at the University of Wisconsin-Madison enabled the development of ... a highly advanced radiation therapy system that targets cancerous tumors while minimizing exposure and damage to surrounding tissue. Each year the technology is used to help improve the outcomes of tens of thousands of difficult to treat cancer patients around the world.
"That original investment generates many times its value in salaries and taxes returned to both the U.S. and Wisconsin governments," says University of Wisconsin-Madison professor and TomoTherapy Co-founder and Chairman Rock Mackie. TomoTherapy employs 600 people. ...
"University-launched startups can be powerhouses for value creation, becoming public companies at a far greater rate than the average for new businesses," according to Krisztina "Z" Holly, vice provost for innovation at the University of Southern California (USC). "Higher education can play a crucial role not just in spurring pioneering ideas, but in creating entrepreneurs who turn breakthroughs into innovations." The results benefit everyone, she says. Holly points to 24 USC startup companies that currently employ 500 full-time workers, more than half of whom are in Los Angeles. Sixteen of these companies have raised at least $148 million in financing over the past two years, during the height of the recession. ...
I'm not sure what to make of this:
Goldman Sachs has first quarter with no trading losses, Bloomberg News: Goldman Sachs Group Inc.'s traders made money every day of the first quarter, a feat the firm has never accomplished before.
Daily trading net revenue was $25 million or higher in all of the first quarter's 63 trading days... The firm reaped more than $100 million on 35 of the days, or more than half the time. ...
The lack of trading losses could add to the perception that Goldman Sachs has an unfair advantage in the markets, one shareholder said.
"It will reinforce the heads we win, tails you lose mentality that people think actually exists and promotes the concept of an unfair advantage," said Douglas Ciocca... "It's too politically charged not to. How is that possible that they only make money?" ...
"This is the first time we have reported zero trading loss days in a quarter," said Samuel Robinson, a Goldman Sachs spokesman. "We believe it shows the strength of our customer franchise and risk management."
Monday, May 10, 2010
Edmund Andrews reinforces the point about "degradation of effective government by anti-government ideology" under the Bush administration that Paul Krugman made this morning:
Reflections on the oil spill, by Edmund Andrews: Executives from BP and its partners in the Gulf oil spill will endure a heavy round of indignant and righteous grilling at Senate hearings on Tuesday, and they deserve it.
But it's also obvious that Congress and the Interior Department failed in all sorts of ways over the years. ...
The Interior Department's hapless Minerals Management Service failed miserably as well. As the Wash Post reported a week ago, MMS exempted BP's ill-fated rig last April from a rigorous environmental analysis after concluding that a big spill was extremely unlikely.
Less than a year ago, it gave BP's partner, Transocean a "Safety Award for Excellence" ("SAFE," get it?) for its work in the Gulf. Randall Luthi, the MMS's last director under President Bush, is now president of the National Oceans Industries Association. The Bush-Cheney, Texas-Wyoming crowd passionately wanted to ramp up drilling logging and mountain-top mining. It had a zero-tolerance policy toward objections of any kind.
I have a personal take on the MMS. Back in 2006, I wrote a long series of stories about how the agency was losing tens of billions of dollars in royalties on oil and gas being pumped in the Gulf of Mexico. (They still are, by the way.) The MMS's accounting was disastrously muddled; political hacks under Bush were blocking the agency's own auditors; and the Interior Department had fouled up leases going back to the Clinton administration. My stories unleashed a slew of investigations, which not only confirmed jaw-dropping incompetence and subservience to industry but also the famous sex-and-drugs scandal in which MMS employees in Denver partied hardy with oil execs.
Now, it's true that the Interior Department and the MMS were in some ways uniquely awful -- especially under the Bush administration. ...
But there was a broader lesson here: antipathy toward government -- any kind of government -- was at all-time highs. Republicans, and to a lesser extent Democrats, were hitting the peak of a 25-year rise in anti-government skepticism. If nobody thinks government can do anything good, then you attract mostly cynics and losers who are mainly interested in leveraging their jobs into lucrative deals with industry.
This wasn't unique to Interior and MMS. The SEC, which was a feared and prestigious enforcement agency back in the 80's (under Reagan, btw), became a laughingstock. The bank regulators competed with each other to make life easy for the banks, on whom most depended for their fees. It was the same deal almost everywhere else: consumer protection, food and drug regulation, occupational safety, the Justice Department.
By the end of the Bush administration, they were all emaciated, hollowed-out shells. Now we're discovering, a little late, that those gray government civil servants and those musty federal buildings might actually be good for something after all.
When appointments to these agencies become a way of rewarding people for their political support and to impose an anti-interventionist government ideology (but only where government might get in the way of profit, the view toward intervention in social issues was different) rather than as an opportunity to provide the best possible government service to the nation, we should expect a bad outcome. These appointments have always served political ends to some degree, but under Bush service became secondary and this was taken to extremes.
This is in today's daily links, but I think it deserves a bit more notice:
Here's a bit more from the article:
Virginia AG Cuccinelli Out To Kill Academic Freedom, by Barkley Rosser: Friday's WaPo reports that Virginia Attorney General Ken Cuccinelli, following up on his efforts to end efforts by state universities and colleges to avoid discriminating against GLBT folks, has decided to interfere directly in scientific research in a criminal way. In particular, Cuccinelli is claiming that climate scientist, Michael Mann of hockey stick fame, engaged in billing fraud with the state while working on this subject while a professor of environmental sciences at the University of Virginia, where he has not been located for some years (now at Penn State). Cuccinelli is demanding all kinds of emails and other materials from the university, apparently attempting to imitate the climategate gang that did this over at East Anglia, only to end up with no fraud being discovered.
I think that some of the critics of Mann's work were correct, but this is an outrage. There is no evidence at all of fraud (and those claiming the email in which he spoke of using a "trick" as evidence for this do not understand or are willfully misrepresenting how this term is used in these situations) on his part, whatever errors he may have made in his study of the hockey stick (and it really does not matter exactly what the temperature was 1000 years ago; I have posted on this here previously). ...
As ammunition for this chilling assault, Mr. Cuccinelli twists beyond recognition a statute designed to punish government contractors who use fake receipts to claim taxpayer funds and those who commit other such frauds. For Mr. Cuccinelli's "investigation" to have any merit, the attorney general must suppose that Mr. Mann "knowingly" presented "a false or fraudulent claim for payment or approval." Mr. Cuccinelli's justification for this suspicion seems to be a series of e-mails that surfaced last year in which Mr. Mann wrote of a "trick" he used in one of his analyses, a term that referred to a method of presenting data to non-experts, not an effort to falsify results. ...
By equating controversial results with legal fraud, Mr. Cuccinelli demonstrates a dangerous disregard for scientific method and academic freedom. The remedy for unsatisfactory data or analysis is public criticism from peers and more data, not a politically tinged witch hunt or, worse, a civil penalty. ... For the commonwealth to persecute scientists because one official or another dislikes their findings is the fastest way to cripple not only its stellar flagship university, but also its entire public higher education system.
Tenure is supposed to offer some protection against these attempts to curtail academic freedom, but If the right people come after you, tenure won't help. There are always ways to bypass the protection tenure offers, e.g. through trumped up charges of fraud as is being attempted in this case. Fortunately, however, though this is not yet fully resolved, Ken Cuccinelli does not appear to be one of the right people, and, in fact, is very obviously wrong.
Rajiv Sethi doesn't understand the logic behind the decision by Nasdaq and the New York Stock Exchange to cancel some trades that were made during last week's plunge in the stock market:
Algorithmic Trading and Price Volatility, by Rajiv Sethi: Yesterday's dramatic decline and rapid recovery in stock prices may have been triggered by an erroneous trade, but could not have occurred on this scale if it were not for the increasingly widespread use of high frequency algorithmic trading.
Algorithmic trading can be based on a variety of different strategies but they all share one common feature: by using market data as an input, they seek to exploit failures of (weak form) market efficiency. Such strategies are necessarily technical and, for reasons discussed in an earlier post, are most effective when they are rare. But they have become increasingly common recently, and now account for three-fifths of total volume in US equities... This is a recipe for disaster:
[In] a market dominated by technical analysis, changes in prices and other market data will be less reliable indicators of changes in information regarding underlying asset values. The possibility then arises of market instability, as individuals respond to price changes as if they were informative when in fact they arise from mutually amplifying responses to noise.
Under such conditions, algorithmic strategies can suffer heavy losses. They do so not because of "computer error" but because of the faithful execution of programs that are responding mechanically to market data. The decision by Nasdaq to "cancel trades of 286 securities that fell or rose more than 60 percent from their prices at 2:40 p.m." might therefore be a mistake: it protects such strategies from their own flaws and allows them to proliferate further. Canceling trades can be justified in response to genuine human or machine error, but not in response to the implementation of flawed algorithms.
I don't know how the losses and gains from yesterday's turmoil were distributed among algorithmic traders and other market participants, but it is conceivable that part of the bounce back was driven by individuals who were alert to fundamental values and recognized a buying opportunity. ...
I would be very interested to know whether the transfer of wealth that took place yesterday as prices plunged and then recovered resulted in major losses or gains for the funds using algorithmic trading strategies. I expect that those engaged in cross-market or spot-futures arbitrage would have profited handsomely, at the expense of those relying on some form of momentum based strategies. If so, then the cancellation of trades will simply set the stage for a recurrence of these events sooner rather than later. ...
I agree - I don't understand the logic behind the decision to cancel the trades either. However, Donald Marron says there's merit to both sides of the argument, and attempts to find a compromise:
Advice to Nasdaq and the NYSE: Cancel Only 90% of the “Erroneous” Trades, by Donald Marron: Nasdaq and the New York Stock Exchange have both announced that they will cancel many trades made during the temporary market meltdown between 2:40 and 3:00 last Thursday afternoon (see, for example, this story from Reuters). These “erroneous” trades include any that were executed at a price more than 60% away from their last trade as of 2:40.
The motivation for these cancellations is clear: a sudden absence of liquidity meant that many stocks (and exchange-traded funds) temporarily traded at anomalous prices that no rational investor would have accepted.
As several analysts have noted, however, canceling these trades creates perverse incentives. It rewards the careless and stupid, while penalizing the careful and smart. It protects market participants who naively expected that deep liquidity would always be there for them, while eliminating any benefits for the market participants who actually were willing to provide that liquidity in the midst of the turmoil. ...
I see merit in both sides of this argument. My economist side thinks people should be responsible for their actions and bear the costs and benefits accordingly. But my, er, human side sees merit in protecting people from trades that seem obviously erroneous.
What’s needed is a compromise–one that maintains good incentives for stock buyers and sellers, but provides protection against truly perverse outcomes.
Happily, the world of insurance has already taught us how to design such compromises: what we need is coinsurance. People have to have some skin in the game, otherwise they become too cavalier about costs and risks. ... Even a little skin in the game gets people to pay attention to what they are doing.
So here is my proposal: NYSE and Nasdaq should cancel only 90% of each erroneous trade. The other 10% should still stand.
If Jack the Algorithmic Trader sold 100,000 shares of Accenture for $1.00 last Thursday, he should be allowed to cancel 90,000 shares of that order. But the other 10,000 shares should stand–as a reminder to Jack (and his boss) of his error and as a reward to Jill the Better Algorithmic Trader who was willing to buy stocks in the midst of the confusion.
When you lose money in the stock market, even for trades that are obviously based upon and erroneous strategy after the fact, do you get a Mulligan? I must be missing something here, can someone explain why these trades should be canceled?
Jon Faust is worried that the Dodd proposal to change the selection process for members of the FOMC (the committee that sets monetary policy) will lead to too much political control of the Fed and all the problems that come with it:
Checks and Balances at the Fed, by Jon Faust, RTE: The financial crisis has provided, among other things, a civics lesson about the Federal Reserve. Some people have been surprised to learn that 5 of 12 votes on the Fed’s main policy committee–the Federal Open Market Committee (FOMC)–are cast people who are not politically appointed. The 7 politically appointed Fed Governors vote on the FOMC, but the remaining 5 votes rotate among the Reserve Bank Presidents, who are chosen by the Board’s of the Reserve Banks. People on those Boards are, themselves, mainly chosen by the member banks of the Federal Reserve System. Senator Dodd’s reform bill attempts to fix this problem.
This supposed fix is dangerously naïve and ignores the lessons of the last great financial crisis.
The bill as reported states: “To eliminate potential conflicts of interest at Federal Reserve Banks, the Federal Reserve Act is amended to state that no company, or subsidiary or affiliate of a company that is supervised by the Board of Governors can vote for Federal Reserve Bank directors…”
The current arrangement of the FOMC was framed as a response to the Great Depression. The framers viewed the conflicts of interest over Fed policy as fundamental and saw no way to eliminate them. Historical precedent suggested (and still suggests) that political control of a central bank leads to lack of discipline and inflation. But complete absence of political influence is also inappropriate in a Democracy.
Thus, the FOMC’s framers looked to the uniquely American solution of checks and balances. In particular, they called upon two widely despised groups during the depression—bankers and politicians—to balance each other’s worst impulses.
Representative Glass and Senator Steagall, of Glass-Steagall fame, fought tenaciously over the balance. Steagall proposed that only the politically-appointed governors would vote on the FOMC. Glass responded that Steagall was “without peer in his advocacy of inflation.” After heated debate, Congress arrived at the 7 to 5 split we have today. Senator Glass summarized the reasoning, “[The vote on the FOMC] will stand 5 to 7 giving the people of the country, as contradistinguished from private banking interest, control by a vote of 7 to 5…” There can be no doubt that the Congress sought to achieve a balance of fundamentally conflicting interests.
I am not arguing that Congress got the balance right, and the recent crisis is certainly reason enough to re-visit what the correct balance would be. But naively fiddling with the balance in the name of eliminating conflicts of interest misses the real civics lesson from the founding of the Fed’s FOMC.
I've written about this topic as well. This is from a post at Maximum Utility, my blog at CBS MoneyWatch:
What’s Wrong With the Dodd Proposal to Restructure the Fed?: A proposal from Senate Banking Committee Chairman Christopher Dodd changes the selection process for key positions within the Federal Reserve system. Unfortunately, this proposal makes the selection process worse, not better. If this proposal is passed into law, it would further concentrate power within the Federal Reserve system, and it would politicize the selection process, both of which are the opposite of where reform should take the system.
The Current Structure of the Federal Reserve System
The Federal Reserve System consists of a Central Bank in Washington and twelve Federal Reserve District (or regional) Banks. The Central Bank's authority resides with the seven member Board of Governors, one of which serves as chair (currently Ben Bernanke). Each of the District Banks has a nine member Board of Directors along with a bank President. It is the selection of the Board of Directors that is at issue.
Currently, the nine member Board of Directors at each of the District Banks consist of three Class A directors, three Class B directors, and three Class C directors. Class A directors are elected by member banks within the district and are professional bankers. Class B directors are also elected by member banks in the district, but these are business leaders, not bankers. Finally, Class C directors are appointed by the Board of Governors and are intended to represent the public interest.
Class B and Class C directors cannot be officers, directors, or employees of any bank, and Class C directors may not be stockholders of any bank. One Class C director is selected by the Board of Governors to serve as Chair of the Board of Directors. The Board of Directors selects the President of each District Bank, but the President must be approved by the Central Bank's Board of Governors.
What is the reasoning behind this structure? When the Fed was created in 1913, there was a concerted attempt to distribute power across geographic regions; between the public and private sectors; and across business, banking, and the public interests. The geographic distinctions were important because it's not unusual for economic conditions to differ regionally -- conditions can be booming in some places and depressed in others -- and the regions would favor different monetary policies. Thus, it's important to bring these different preferences to the table when policy is being determined so that the best overall strategy can be implemented.
Changes in the Distribution of Power over Time
In the early days of the Fed, power over monetary policy -- which at that time was mainly discount rate policy within each Federal Reserve District -- was shared between Washington and the District Banks, so the intent of the system was largely realized.
However, the shared power arrangement within the Federal Reserve system changed after the Great Depression. The Fed did not perform well during the great Depression and one of the problems, it seemed, was that the deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances rather than problems with individual banks (the discount window is well-suited to help individual banks, but it's not an effective tool to combat system wide disruptions; on the other hand, open-market operations -- a policy tool the Fed obtained after the Great Depression -- can inject reserves system-wide and are much more useful to deal with system-wide problems).
The result was that after the Great Depression, power was concentrated in the Central Bank's Board of Governors in Washington D.C., and increasingly over time, in the hands of one person -- the Chair of the Federal Reserve. Thus, over time the Fed has evolved from a democratic, shared power arrangement at its inception to a system that functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.
The Dodd Proposal
How would the Dodd proposal change this? Under the proposal, the Board of Directors for each District Bank would be chosen by the Central Bank's Board of Governors (who are themselves chosen by the President with the advice and consent of the Senate). The chair of the Board of Directors at each District Bank would be chosen by the President and confirmed by the Senate.
This means that the key figures within each District Bank would be chosen by Washington, and unlike the present system, there is no attempt at all to represent geographic, business, banking, and public interests explicitly in this arrangement. In addition, it no longer has the explicit safeguards contained in the current rules to prevent bankers from dominating the directorships (e.g. under the new rules the Chair of the Board of Directors could be a banker, currently that can't happen). Given that the appointments are coming from Washington (as opposed to a vote of banks within the District for six of the nine positions on the Board like we have now), there is no guarantee that the District bank Boards won't be stacked with one special interest or another. Thus one of the main reasons given by Dodd for the change in the selection process -- to remove the influence of bankers -- is actually undermined by his proposal because it removes the safeguards against the Board being dominated by banking interests.
I believe that the current structure of the Fed already gives too much power to Washington and not enough to the District Banks, and this has helped to feed the perception that the Fed does not represent the interests of the typical person. Unfortunately, the Dodd proposal further concentrates power in Washington and adds more political elements to the selection process thereby making these problems even worse.
Thus, I agree with this:Bullard, 48, the St. Louis Fed’s president since April 2008, said ... the Fed is ultimately controlled by political appointees as it stands... “We don’t want to put all the power into Washington and New York,” Bullard said. “That’s just the opposite of what this crisis is teaching us. So you want the input from around the country, and I think it’s really important for informing monetary policy.”Richmond Fed President Jeffrey Lacker said ... “I wouldn’t want to see the reserve bank governance mechanism politicized in any way,”... Asked if Dodd’s plan would politicize the process, Lacker said: “I think it could.”Finally, while the proposal claims to insulate the Fed's monetary policy decision from political pressure, this quote from the same article illustrates the dangers of political interference. The quote is in response to another part of the Dodd proposal that would take away some of the power the District Bank Presidents have in setting monetary policy (which is already much less than the power of the Board of Governors):
“I doubt very much that by a year from now Fed presidents are going to have as big a role as they now have,” Financial Services Committee Chairman Barney Frank told reporters... He has said the presidents too often vote in favor of higher interest rates.
That last sentence means he believes the Fed has favored low inflation over low unemployment as it has set interest rate policy. That may or may not be true, but do we really want members of the House setting interest rate policy or changing the structure of the Fed whenever they disagree? I don't.
I fully agree that the selection process for the Directors and the District Bank Presidents could and should be changed (that includes redrawing geographic districts). It's not clear that the present system does the best possible job of representing the array of interests that have a stake in the outcome of policy decisions. But concentrating power in Washington is not the way to solve this problem. Instead we need to redistribute power over a wider range of interests, including geographic interests, and make sure the selection process for key positions within the Federal Reserve system brings those interests to the table when policy is determined.
[Update: See also Alan Blinder's "Threatening the Fed's Independence".]
And one more post from Maximum Utility:
Why The Federal Reserve Needs To Be Independent, by Mark Thoma: There are several bills that have been proposed in Congress directed at the Federal Reserve. The two most prominent proposals are Senate Banking Committee Chairman Christopher Dodd's bill to take away most of the Fed's regulatory authority, and Congressman Ron Paul's bill to force the Fed to allow its monetary policies to be audited by the Government Accountability Office (GAO).
Many people worry, rightly in my opinion, that if these proposals or others like them are passed into law, then the Fed's independence would be threatened.
Political business cycles and inflation
Why is the Fed's independence so important? One reason is the control of inflation. As former Federal Reserve Governor Frederic Mishkin wrote this week in an op-ed coauthored with Anil Kashyup of the University of Chicago:
Economic theory and massive amounts of empirical evidence make a strong case for maintaining the Fed's independence. When central banks are subjected to political pressure, authorities often pursue excessively expansionary monetary policy in order to lower unemployment in the short run. This produces higher inflation and higher interest rates without lowering unemployment in the long term. This has happened over and over again in the past, not only in the United States but in many other countries throughout the world.
What Mishkin and Kashyup are referring to are "political business cycles." The idea is that monetary policy acts faster on output and employment than it does on inflation. To take a concrete example, suppose that the impact of a change in the money supply on output peaks about six months after the change in policy, and then fades after that. And also suppose that the impact of the change in the money supply on prices is delayed six months and is not fully felt until eighteen months after the policy change (these are roughly consistent with econometric estimates of the impact of changes in money on output and prices).
This situation opens up the possibility for a politician in control of the money supply to manipulate the economy in an attempt to increase the chances of getting reelected. If votes depend upon output growth, as they seem to, then the politician can pump up the money supply around six months before the election so that output will peak just as the election is held. Then, the politician could plan to reduce the money supply just after the election to avoid having inflation problems down the road.
So the politician implements this strategy, gets reelected, and now comes the time to cut back on the money supply. But there's a problem. Output peaked the month of the election, and has been falling ever since. Will the politician actually cut the money supply and raise interest rates to avoid inflation -- which would reduce output and employment growth even further, something that is sure to bring protests -- or decide to live with the inflation? The choice is often to live with inflation, and as the cycle repeats with each election, inflation slowly ratchets upward.
Budget deficits and inflation
But political manipulation of the money supply is not the problem most people are worried about, it's the expected increase in the government debt that is creating the inflation worry.
When the government purchases goods and services, those purchases must be financed in one of three ways--raising taxes, borrowing from the public (i.e., issuing government debt), or printing new money. Thus, if government spending is much larger than taxes, and if raising taxes is political poison, then the deficit must be financed by either printing money or issuing new government debt. However, increasing the government debt is often a bad choice politically, so when faced with this decision politicians often choose to increase the money supply rather than increase the debt, and the result is inflation. The inflation is a hidden tax--in essence the government spending is paid for by inflating away the value of the dollar, but the blame for the inflation can often be displaced onto things like oil and other commodity prices, and thus the political consequences are not as large as for changes in taxes or in the debt.
The hope is that an independent Fed can overcome the temptation to use monetary policy to influence elections, and also overcome the temptation to monetize the debt, and that it will do what's best for the economy in the long-run rather than adopting the policy that maximizes the chances of politicians being reelected.
Many people are worried that if the US does not get its long-run debt problem under control, a problem driven mainly by escalating health care costs, then politicians worried about their reelection chances will begin pressuring the Fed to finance the debt by printing money. And if the Fed is uncooperative, its independence may be taken away legislatively.
I believe these threats are real, and as noted above, experience shows that once politicians get involved in monetary policy, inflation generally becomes a problem. For that reason, I am very opposed to anything that threatens the Fed's ability to assert its independence and keep the economy on the best long-run path.
(For more discussion of the pros and cons of Fed independence, see here; for more on the degree of the Fed's independence in the U.S., see the bottom of this post.)