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Monday, May 10, 2010

Paul Krugman: Sex & Drugs & the Spill

The "degradation of effective government by anti-government ideology" during the Bush years, and, I'd add, the belief that markets take care of these problems on their own that pervaded regulatory culture, undermined the ability of government regulators to require companies to take precautions that might have prevented the disaster in the gulf. This was also the story of the financial crisis, and these two recent disasters illustrate the more general need for a reversal of "the collapse in government competence and effectiveness that took place during the Bush years":

Sex & Drugs & the Spill, by Paul Krugman, Commentary, NY Times: “Obama’s Katrina”: that was the line from some pundits and news sources, as they tried to blame the current administration for the gulf oil spill. It was nonsense, of course. ...
Yet there is a common thread running through Katrina and the gulf spill — namely, the collapse in government competence and effectiveness that took place during the Bush years. ... BP failed to take adequate precautions, and ... federal regulators made no effort to ensure that such precautions were taken.
For years, the Minerals Management Service, the arm of the Interior Department that oversees drilling in the gulf, minimized the environmental risks of drilling. It failed to require a backup shutdown system that is standard in much of the rest of the world, even though its own staff declared such a system necessary. It exempted many offshore drillers from the requirement that they file plans to deal with major oil spills. And it specifically allowed BP to drill Deepwater Horizon without a detailed environmental analysis.
Surely, however, none of this — except, possibly, that last exemption, granted early in the Obama administration — surprises anyone who followed the ... Interior Department during the Bush years.
For the Bush administration was, to a large degree, run by and for the extractive industries — and I’m not just talking about Dick Cheney’s energy task force. Crucially, management of Interior was turned over to ... J. Steven Griles, a coal-industry lobbyist who became deputy secretary and effectively ran the department. (In 2007 Mr. Griles pleaded guilty to lying to Congress about his ties to Jack Abramoff.)
Given this history, it’s not surprising that the Minerals Management Service became subservient to the oil industry — although what actually happened is almost too lurid to believe. According to reports by Interior’s inspector general, abuses at the agency went beyond undue influence: there was “a culture of substance abuse and promiscuity” — cocaine, sexual relationships with industry representatives, and more. Protecting the environment was presumably the last thing on these government employees’ minds.
Now, President Obama isn’t completely innocent of blame in the current spill. As I said, BP received an environmental waiver for Deepwater Horizon after Mr. Obama took office. ...
And it’s worth noting that environmentalists were bitterly disappointed when Mr. Obama chose Ken Salazar as secretary of the interior. They feared that he would be too friendly to mineral and agricultural interests, that ... there wouldn’t be a sharp break with Bush-era policies — and in this one case at least, they seem to have been right. In any case, now is the time to make that break — and I don’t just mean by cleaning house at the Minerals Management Service. What really needs to change is our whole attitude toward government. For the troubles at Interior ... were part of a broader pattern that includes the failure of banking regulation and the transformation of the Federal Emergency Management Agency, a much-admired organization during the Clinton years, into a cruel joke. And the common theme in all these stories is the degradation of effective government by anti-government ideology.
Mr. Obama understands this: he gave an especially eloquent defense of government at the University of Michigan’s commencement... Yet anti-government ideology remains all too prevalent, despite the havoc it has wrought. In fact, it has been making a comeback with the rise of the Tea Party movement. If there’s any silver lining to the disaster in the gulf, it is that it may serve as a wake-up call, a reminder that we need politicians who believe in good government, because there are some jobs only the government can do.

    Posted by on Monday, May 10, 2010 at 12:24 AM in Economics, Environment, Regulation | Permalink  Comments (50) 


    Sunday, May 09, 2010

    links for 2010-05-09

      Posted by on Sunday, May 9, 2010 at 11:03 PM in Economics, Links | Permalink  Comments (5) 


      Agreement in Europe

      An agreement emerges from the late night meetings in Europe:

      E.U. in Deal to Aid Troubled Economies, NY Times: Pressured by sliding markets and doubts over their ability to act in unison, European leaders agreed on Sunday to provide $640 billion in new loans to the Continent’s debt-riddled nations in a sweeping effort to regain lost credibility with investors.
      After more than 10 hours of talks, finance ministers from the European Union agreed on a deal that would provide $560 billion in bilateral loans and $76 billion under an existing lending program managed by the European Commission, the union’s executive body. Elena Salgado, the Spanish finance minister, who announced the deal, said the International Monetary Fund was prepared to give up to $280 billion separately.
      Officials are hoping the size of the program will signal a “shock and awe” commitment that will be viewed in the same vein as the $700 billion package the United States government provided to help its own ailing financial institutions in 2008. The leaders were making yet another attempt to stem a debt crisis that has engulfed Europe and global markets. ...
      While the sums being discussed are eye-catching, some bankers questioned whether they would be enough to calm the markets. One banker said that with more and more European economies coping with rising deficits that raising, guaranteeing or backing such a large number would not be an easy task — unless the European Central Bank stepped in a more forceful and specific manner. The bank has so far rebuffed calls to inject liquidity into the markets by buying back European bonds.
      There were many complications in trying to forge a consensus on a new package. They included defining the role of Britain, which lies outside the euro zone and had said it would not help in propping up the euro, as well as the European Central Bank. The fractiousness underscores the frailty of a monetary union in which its richest member, Germany, is also the most opposed to a financial rescue. ...
      Even now, despite the lashing rhetoric and the Sunday night pan European meeting, there is still a feeling that Europe should be doing more — notably with regard to freeing the European Central Bank to go against its charter and print money by buying back distressed European bonds from the secondary market. ...

      Speaking of central banks, the Fed announced that it is reopening liquidity swap facilities to send dollars to Europe:

      Press Release
      Release Date: May 9, 2010
      For release at 9:15 p.m. EDT
      In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the re-establishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.
      Federal Reserve Actions
      The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Swiss National Bank. The arrangements with the Bank of England, the ECB, and the Swiss National Bank will provide these central banks with the capacity to conduct tenders of U.S. dollars in their local markets at fixed rates for full allotment, similar to arrangements that had been in place previously. The arrangement with the Bank of Canada would support drawings of up to $30 billion, as was the case previously.

      These swap arrangements have been authorized through January 2011. Further details on these arrangements will be available shortly.

      One thing I learned from the recent financial crisis is that measures that seemed more than adequate at the time were never enough in retrospect. Is this response of sufficient magnitude? It's a good chunk of change, no doubt about that, but a larger response would have provided more comfort.

      Update: From Real Time Economics at the WSJ:

      The European Central Bank, in a stunning change of position, said Sunday night it will buy government and private debt on “dysfunctional” European markets as part of a concerted show of force by European authorities to persuade financial markets that they are, in fact, responding to the spreading sovereign debt crisis in the euro zone.  http://www.ecb.int/press/pr/date/2010/html/pr100510.en.html.

        Posted by on Sunday, May 9, 2010 at 06:48 PM in Economics, International Finance | Permalink  Comments (16) 


        Urban Inequalities and Social Mobility

        Daniel Little returns to the topic of social mobility:

        Urban inequalities and social mobility, by Daniel Little: Most American cities commonly look a lot like this poverty map of Cleveland when it comes to the spatial distribution of poverty and affluence.  There is a high-poverty core, in which residents have low income, poor health, poor education, and poor quality of life; there are rings of moderate income; and there are outer suburbs of affluent people with high quality of life.

        We can ask two different kinds of sociological questions about these facts: What factors cause the reproduction of disadvantage over multiple generations? And what policy interventions have some effect on enhancing upward social mobility within disadvantaged groups? How can we change this cycle of disadvantage?

        The persistence of inequalities in urban America was addressed in a special 2008 issue of the Boston Review in a forum on "ending urban poverty."  Particularly interesting is Patrick Sharkey's article "The Inherited Ghetto." Sharkey begins with a crucial and familiar point: that racial inequality has changed only very slightly since the passage of the Fair Housing Act in 1968. The concentration of black poverty in central cities has not substantially improved over that period of time, and the inequalities of health, education, and employment associated with this segregation have continued. And the association between neighborhood, degree of segregation, and income and quality of life is very strong: children born into a poor and segregated neighborhood are likely to live as adults -- in a poor and segregated neighborhood.

        Sharkey documents these statements on the basis of his analysis of the data provided the University of Michigan Panel Study of Income Dynamics, the first major statistical study of several generations of families in terms of residence, income, occupation, health, and other important variables. Using a computer simulation based on the two-generation data provided by the Panel Study, Sharkey indicates that it would take five generations for the descendants of a family from a poor, black neighborhood to have a normal expectation of living in a typical American neighborhood. (That's one hundred years in round numbers.)  In other words: the progress towards racial equality in urban America is so slow as to be virtually undetectable.

        Particular frustrating is the persistence of segregation in the forty years since the passage of the Fair Housing Act. Sharkey argues that this fact is partially explained by the fact that the policy choices made by federal and local authorities concerning housing patterns have more or less deliberately favored segregation by race. Beginning with the initial Fair Housing legislation -- which was enacted without giving the Federal agencies the power of enforcement -- both federal and state policies have reinforced segregation in housing. Sharkey notes that federal housing programs have subsidized the growth of largely white suburbs, while redlining and other credit-related restrictions have impeded the ability of black families to follow into these new suburban communities. The continuation of informal discrimination in the housing market (as evidenced by "testers" from fair housing agencies) further reinforces continuing segregation between inner-city black population and the suburban, mostly white population.

        So racial segregation is one important mechanism that maintains the economic and social inequalities that  our society continues to embody.

        How about policies that would work to speed up social progress?  It is commonly agreed that improving access to higher education for disadvantaged people is the best way to speed their economic advancement.  The theory is that individuals within the group will benefit from higher education by enhancing their skills and knowledge; this will give them new economic opportunities and access to higher-wage jobs; the individuals will do better economically, and their children will begin life with more economic support and a set of values that encourage education. So access to higher education ought to prove to be a virtuous circle or a positive feedback loop, leading to substantial social mobility in currently disadvantaged groups.

        This theory appears to be substantially true: when it is possible to prepare poor children for admission to college, their performance in college and subsequent careers is good and lays a foundation for a substantial change in quality of life for themselves and their families (link).

        However, most of our cities are failing abysmally in the task of preparing poor children for college.  High school graduation rates are extremely low in many inner-city schools -- 25-50%, and performance on verbal and math assessment tests are very low.  So a very substantial number of inner-city, high-poverty children are not being given the opportunity to develop their inherent abilities in order to move ahead in our society.  This is true in Detroit (link), and much the same is true in Cleveland, Oakland, Miami, Houston, New Orleans, and dozens of other cities.  (Here is a survey of the issues by Charles Payne in So Much Reform, So Little Change: The Persistence of Failure in Urban Schools.  And here is a striking report from 1970 prepared by the HEW Urban Education Taskforce.)  High poverty and poor education go hand in hand in American cities.

        One important research question is whether there are behavioral or structural factors that predict or cause low performance by groups of students.  Here is a fascinating graph of high school graduation rates broken down by freshman-year absenteeism (MDRC report).  Important research is being done at the Center for the Social Organization of Schools at Johns Hopkins on the dropout crisis in urban schools (link).  (Here is an earlier post on CSOS and its recommendations for improving dropout rates from urban high schools.)  The topic is important because research findings like these may offer indications of the sorts of school reforms that are most likely to enhance school success and graduation.

        It is clear that finding ways of dramatically increasing the effectiveness of high-poverty schools is crucial if we are to break out of the multi-generational trap that Sharkey documents for inner-city America.  Here is a specific and promising strategy that is being pursued in Detroit by the Skillman Foundation and its partners (link), based on small schools, greater contact with caring adults, and challenging academic curricula.  This turn-around plan is based on a specific set of strategies for improving inner-city schools developed by the Institute for Student Achievement, and ISA provides assessment data that support the effectiveness of the plan in other cities.  With support from the United Way of Southeast Michigan, several large high schools are being restructured along the design principles of the ISA model.

        But the reality is that this problem is immense, and a few successful experiments in school reform are unlikely to move the dial.  Somehow it seems unavoidable that only a Marshall Plan for addressing urban poverty would allow us to have any real confidence in the possibility of reversing the inequalities our cities reveal.  And none of our political leaders -- and few of our taxpayers -- seem to perceive the urgency of the problem.

          Posted by on Sunday, May 9, 2010 at 10:17 AM in Economics, Income Distribution | Permalink  Comments (24) 


          Neanderthal Science

          Are you part Neanderthal? The answer isn't as clear as you may have been led to believe, and this illustrates a problem I see in economics as well. There is often a large difference in the way academic results are reported in the news and what the underlying academic research actually says (this happens frequently, especially with working papers that have not yet been through the refereeing process). The academic work is often much more qualified and tentative than the way it is presented in the media. The problem is that even when subsequent research calls into question or overturns the original work, many of these "facts" live on:

          All in the (human) family?, by Rosemary Joyce: Big news in anthropology this past week:... we are all 1% to 4% Neanderthal– or rather, humans of non-African ancestry are. Or maybe not.
          As Serge Bloch of the New York Times framed the story, there are “cavemen among us” because “the species most likely had a dalliance or two in the Middle East 60,000 to 100,000 years ago”.
          Nicholas Wade’s science story for the Times played it somewhat straighter, but still went for the sex angle with the headline “Signs of Neanderthals Mating with Humans”.
          The distance from the more clinical “mating” to Bloch’s cartoon of a Neanderthal man holding a club offering flowers to a woman in a dainty skirt may seem like the span from science to popular imagination. But as UCSC Professor of Anthropology Diane Gifford-Gonzalez, Berkeley Anthropology Professor Margaret Conkey, and University of Southampton Professor Stephanie Moser have all shown in different ways, the science of human origins is drenched in the same images as the popular press.
          So I have to ask: why is the man in Serge Bloch’s cross-species couple the Neanderthal? Shades of Clan of the Cave Bear! Apparently, in the popular imagination it takes a more evolved woman to make a husband out of a man…
          The researchers sequencing Neanderthal DNA from three fragments of bone recovered from a Croatian cave have reportedly completed 60% of the Neanderthal genome. And while other researchers applaud the technical work done at the Max Planck Institute for Evolutionary Anthropology in Germany, they are cautious about the interpretation of the data.
          The problems start with the proposed time and place for Neanderthal-human romance: not in the Europe of 40,000 to 30,000 years ago imagined in Clan of the Cave Bear, but in the Middle East, and at least 20,000 years earlier, maybe as much as 60,000 years before the period when we know Neanderthal and early modern humans co-existed in Europe. To quote the Times again, “There is much less archaeological evidence for an overlap between modern humans and Neanderthals at this time and place.”
          The times draws the line of disagreement along disciplinary lines:
          Geneticists have been making increasingly valuable contributions to human prehistory, but their work depends heavily on complex mathematical statistics that make their arguments hard to follow. And the statistical insights, however informative, do not have the solidity of an archaeological fact.
          Archaeologists do have well-developed models for recognizing human and Neanderthal populations in Europe during their period of overlap through different stone tools and other cultural features. It is the lack of such well-defined models for the Middle East of 100,000 to 60,000 years ago that gives archaeologists pause.
          As an archaeologist, I found the idea that archaeological “facts” have solidity interesting for other reasons entirely. Like the image of the club-toting Neanderthal with stubble on his chin, it is a commonplace of everyday understanding of my discipline. And it is not quite true, or not true in the way that writers think it is.
          The image of “solid” archaeological facts stems from the idea that our discipline studies hard, visible things that everyone can agree about. And there are lots of things involved in every archaeological analysis. But we quarrel all the time about what exactly they mean; how best to measure them and quantify them; and how the solid things in archaeology relate to the not-so-solid theories we develop.
          And increasingly, our studies are not limited to, or even dominated by, the “solid facts” of popular imagination of archaeology. Instead, archaeologists today may study microscopic grains of starch invisible to the naked eye, or the traces of past human actions like sweeping a dirt floor visible under a microscope, or simply the chemical traces left behind when people sit in one place or do some everyday task in a particular location.
          So, are we “part caveman”? the question is meaningless. If the findings of the Neanderthal genome sequencing hold up, they will tell us that the history of humans and our closest relatives was even more intimate than many had thought.
          But the popular image of the crude Neanderthal should long ago have been set aside, replaced by our understanding of this human species as a cold-adapted contemporary of early modern humans. The visible differences in Neanderthal stature and facial shape would not necessarily have given a contemporary human pause. Those humans occupied the caves of Europe that gave us the scene for our cave man image as much as Neanderthals did.
          As Stephanie Moser has shown us, we have populated those caves in our professional and popular imagination... Less reflections of what the “solid facts” of archaeology tell us than mirrors reflecting our own vision of our past, the cavemen are us.

            Posted by on Sunday, May 9, 2010 at 10:08 AM in Economics, Science | Permalink  Comments (9) 


            Saturday, May 08, 2010

            links for 2010-05-08

              Posted by on Saturday, May 8, 2010 at 11:03 PM in Economics, Links | Permalink  Comments (29) 


              Duration of Unemployment

              Calculated Risk notes that the long-term unemployment problem isn't going away anytime soon:

              Duration of Unemployment, by CalculatedRisk: This graph shows the duration of unemployment as a percent of the civilian labor force. The graph shows the number of unemployed in four categories as provided by the BLS: less than 5 week, 6 to 14 weeks, 15 to 26 weeks, and 27 weeks or more.


              Note: The BLS reports 15+ weeks, so the 15 to 26 weeks number was calculated.
              This really shows the change in turnover - there was more turnover in the '70s and '80s, since the 'less than 5 weeks' category was much higher as a percent of the civilian labor force than in recent years. This changed in the early '90s - perhaps as a result of more careful hiring practices or changes in demographics or maybe other reasons - but if the level of normal turnover was the same as in the '80s, the current unemployment rate would probably be the highest since WWII.

              What really makes the current period stand out is the number of people (and percent) that have been unemployed for 27 weeks or more. In the early '80s, the 27 weeks or more unemployed peaked at 2.9 million or 2.6% of the civilian labor force.

              In April 2010, there were 6.72 million people unemployed for 27 weeks or more, or 4.34% of the labor force. This is significantly higher than during earlier periods.

              It is worth repeating some of the comments Atlanta Fed President Dennis Lockhart made in March:

              There are two key types of match inefficiency. One is geographic mismatch. In 2008, the percentage of individuals living in a county or state different than the previous year was the lowest recorded in more than 50 years of data. People may be reluctant to relocate for a new job if the value of their house has declined. In addition, many who would like to move are under water in their mortgage or can't sell their homes.

              The second inefficiency is skills mismatch. In simple terms, the skills people have don't match the jobs available. Coming out of this recession there may be a more or less permanent change in the composition of jobs.
              Both of these mismatches are contributing to the long term unemployment problem - and the housing bubble was a direct cause of both. Usually people can move freely in the U.S. to pursue employment (geographic mobility), but now many people are tied to an anchor (their home). And many workers went into the construction trades and acquired skills that are not easily transferable.

              The good news is the economy is now adding jobs. But the lack of mobility and the skills mismatch make the long term unemployment problem a difficult challenge.

              The lack of attention from Congress doesn't help either.

                Posted by on Saturday, May 8, 2010 at 07:11 PM in Economics, Unemployment | Permalink  Comments (32) 


                "Tax Cuts And 'Starving The Beast'"

                Bruce Bartlett argues that "starve the beast" doesn't work, and may even lead to the opposite of the intended effect:

                Tax Cuts And 'Starving The Beast', by Bruce Bartlett, Commentary, Forbes: I believe that to a large extent our current budgetary problems stem from the widespread adoption of an idea by Republicans in the 1970s called "starve the beast." It says that the best, perhaps only, way of reducing government spending is by reducing taxes. While a plausible strategy at the time it was formulated, STB became a substitute for serious budget control efforts, reduced the political cost of deficits, encouraged fiscally irresponsible tax cutting and ultimately made both spending and deficits larger.
                Once upon a time Republicans thought that budget deficits were bad, that it was immoral to live for the present and pass the debt onto our children. ... Republicans also thought that deficits had a cost over and above the spending that they financed and that it was possible for this cost to be so high that tax increases were justified if spending could not be cut.
                Dwight Eisenhower kept in place the high Korean War tax rates throughout his presidency, which is partly why the national debt fell from 74.3% of gross domestic product to 56% on his watch. Most Republicans in the House of Representatives voted against the Kennedy tax cut in 1963. Richard Nixon supported extension of the Vietnam War surtax instituted by Lyndon Johnson... And Gerald Ford opposed a permanent tax cut in 1974 because he feared its long-term impact on the deficit.
                By 1977, however, Jack Kemp, Dave Stockman and a few other House Republicans concluded that the economy was desperately in need of a permanent tax rate reduction. Kemp believed that such a tax cut would so expand the economy that the revenue loss would be minimal. He also thought that much government spending was driven by slow economic growth--welfare, unemployment benefits and so on--that would fall automatically if growth increased.
                But the Republican Party's economic gurus--Alan Greenspan and Herb Stein, in particular--were not comfortable supporting a tax cut without stronger assurances that the deficit would not increase too much. ...
                After enactment of California's Proposition 13--a big property tax cut with no offsetting spending cuts or tax increases--on June 6, 1978, there was an immediate change in attitude among Republican economists who were previously skeptical of a permanent cut in federal income tax rates. They could see that a tax revolt was in the making and that Republicans could very possibly ride it all the way back into the White House in 1980.
                On July 14, 1978, a few weeks after the Prop. 13 vote,... Greenspan ... was the first Republican to articulate what came to be called "starve the beast" theory. ... Citing Greenspan's testimony, conservative columnist George Will endorsed Kemp-Roth and STB in a column on July 27, 1978. ...
                On Aug. 7, 1978, economist Milton Friedman added his powerful voice to the discussion. Writing in Newsweek magazine, he said, "the only effective way to restrain government spending is by limiting government's explicit tax revenue--just as a limited income is the only effective restraint on any individual's or family's spending."
                By 1981 STB was well-established Republican doctrine. In his first major address on the economy as president on Feb. 5, Ronald Reagan articulated the idea perfectly. ... Unfortunately there is no evidence that the big 1981 tax cut enacted by Reagan did anything whatsoever to restrain spending. ...
                Rather than view this as refutation of starve the beast theory, however, Republicans concluded that Reagan's true mistake was acquiescing to tax increases... By the end of his presidency, Reagan signed into law tax increases that took back half the 1981 tax cut. His hand-picked successor, George H.W. Bush, compounded the error, Republicans believe, by supporting a tax increase in 1990.
                When Bill Clinton became president in 1993, one of his first acts in office was to push through Congress--with no Republican support--a big tax increase. Starve the beast theory predicted a big increase in spending as a consequence. But in fact, federal outlays fell...
                Although all of evidence of the previous 20 years clearly refuted starve the beast theory, George W. Bush was an enthusiastic supporter, using it to justify liquidation of the budget surpluses he inherited from Clinton on massive tax cuts year after year. Bush called them "a fiscal straightjacket for Congress" that would prevent an increase in spending. Of course nothing of the kind occurred. Spending rose throughout his administration... Nevertheless STB remains a critical part of Republican dogma. ...
                Despite its continuing popularity among Republican politicians, at least a few conservative intellectuals are starting to have misgivings about STB. ... By eliminating tax increases as a necessary consequence of deficits, it also reduced the implicit cost of spending. Thus, ironically, STB led to higher spending rather than lower spending as the theory posits.
                In the latest study of STB, political scientist Michael New of the University of Alabama ... concluded. "The evidence suggests that lower levels of federal revenue may actually lead to greater increases in spending."
                In effect STB became a substitute for spending restraint among Republicans. They talked themselves into believing that cutting taxes was the only thing necessary to control the size of government. Thus, rather than being a means to an end--the end being lower spending--tax cuts became an end in themselves, completely disconnected from any meaningful effort to reduce spending or deficits.
                Starve the beast was a theory that seemed plausible when it was first formulated. But more than 30 years later it must be pronounced a total failure. There is not one iota of empirical evidence that it works the way it was supposed to, and there is growing evidence that its impact has been perverse--raising spending and making deficits worse. In short, STB is a completely bankrupt notion that belongs in the museum of discredited ideas, along with things like alchemy.

                Starve the beast was always backwards. There is some simultaneity in the choice of spending and taxes, and causal lines likely run in both directions, but the main causal effect is that tax rates adjust to spending over time, causality from taxes to spending in not as strong.

                However, I don't want to say that starve the beast has been a complete failure. I believe our response to the crisis would have been different - hopefully it would have been considerably larger -- if we had been running a large surplus rather than a large deficit. Tax cuts weren't the only factor that put pressure on the budget, spending on the war mattered too, but I believe the tax cuts did reduce the magnitude of the response to the crisis. The tax cut portion of the stimulus package was smaller than it might have been if taxes hadn't been cut so much already, and spending would have been larger if surplus monies were present. I also think that discussions over spending on Social Security and other social programs would be different if the government's finances were in better shape, i.e. if taxes had not been cut. There would still be issues to resolve in the long-run, but there wouldn't be as much pressure to solve the problem immediately through drastic cuts in benefits.

                So while I do believe that the strongest causal effects run from spending to taxes, I don't think we can say that causality in the other direction -- from say tax cuts to spending during an economic crisis -- is insignificant. It mattered.

                  Posted by on Saturday, May 8, 2010 at 01:17 AM in Budget Deficit, Economics, Politics | Permalink  Comments (74) 


                  "The Universe on a String"

                    Posted by on Saturday, May 8, 2010 at 01:08 AM in Economics, Science | Permalink  Comments (16) 


                    Friday, May 07, 2010

                    links for 2010-05-07

                      Posted by on Friday, May 7, 2010 at 11:01 PM in Economics, Links | Permalink  Comments (18) 


                      Eichengreen: It is not too late for Europe

                      Barry Eichengreen, who will be a discussant on Guillermo Calvo's paper to be presented later today at the conference, says, in his latest at Vox EU, that "It may be too late for Greece, but it is not too late for Europe." However, "a solution will require everyone to wake up." Richard Baldwin, editor of Vox EU, says in an email "I think you'll like this":

                      It is not too late for Europe, by Barry Eichengreen, Commentary, Project Syndicate: European leaders and the IMF have badly bungled their efforts to stabilise Europe’s financial markets. They have one last chance, but success will require a radical change in mindset.

                      First the easy part: Greece will restructure its debt. This point is no longer controversial; the only controversy is why a restructuring was not part of the initial IMF-EU rescue package.

                      Continue reading "Eichengreen: It is not too late for Europe" »

                        Posted by on Friday, May 7, 2010 at 12:24 PM in Economics, Financial System, International Finance | Permalink  Comments (117) 


                        The Employment Report

                        Since I'm at a conference today, I didn't have time to say much about the employment report released this morning, but here's a quick reaction, links to other discussions, and a reaction from Larry Mishel at the EPI:

                        The Employment Report

                        The big questions are, I think, if the current rate of growth will continue and, if it does, how long it will take for employment to return to normal (which depends, in part, on how fast labor force participation rebounds as the economy recovers).

                          Posted by on Friday, May 7, 2010 at 08:53 AM in Economics, Unemployment | Permalink  Comments (33) 


                          CEGE Annual Conference: Financial Shocks and the Real Economy

                          I am here today:

                          CEGE Annual Conference
                          Financial Shocks and the Real Economy
                          Andrews Conference Room, 2203 Social Science/Humanities Building
                          University of California, Davis
                          Friday, May 7, 2010

                          8:30 Continental Breakfast

                          9:00 Financial Intermediation, Asset Prices, and Macroeconomic Dynamics

                          Tobias Adrian (NY Fed) (with Emanuel Moench and Hyun Song Shin)
                          Discussant:
                          Oscar Jorda (UC Davis)

                          10:00 Credit Risk and the Macroeconomy

                          Simon Gilchrist (Boston University)
                          Discussant:
                          Eric Swanson (Federal Reserve Bank of San Francisco)

                          11:00 Coffee Break

                          11:30 Financial Liberalization, Boom-Bust Cycles and Production Efficiency

                          Aaron Tornell (UCLA)
                          Discussant:
                          Maurice Obstfeld (UC Berkeley)

                          12:30 Lunch Break

                          1:30 Macroeconomic Effects of Financial Shocks

                          Vincenzo Quadrini (USC) (with Urban Jermann)
                          Discussant:
                          Michael Devereux (British Columbia)

                          2:30 Looking at Financial Crises in the Eye: Some Basic Observations

                          Guillermo Calvo (Columbia)
                          Discussant:
                          Barry Eichengreen (UC Berkeley)

                          3:30 Coffee Break

                          4:00 Off the Cliff and Back? Credit Conditions and International Trade during the Global Financial Crisis

                          Kalina Manova (Stanford) (with Davin Chor)
                          Discussant:
                          Dennis Novy (Warwick)

                          6:30 Dinner at Seasons Restaurant, 102 F Street

                          Sponsored by the Center for the Evolution of the Global Economy and the Institute of Governmental Affairs

                            Posted by on Friday, May 7, 2010 at 06:30 AM in Academic Papers, Economics, Financial System, Macroeconomics | Permalink  Comments (2) 


                            Paul Krugman: A Money Too Far

                            Will Greece leave the euro? At present, that appears to be the only plausible alternative it has:

                            A Money Too Far, by Paul Krugman, Commentary, NY Times: So, is Greece the next Lehman? No. It isn’t either big enough or interconnected enough to cause global financial markets to freeze up the way they did in 2008. Whatever caused that brief 1,000-point swoon in the Dow, it wasn’t justified by actual events in Europe.

                            Nor should you take seriously analysts claiming that we’re seeing the start of a run on all government debt. U.S. borrowing costs actually plunged on Thursday to their lowest level in months. ...

                            That’s the good news. The bad news is that Greece’s problems are deeper than Europe’s leaders are willing to acknowledge,... and they’re shared, to a lesser degree, by other European countries. Many observers now expect the Greek tragedy to end in default; I’m increasingly convinced that they’re too optimistic, that default will be accompanied or followed by departure from the euro.

                            In some ways, this is a chronicle of a crisis foretold. I remember quipping, back when the Maastricht Treaty setting Europe on the path to the euro was signed, that they chose the wrong Dutch city for the ceremony. It should have taken place in Arnhem, the site of World War II’s infamous “bridge too far,” where an overly ambitious Allied battle plan ended in disaster. The problem ... is that Europe lacks some of the key attributes of a successful currency area. Above all, it lacks a central government.

                            Greece ...[is] in deep fiscal trouble,... despite the demonstrations, Greece’s Parliament has ... approved harsh austerity measures. ... Greece’s budget cuts ... will have a strong depressing effect on an already depressed economy.

                            So is a debt restructuring — a polite term for partial default — the answer? It wouldn’t help nearly as much as many people imagine, because interest payments only account for part of Greece’s budget deficit. Even if it completely stopped servicing its debt, the Greek government wouldn’t free up enough money to avoid savage budget cuts.

                            The only thing that could seriously reduce Greek pain would be an economic recovery... If Greece had its own currency, it could try to engineer such a recovery by devaluing that currency, increasing its export competitiveness. But Greece is on the euro.

                            So how does this end? Logically, I see three ways Greece could stay on the euro.

                            First, Greek workers could redeem themselves through suffering, accepting large wage cuts that make Greece competitive enough to add jobs again. Second, the European Central Bank could engage in much more expansionary policy, among other things buying lots of government debt, and accepting — indeed welcoming — the resulting inflation; this would make adjustment in Greece and other troubled euro-zone nations much easier. Or third,... fiscally stronger European governments could offer their weaker neighbors enough aid to make the crisis bearable.

                            The trouble, of course, is that none of these alternatives seem politically plausible.

                            What remains seems unthinkable: Greece leaving the euro. But when you’ve ruled out everything else, that’s what’s left.

                            If it happens, it will play something like Argentina in 2001, which had a supposedly permanent, unbreakable peg to the dollar. Ending that peg was considered unthinkable for the same reasons leaving the euro seems impossible: even suggesting the possibility would risk crippling bank runs. But the bank runs happened anyway... This left the door open for devaluation, and Argentina eventually walked through that door.

                            If something like that happens in Greece, it will send shock waves through Europe, possibly triggering crises in other countries. But unless European leaders are able and willing to act far more boldly than anything we’ve seen so far, that’s where this is heading.

                              Posted by on Friday, May 7, 2010 at 01:08 AM in Economics, International Finance | Permalink  Comments (71) 


                              "Deficit Hawkery's Harsh Impact on Education"

                              Why are we letting this happen?:

                              Deficit hawkery's harsh impact on education, by Harold Meyerson, Commentary, Washington Post: ...The worst recession since the 1930s is clobbering the nation's schools. ... A recent American Association of School Administrators survey ... shows how bad things are. One-third of the districts are looking at eliminating summer school... Fourteen percent are considering going to four-day weeks (last year, just 2 percent did). Fully 62 percent anticipate increasing class size next year, up from 26 percent in the current school year. ... Nationwide, estimates of teacher layoffs range from 100,000 to 300,000, with some experts pegging the most likely number nearer the high end. ...
                              One of the signal accomplishments of the Obama stimulus package ... was to spare school districts from more draconian cuts. Of the $787 billion legislation, $100 billion was directed to schools; while districts still had to lay off teachers and reduce course offerings, hundreds of thousands of layoffs and other cuts were averted. ...
                              But the $100 billion ... is largely spent, and no omnibus second stimulus looms. One problem with the current wave of deficit hawkery is that while it purports to be concerned with the nation's long-term debt,... it endangers our short-term recovery and our long-term economic prospects. Not to mention the development of America's children.
                              "You can't just push the pause button on kids' education and say, 'Wait a while,' " says Iowa Democrat Tom Harkin... Yet there is little willingness in Congress to craft another broad stimulus package even though education provisions plainly enhance the nation's ability to create a globally competitive workforce. There is also little support for finding offsetting cuts or tax hikes to pay for such a bill. ...
                              It is a mantra of the deficit hawks that they are working to ensure their children and grandchildren will one day have the same opportunities that they have had. But right now, in real time, those same children and grandchildren are having those opportunities taken away. ...

                                Posted by on Friday, May 7, 2010 at 12:42 AM Permalink  Comments (16) 


                                A "Foreclosure Society"

                                It's hard to defend the home mortgage interest deduction, but if you're so inclined, feel free to try:

                                A tax break that is breaking us, by Edward L. Glaeser, Commentary, Boston Globe: The latest Case-Shiller housing data suggest that housing markets have now stabilized. ... This stability makes it possible to move beyond stop-gap measures and to envision fundamental reforms that will make the next housing crisis less damaging. Lowering the $1 million cap on the home mortgage interest deduction is a good place to start. ...
                                I’m not claiming that government policies, like the mortgage interest deduction, caused the bubble. The deduction is an old policy that has remained a constant in good times and bad. Moreover, the bubble can’t be explained by low interest rates or easy mortgage approvals or high loan-to-value ratios. The historical relationship between these variables and housing prices is just not large enough to explain either the boom or bust. America’s great housing convulsion is best seen as an enormous, almost inexplicable whirlwind that was created by ebullient, but incorrect, beliefs about never-ending home price appreciation.
                                But while government policies cannot be blamed for the bubble, they did exacerbate its damage. For decades, the home mortgage interest deduction and government-subsidized institutions like Fannie Mae and Freddie Mac have made mortgages artificially inexpensive. This subsidy encouraged homebuyers to borrow like mad and tie their fortunes to the housing market.
                                During the boom, these policies were thought to lead Americans to accumulate housing wealth and create an “ownership society.’’ We now know that encouraging people to borrow to buy homes can just as easily lead towards a "foreclosure society"...
                                The home mortgage interest deduction also subsidizes Americans to buy bigger homes... In an age of global warming, why should we subsidize the greater energy use inherent in larger homes? There is a powerful connection between structure type and ownership, which means that encouraging homeownership implicitly encourages sprawl..., which is bad for cities, bad for traffic congestion and bad for carbon emissions.
                                The mortgage interest deduction is also extremely regressive. ... Now that prices have stabilized, we can imagine slowly leading this political sacred cow towards a good stockyard. The interest deduction currently has an upper limit of $1 million. That limit could be reduced by $100,000 per year over the next seven years, which would lead to a less regressive $300,000 cap. After that point, we could consider replacing the interest deduction altogether with a flat homeowner’s tax credit that would encourage homeownership without encouraging borrowing or big houses. ...

                                  Posted by on Friday, May 7, 2010 at 12:33 AM in Economics, Housing, Taxes | Permalink  Comments (31) 


                                  Thursday, May 06, 2010

                                  links for 2010-05-06

                                    Posted by on Thursday, May 6, 2010 at 11:02 PM in Economics, Links | Permalink  Comments (16) 


                                    Should Hank Paulson be Congrtulated for a Job Well-Done?

                                    I see Hank Paulson is defending is policies during the financial crisis once again, e.g. see "Paulson defends actions in financial crisis."

                                    Here's what I wrote about Hank Paulson in November 2008 when he "pats himself on he back" for a job well done:

                                    I see it a bit different. The financial bailout was necessary, but the initial rollout was botched badly and it created a huge backlash against the bailout program by the public. That didn't have to happen, and it has made it much more difficult to do what is needed.

                                    But that is another problem, getting the Treasury to understand what is needed, and then do it. I think the toxic asset removal program might have worked - a year ago - but they waited too long to do anything and it won't work now. Buying the assets months ago when they were at a higher value would have, essentially, recapitalized the banks and helped them to avoid insolvency. (But it also means that the government would have probably taken losses on these assets. I think the losses would have been less than they will be now when you include the deterioration in the overall economy, but taking the losses would have likely created a public backlash. Demanding a share of future profits in return for removing the toxic assets might have helped on this front.)

                                    For the most part - in every case I can think of - Paulson generally waited until he was forced to act. After dealing with a series of problems with individual financial intermediaries that were on the brink of failure, then making a big mistake by letting Lehman fail, things got so bad he was convinced we were close to, or at the meltdown point. Given that, he had no choice but to ask for a massive bailout.

                                    Paulson now claims the problem is too large to do anything about now, or even on October 3 when the plan was passed, though the toxic asset removal plan would of worked a couple of weeks earlier in mid September. However, as he admits, the plans weren't ready then, it took them until now to have the asset removal plans ready to go, so how could he have put the plan in place by October 3 even if congress had approved it the day he asked for it?

                                    Instead of having plans ready, plans that that had been thought through enough so they could explain how they were supposed to work, they fiddled around with various ideas while bank balance sheets deteriorated. That left banks with a insolvency problem that needed to be addressed, but again Treasury was slow to do anything about it. They only acted when they were forced into this step and led by the nose by the British (and Paulson is now taking credit for doing this).

                                    This financial crisis has been going on a long, long time, and they should have been planning long ago about how to deal with various contingencies. Plans should have been on the shelf and ready to go. Even now, they don't have an agreed upon plan to address the foreclosure problem, something Paulson says he has believed all along is the key to stopping the deterioration. Then why don't we have a plan? It has been in the planning stages for who knows how long, and the plans are now being abandoned since the clock has run out. It's hard not to wonder if the delaying tactics are ideologically based and intentional. Hem and haw long enough so that nothing gets done.

                                    A committed and competent Treasury could have done a lot to help the situation, but unfortunately, that is not what we got. Let's hope the next administration makes better choices.

                                      Posted by on Thursday, May 6, 2010 at 07:38 PM in Economics, Financial System, Regulation | Permalink  Comments (18) 


                                      "Gambling with Other People's Money"

                                      This paper on the cause of the financial crisis is from Russell Roberts of the Mercatus Center at George Mason University. As you might expect, it puts government front and center when it comes to assigning blame. [This summary of the paper is from an email]:

                                      Gambling with Other People's Money, by Russell Roberts: The argument in the paper is:
                                      1. It isn't "too big to fail" that's the problem, it's the relentless government rescue of creditors over the last three decades. That policy encouraged imprudent lending and allowed large financial institutions to become highly leveraged.
                                      2. Shareholder losses do not reduce the moral hazard problem even when the executives making the decisions are shareholders
                                      3. These incentives allowed execs to justify and fund enormous bonuses until they blew up their firms. Whether they planned on that or not doesn't matter. The incentives remain as long as creditors get bailed out 100 cents on the dollar.
                                      4. Changes in regulations encouraged risk-taking by artificially encouraging the attractiveness of AAA-rated securities.
                                      5. Changes in US housing policy helped inflate the housing bubble, particularly the expansion of Fannie and Freddie into low down payment loans.
                                      6. The increased demand for housing resulting from Fannie and Freddie's expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.
                                      7. Unless we stop bailing out creditors, we will have a very fragile financial system that allocates capital unwisely and transfers money from taxpayers to very wealthy people.

                                      I'm on the road again (to this conference), so I don't have time to say much about this -- hopefully you will -- but I disagree with the part on Fannie and Freddie's role in the crisis, e.g. see these links for several posts on this topic.

                                        Posted by on Thursday, May 6, 2010 at 10:08 AM in Economics, Financial System | Permalink  Comments (68) 


                                        Initial Claims for Unemployment insurance Fall Slightly

                                        A MoneyWatch, I give two views of recent labor market data, a pessimistic view and an optimistic view:

                                        Initial Claims for Unemployment Insurance Fall Slightly

                                        I also ask which of the two views you think policymakers will adopt.

                                          Posted by on Thursday, May 6, 2010 at 09:00 AM in Economics, Unemployment | Permalink  Comments (12) 


                                          Stiglitz and Rogoff on Europe's Financial Troubles

                                          Here are two views of the situation in Europe. First, Joseph Stiglitz isn't sure the euro can survive, or that it should:

                                          Can the Euro be Saved?, by Joseph E. Stiglitz, Commentary, Project Syndicate: The Greek financial crisis has put the very survival of the euro at stake. At the euro’s creation, many worried about its long-run viability. When everything went well, these worries were forgotten. But the question of how adjustments would be made if part of the eurozone were hit by a strong adverse shock lingered. Fixing the exchange rate and delegating monetary policy to the European Central Bank eliminated two primary means by which national governments stimulate their economies to avoid recession. What could replace them? ...
                                          Some hoped that the Greek tragedy would convince policymakers that the euro cannot succeed without greater cooperation (including fiscal assistance). But Germany (and its Constitutional Court), partly following popular opinion, has opposed giving Greece the help that it needs. ...
                                          For the EU’s smaller countries, the lesson is clear: if they do not reduce their budget deficits, there is a high risk of a speculative attack, with little hope for adequate assistance from their neighbors, at least not without painful and counterproductive pro-cyclical budgetary restraints. As European countries take these measures, their economies are likely to weaken – with unhappy consequences for the global recovery. ...
                                          The social and economic consequences of the current arrangements should be unacceptable. Those countries whose deficits have soared as a result of the global recession should not be forced into a death spiral – as Argentina was a decade ago.
                                          One proposed solution is for these countries to engineer the equivalent of a devaluation – a uniform decrease in wages. This, I believe, is unachievable, and its distributive consequences are unacceptable. The social tensions would be enormous. It is a fantasy.
                                          There is a second solution: the exit of Germany from the eurozone or the division of the eurozone into two sub-regions. The euro was an interesting experiment, but ... it lacks the institutional support required to make it work.
                                          There is a third solution, which Europe may come to realize is the most promising for all: implement the institutional reforms, including the necessary fiscal framework, that should have been made when the euro was launched.
                                          It is not too late for Europe to implement these reforms and thus live up to the ideals, based on solidarity, that underlay the euro’s creation. But if Europe cannot do so, then perhaps it is better to admit failure and move on than to extract a high price in unemployment and human suffering in the name of a flawed economic model.

                                          Next, Kenneth Rogoff on whether Greece and other countries will eventually default:

                                          Europe finds the old rules still apply, by Kenneth Rogoff , Commentary, Financial Times: ...A recurring theme of my academic research with Carmen Reinhart is that “graduation” from emerging market status is a long, painful process that can take 75 years or more to complete. ...
                                          The eurozone experiment was, in effect, an attempt to speed up the graduation process through the carrot of the single currency and the stick of harsher bail-out rules. Instead of having to demonstrate fortitude and commitment through decades of surpluses and declining public debt levels (as for example, Chile has done), euro members were allowed to have their cake and eat it, too. ... Greece could run up its public debt to more than 115 per cent of GDP. Even more stunning a figure is Greece’s total external debt to GDP, which is more than 170 per cent, counting both public and private debt. Prof Reinhart and I find that most emerging markets run into trouble at external debt levels of merely 60 per cent of GDP. ...
                                          Is it realistic for the IMF and Europe to hope that Greece (and other struggling euro members) will survive without an eventual default? ... Unfortunately, “near misses” are the exception, not the rule. ...
                                          Will Europe’s crisis end only in “near misses” rather than outright defaults or reschedulings? The answer involves a range of political, social and economic questions that are not easily quantifiable. ... It is very rare for a country to default because it literally cannot pay. In most cases, and certainly in southern Europe today, the issue is willingness to pay. ...
                                          In the case of Europe, the decision to repay involves not only the usual costs and benefits, but also the added question of how a nation’s status in the European Union will be affected. Is Europe prepared to go to great pains to punish Greece if it defaults, imposing costs much higher than those a non-euro country would face? If not, how can it seriously expect Greece to pay down debt levels far in excess of those navigated by almost any other large emerging market?
                                          In our book on financial history, Prof Reinhart and I find that international banking crises are almost invariably followed by sovereign debt crises. Will the euro prove to be a firewall against this process, or a debt machine that fuels it? It is going to be extremely difficult for some of the peripheral eurozone economies to escape without large-scale defaults on their massive private external debts, public external debts, or both.

                                            Posted by on Thursday, May 6, 2010 at 01:26 AM in Economics, International Finance | Permalink  Comments (99) 


                                            Wednesday, May 05, 2010

                                            links for 2010-05-05

                                              Posted by on Wednesday, May 5, 2010 at 11:01 PM in Economics, Links | Permalink  Comments (41) 


                                              Galbraith: The Role of Fraud in the Financial Crisis

                                              Recent testimony from Jamie Galbraith before the Subcommittee on Crime on the role that fraud played in the financial crisis:

                                              Statement by James K. Galbraith, Lloyd M. Bentsen, jr. Chair in Government/Business Relations, Lyndon B. Johnson School of Public Affairs, The University of Texas at Austin, before the Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010: Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.
                                              I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including "rational expectations," "market discipline," and the "efficient markets hypothesis" led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on, and that widespread fraud therefore could not occur. Not all economists believed this – but most did.
                                              Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft- pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble. They continue to do so now. At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word "naughtiness." This was on the day that the SEC charged Goldman Sachs with fraud.
                                              There are exceptions. A famous 1993 article entitled "Looting: Bankruptcy for Profit," by George Akerlof and Paul Romer, drew exceptionally on the experience of regulators who understood fraud. The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financial crime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: "the best way to rob a bank is to own one." The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle. Other useful chronicles of modern financial fraud include James Stewart's Den of Thieves on the Boesky-Milken era and Kurt Eichenwald's Conspiracy of Fools, on the Enron scandal. Yet a large gap between this history and formal analysis remains.
                                              Formal analysis tells us that control frauds follow certain patterns. They grow rapidly, reporting high profitability, certified by top accounting firms. They pay exceedingly well. At the same time, they radically lower standards, building new businesses in markets previously considered too risky for honest business. In the financial sector, this takes the form of relaxed – no, gutted – underwriting, combined with the capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles Keating realized that an S&L charter was a "license to steal." In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.
                                              The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. In the system that developed, the original mortgage documents lay buried – where they remain – in the records of the loan originators, many of them since defunct or taken over. Those records, if examined, would reveal the extent of missing documentation, of abusive practices, and of fraud. So far, we have only very limited evidence on this, notably a 2007 Fitch Ratings study of a very small sample of highly-rated RMBS, which found "fraud, abuse or missing documentation in virtually every file." An efforts a year ago by Representative Doggett to persuade Secretary Geithner to examine and report thoroughly on the extent of fraud in the underlying mortgage records received an epic run-around.

                                              Continue reading "Galbraith: The Role of Fraud in the Financial Crisis" »

                                                Posted by on Wednesday, May 5, 2010 at 11:07 AM in Economics, Financial System, Regulation | Permalink  Comments (59) 


                                                "Automatic Stabilizers Work, Always and Everywhere"

                                                One of the lessons of this recession is that fiscal policy is a very imperfect policy tool. In deep recessions when monetary policy has run its course -- when moving interest rates all the way to zero and trying non-traditional policies has not fixed the problem -- fiscal policy can provide the needed boost to aggregate demand. But the politics surrounding fiscal policy means it will be put into place far too late, if it is put into place at all, there will be fights over how to structure the stimulus, e.g. tax cuts versus government spending and the compromise may not be good policy, and there is no guarantee at all that the policies will be paid for when times improve (which undermines the policy the next time politicians promise it will be "temporary")..

                                                One option would be to create a Fed-like structure responsible for fiscal policy, an agency that has a reasonable degree of independence from Congress and the administration. This agency would be required to be in balance its budget over, say, a ten year period, but could run surpluses or deficits in the interim as needed to manage the economy (it could have a list of ready to go infrastructure projects, use tax changes, etc.). So it could not change the average level of spending, that would still be determined by Congress, but it could shift that spending around as needed. But a proposal like this would never, ever make it through Congress, and even if it did I'm not sure I could support such an institution.

                                                So what to do? One answer is automatic stabilizers such as social insurance programs that kick in when things get bad and turn off automatically when things get better. These worked well during the current recession, but by themselves weren't large enough to provide the needed stimulus. So more automatic stabilization is needed. When these policies are set in advance, and implemented down the road when the next recession hits, it avoids the political problems that plague discretionary policy. Congress doesn't have to do anything, and if their constituents don't like it, they can blame the program on their predecessors. And we don't have to limit ourselves to enhancing current programs, we could get much more creative with these stabilizers, e.g. payroll taxes that vary with the unemployment rate.

                                                A harder problem is how to use automatic stabilizers to help to backfill the hole that recessions blow in state and local government budgets, but creative policies ought to be able to help here as well (however, the automatic nature of the help means that the policies must address potential gaming of the system -- states would have an incentive to make their budgets look bad in recessions -- but cost-sharing and other mechanisms can help with this). I think it's particularly important to add an automatic mechanism that provides help to states since states can quickly undo attempts to stimulate the economy at the federal level as they cut spending or raise taxes to balance their budgets as required by law, and the political problems with providing help to states in real time are severe.

                                                Unless we get better legislators, and a couple of hundred years of history says not to count on that, enhancing the automatic stabilizers may be our best bet going forward. There's considerable empirical evidence showing that they work, including this new evidence that automatic stabilizers work "always and everywhere":

                                                Fiscal Policy and Macroeconomic Stability: Automatic Stabilizers Work, Always and Everywhere, by Xavier Debrun and Radhicka Kapoor, IMF Working paper: [Full Text]: Summary: The paper revisits the link between fiscal policy and macroeconomic stability. Two salient features of our analysis are (1) a systematic test for the government’s ambivalent role as a shock absorber and a shock inducer—removing a downward bias present in existing estimates of the impact of automatic stabilizers—and (2) a broad sample of advanced and emerging market economies. Results provide strong support for the view that fiscal stabilization operates mainly through automatic stabilizers. ...

                                                  Posted by on Wednesday, May 5, 2010 at 09:09 AM in Economics, Fiscal Policy, Social Insurance | Permalink  Comments (42) 


                                                  Fed Watch: Still Unbalanced

                                                  Tim Duy on the prospects for global rebalancing:

                                                  Still Unbalanced, by Tim Duy: The recent flow of data is interesting to say the least. While headline numbers are generally solid, the underlying story looks shaky. Shaky enough that disinflationary trends remain firmly entrenched in the US, whereas inflationary risks appear to be growing in emerging markets. The former suggests the Fed is set to remain on hold, while the latter will push foreign central banks to tighten. In a perfect world, that combination would put downward pressure on the Dollar and support a shift to a more balanced pattern of growth for both the world in general and the US in particular. Yet we persistently fall short of a perfect world. Will this time be any different? The Greek crisis is saying it won't.

                                                  Manufacturing remains a clear bright spot in the economic environment, a point reiterated by the most recent ISM survey. The headline 60.4 was the strongest since 2004, and the underlying details were solid. Employment continues to expand, providing at least a modicum of relief for the beleaguered labor market. The inventory drain became apparent, with more firms than not reporting stockpiles as too low. This suggests further room for manufacturing expansion. The proportion of firms reporting rising prices edged up again, not unexpected considering the complete lack of pricing power and drop in commodity prices at the low point of the recession. Note too that the strength in the ISM numbers is consistent with the solid manufacturing report, with a strong gain in new orders for nonair, nondefense capital goods.

                                                  Although the positive tenor to manufacturing is welcome, the first quarter read on GDP reveals a more uneven pattern of recovery, and more worrisome, a recovery that looks a little too dependent on US households. Consumer spending gained 3.6%, contributing 2.55 percentage points to the headline 3.2% gain. The sustainability of such spending, however, remains in doubt. Note that spending growth was heavily supported by falling savings rates, while income growth less transfer payment remains stagnant. This suggests that consumers are once again leveraging up the balance sheets while the deleveraging outside of housing was likely not as deep as initially believed, once bank loan write-offs are accounted for. In short, it looks like we have come full circle. The US economy is again excessively dependent on consumer spending, and that spending is fueled by anything but organic income growth.

                                                  The next largest contributor was inventories, which add 1.57 percentage points - clearly part and parcel of the manufacturing revival. Also supportive of that sector was the 13.4% gain in equipment and software category, down from the previous quarter. But a closer look reveals that category, a small part of overall spending, contributed only 0.83 percentage points to growth, and the bulk of that was information technology; industrial and transportation were basically flat. Residential and nonresidential structures were both a drag on growth, illustrating the ongoing weakness of both sectors - weakness that prevents a true V-shaped recovery. Growth, yes, and even sustainable growth. But growth that leaves the economy limping along, heavily dependent on policies to stimulate consumer spending.

                                                  With overall investment still falling short of fully supportive of recovery, attention turns to the export story. And, yes, export growth is supportive. The problem is the import drag swamped the export push, leaving the external sector a net negative for growth, sapping 0.61 percentage points from the headline number. This drag throws a wrench into hope that external growth will support the recovery or a rebalancing of global activity. We need to acknowledge the possibility (likelihood) that outsourcing during the past twenty years has left the US structurally dependent on trade deficits. Fueling consumer spending simply translates into a substantially offsetting import increase, thereby preventing the external sector from contributing to growth on net.

                                                  Presumably, what we need is policy supportive of a real rebalancing, in which the US consumer is comparatively subdued, keeping a lid on import growth, while the rest of the world is firing on most cylinders. And here is where exchange rate adjustment is important. Faster growth abroad should translate into higher foreign interest rates, which should in turn be Dollar negative. Part of that story is in play. From the Wall Street Journal:

                                                  Prices across Asia are rising faster than expected, highlighting the region's strong recovery compared with the West and raising the likelihood for tighter monetary policy.

                                                  South Korea and Indonesia reported higher-than-expected inflation Monday, coming a day after China raised banking reserve requirements in a bid to cool its economy. In a sign that inflation is becoming entrenched, core prices, which exclude volatile food and energy, are ticking up.

                                                  Meanwhile, the Fed last week reiterated its commitment to ultra-low rates, which should come as no surprise given the uneven and inventory cycle dependent nature of US growth so far - note that real final sales posted another anemic reading of 1.6% in the first quarter. There is simply not enough growth to rapidly alleviate stress in the labor market, thereby keeping disinflation in play. The March read on core-PCE inflation confirmed the downward trend:

                                                  FW050510

                                                  A declining Dollar is the signal to shift production to US shores and alleviate inflationary pressures abroad (while stimulating such pressure domestically), thereby limiting the need for foreign monetary policymakers to hit the brakes so fast that they stifle growth. There is no such thing as immaculate adjustment; a Dollar decline is critical to this process.

                                                  It should be a nice, textbook story. Alas, the US external adjustment is anything but textbook. The challenges I see to this adjustment:

                                                  1. Export supporting foreign policymakers. Foreign policymakers could attempt to simply shift demand away from internal sources and to the US by raising rates while accelerating reserve accumulation (and sterilizing the subsequent domestic money growth). Indeed, emerging Asian nations would be hesitant to hobble their exporting industries, more so if China does not first revalue the renminbi.

                                                  2. The Greek crisis. The Greek drama is obviously far from over; it is not clear that the threat of contagion is even significantly reduced, let alone eliminated. Nor would it be until all the PIIGS committed to a growth sapping fiscal stance, which the Greek public are finding hard to accept. That stance, while perhaps necessary, weighs against global growth and tends to strengthen the Dollar, slowing the rebalancing process. Moreover, I find it difficult if not impossible to believe that the impacted nations can adjust without a significant devaluation. Which suggests the Euro has further to fall. But it is reasonable to believe that, given the German weight in the Eurozone, any decline in the Euro would fall short of what is necessary for the PIIGS to fully adjust. Are we really down to just two choice then? Either Northern Europe commits to perpetual fiscal transfers to Southern Europe (not going to happen), or the Eurozone shrinks? Both suggest a weaker Euro, but the latter points to an outright collapse.

                                                  3. The size of the Dollar adjustment. Given the substantial fixed costs of offshoring, it is possible that very large adjustments in the Dollar are necessary to give a lift to importing competing industries in particular. Policymakers may not have the stomach for such an adjustment, resulting in a slow pace of Dollar decline that the support provided net growth is almost negligible.

                                                  4. The dependence of everyone on the US consumer. Any rebalancing requires the importance of the US consumer to decline from the current 71% of US GDP. Yet US officials welcome the consumer recovery, and would be hesitant to accept renewed consumer weakness without a clear offset (which they could provide via increase public investment, if they wanted to). And foreign officials, faced with a political class of exporters dependent on US consumers, would be hesitant to risk angering that constituency with a substantial adjustment (see point 1 above).

                                                  These are challenges, and are not meant to imply that adjustment cannot occur. Only that so far that recovery has seen precious little such adjustment, with net exports subtracting from growth two of the last three quarters. The combination of tepid US consumer growth, rapid foreign growth, and a steady although not disruptive decline in the Dollar - the combination of factors that present in 2006 and early 2007 - appears difficult to achieve and sustain. I fear it requires a much more substantial global commitment to rebalancing than we have seen to date. And that commitment will be sorely lacking given the Greek crisis. Where the American-led financial crisis forced global policymaker to pull together, the European crisis may push them back apart.

                                                    Posted by on Wednesday, May 5, 2010 at 01:08 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (56) 


                                                    Tuesday, May 04, 2010

                                                    links for 2010-05-04

                                                      Posted by on Tuesday, May 4, 2010 at 11:02 PM in Economics, Links | Permalink  Comments (13) 


                                                      Do Small Firms Account for Most Net Job Creation?

                                                      Is it true that small businesses account for most of the growth and cyclical variation in net job creation? Small firms are an important and stable component of job growth, but most of the cyclical variation comes from large, existing firms:

                                                      The young and the restless, by John Robertson, macroblog: I have been reading a lot lately about the role of small firms in the economy. Recommended resources in this regard include these Kauffman Foundation papers.

                                                      One of the themes emerging from this literature is that focusing just on firm size misses an important aspect of job creation and destruction in the U.S. economy—namely, the interaction between firm size and firm age. To illustrate this, the following chart is a dissection of the U.S. Bureau of Labor Statistics (BLS) quarterly Business Employment Dynamics (BED) data into private employer firms with fewer than 50 employees and those with at least 50 employees (note that the BED classifies businesses using a dynamic size measure in which the job creation/destruction is allocated to a size class dynamically as a business moves through a size class from prior quarter to the current quarter). Within each firm type it is possible to allocate net employment change accounted for by opening firms (firms that had zero employment in the previous quarter), closing firms (firms with zero employment this quarter), and the net job change at surviving firms (employment at firms that expanded over the quarter less employment at firms that downsized over the quarter).

                                                      050410
                                                      (enlarge)

                                                      This chart displays some striking features:

                                                      • The contribution of opening small firms to net job growth is very large (averaging about 1 million jobs a quarter). In fact, when opening firms are netted out of the data, existing firms on average destroy more jobs than they create.
                                                      • Job creation at new firms has been relatively stable over time. During the recessionary period from the end of 2007 through the second quarter of 2009, the decline in jobs created at opening firms was surprisingly small.
                                                      • Job losses at closing firms did not surge in the most recent recession. In fact, job destruction caused by closing firms is relatively stable over time (research suggests that, in addition to the fact that many firms get smaller before they finally close, there is a significant "up or out" phenomenon in that many firms that closed were recently opened firms that failed).
                                                      • Most of the cyclical action is at surviving firms, and larger surviving firms tend to account for most of the variation in net employment change. During the recessionary period from the end of 2007 through the second quarter of 2009, surviving firms with at least 50 employees lost about twice as many jobs as firms with fewer than 50 employees (see for example, the study by Moscarrini and Postel-Vinay on the relative cyclical sensitivity of large and small firms).

                                                      Of course, this is largely an accounting exercise. The challenge is trying to understand the causes for these features, and how they may change over time. It seems that there is much we don't know about the underlying factors. For instance, this paper by Dane Stangler and Paul Kedrosky investigates in considerable detail the possible explanations for why the number of new firms is so stable over time. In the end, the phenomenon remains largely a puzzle, and there are many subplots. For instance, the correlation between venture capital spending and overall firm creation is negligible but very important in high-tech industries. Also, the dramatic increase over time in the number of entrepreneurship courses offered at colleges and universities had no appreciable impact on the number of new firms in the United States (although it may have prevented a decline).

                                                      Perhaps the focus on the number of new firms is misguided. What really matters might be who these new firms are—not how many there are. Research by Dane Stangler suggests that, at any point in time, a relative handful of high-performing companies account for a large share of job creation and innovation. This conclusion suggests that a key to long-term economic growth may lie in ensuring that the economic environment is conducive to the ongoing creation of these types of high-growth performers.

                                                        Posted by on Tuesday, May 4, 2010 at 02:07 PM in Economics, Unemployment | Permalink  Comments (35) 


                                                        Why It's Essential That Universities Return To Teaching Economic History

                                                        Here's a post I did for a discussion of Simon Johnson and James Kwak's 13 Bankers. It reiterates many of the points I've made here:

                                                        13 Bankers: Why It's Essential That Universities Return To Teaching Economic History

                                                        I also talk about the too-big-to-fail problem.

                                                          Posted by on Tuesday, May 4, 2010 at 10:17 AM in Economics, Financial System | Permalink  Comments (19) 


                                                          The Rebirth of Regulation?

                                                          Robert Reich says its time for regulation to make a comeback:

                                                          The Rebirth of Regulation, by Robert Reich: What do oil giant BP, the mining company Massey Energy, and Goldman Sachs have in common? They’re all big firms involved in massive plunder. BP’s oil spill is already one of the biggest and most damaging in American history. Massey’s mine disaster, claiming the lives of 29 miners, is one of the worst in recent history. Goldman’s alleged fraud is but a part of the largest financial meltdown in 75 years. ...

                                                          Where were the regulators? Why didn’t the Department of Interior’s Minerals Management Service make sure offshore oil rigs have backup systems to prevent blowouts? One clue: You may remember MMS’s wild drinking parties exposed during the Bush era.

                                                          Where was the Mine Safety and Health Administration before the Upper Big Branch mine exploded? MSHA says it fined the company for a whole string of violations, but the law didn’t allow fines high enough to deter the company. Which raises the next question: Given Massey’s record, why didn’t the Bush-era MSHA seek to change the law and increase the penalties?

                                                          Why didn’t the Securities and Exchange Commission spot fraud on the Street when it was happening? Well, as we all now know, the Bush SEC was asleep at the wheel.

                                                          But don’t blame it all on George W. For thirty years, deregulation has been all the rage in Washington. Even where regulations exist, Congress has set such low penalties that disregarding the regulations and risking fines has been treated by firms as a cost of doing business. And for years, enforcement budgets have been slashed, with the result that there are rarely enough inspectors to do the job. The assumption has been markets know best, and when they don’t civil lawsuits and government prosecutions will deter wrongdoing.

                                                          Wrong. When shareholders demand the highest returns possible and executive pay is linked to stock performance, many companies will do whatever necessary to squeeze out added profits. And that will spell disaster – giant oil spills, terrible coal-mine disasters, and Wall Street meltdowns – unless the nation has tough regulations backed up by significant penalties, including jail terms for executives found guilty of recklessness, and vigilant enforcement.

                                                          After thirty years of deregulation, it’s time for the rebirth of regulation: Not heavy-handed and unncessarily costly regulation, but regulation that’s up to the task of protecting the public from companies and executives that will do almost anything to make a buck.

                                                          It's not at all clear that "the largest financial meltdown in 75 years" will result in new financial regulation that is more than window dressing designed to appease voters without actually curtailing financial sector activity. If, in the end, the regulatory change that is implemented does little to make us safer from future financial meltdowns even after such a large economic downturn, that's not a good sign for those who are hoping that the gulf oil spill will provide the motivation for new and substantial environmental regulation. But maybe financial regulation will turn out better than I expect.

                                                            Posted by on Tuesday, May 4, 2010 at 02:07 AM in Economics, Market Failure, Politics, Regulation | Permalink  Comments (23) 


                                                            Is the Personal Saving Rate Headed to Seven Percent?

                                                            Macroadvisors says the saving rate won't rise as much as some people are expecting:

                                                            The Saving Rate Does Not Have to Rise to 7% in the Near Term, Macroavisors: The argument that the personal saving rate is headed to 7% is based on a long-term relationship between the wealth-to-income ratio and the personal saving rate (pictured above) that is assumed to be stable over time. In fact, this long-term relationship shifts for reasons that are well understood. ...

                                                            Over the next 2 years, the relationship between the wealth-to-income ratio and the personal saving rate is expected to shift in such a way as to suggest only modest upward pressure on the personal saving rate — enough pressure to suggest an increase to about 3½% — but not nearly enough pressure to raise it to 7%.

                                                            Tim Kane of Growthology has a survey of 76 economics bloggers. In the survey that is about to be published, I asked about the saving rate after the economy recovers (74 responses):

                                                            In the post-recession economy, the savings rate will ...
                                                             
                                                            Answer Options Response Percent Response Count  
                                                             
                                                            be substantially higher than before the recession    12%     9  
                                                             
                                                            be somewhat higher than before the recession    66%    49  
                                                             
                                                            return to its pre-recession level    20%    15  
                                                             
                                                            be lower than before the recession     1%     1  

                                                            I was in the "somewhat higher" group. Update: here's a visual representation:

                                                            Saving-Kaufman

                                                              Posted by on Tuesday, May 4, 2010 at 12:24 AM in Economics, Saving | Permalink  Comments (14) 


                                                              Monday, May 03, 2010

                                                              links for 2010-05-03

                                                                Posted by on Monday, May 3, 2010 at 11:01 PM in Economics, Links | Permalink  Comments (49) 


                                                                "Outcast London"

                                                                Daniel Little on Outcast London:

                                                                Outcast London, by Daniel Little : A city is a complex social agglomeration, and all too often it represents a concentration of social ills that are very difficult to eradicate. Poverty, violence, and poor public health are three social problems that seem to be almost synonymous with "urban." We might ask two rather different sorts of questions about these facts. One is "Why so?", and the other is, "Under what circumstances not?"

                                                                The "why" question has a number of fairly obvious answers -- not all consistent with each other. A city is often a magnet for extremely poor people looking for better opportunities than those afforded in their current locations. A city is often segregated and stratified, with high barriers to exit; so poor people are concentrated in their cores. Extreme poverty reproduces extreme poverty, as businesses and other social activities exit the core.

                                                                The question, "what circumstances help a city to avoid these outcomes?" also has some obvious answers. Robust business growth promotes jobs at a range of skill levels, so unemployed unskilled people (usually poor) are able to find work and to climb the ladder of economic advancement. The presence of a well funded and robust social welfare net helps the poor population. A high degree of civic pluralism in the population facilitates easy movement across the neighborhoods and jobs of the city. And there are virtuous circles at work among these factors: more job growth enables more pluralism, and helps to fund more social welfare spending; which in turn stimulates more job growth.

                                                                As we contemplate these social processes in the contemporary U.S. city, it is instructive to think about an important historical example as well. In this context it is interesting to reread Gareth Stedman Jones' Outcast London: Study in the Relationship Between Classes in Victorian Society, a brilliant piece of social and urban history first published in 1971.

                                                                Stedman Jones frames his narrative around the shocking puzzle that London presented to the English nation in the first half of the nineteenth century. London was the cultural, financial, and political center of England, a world city with a privileged and affluent population. But at the same time it was the home to a large population of extremely poor people who fell under the general label of "casual labor." And, as Stedman Jones points out repeatedly, educated London had almost no conceptual framework within which to categorize the social reality of the slum.

                                                                In fact, there was a growing perception of "two Englands" and two races of English people -- the poor and the rest. As Stedman Jones makes clear, the political economists of the mid-nineteenth century devoted a good deal of their time to the effort to decipher this paradox of wealth and poverty.

                                                                Continue reading ""Outcast London"" »

                                                                  Posted by on Monday, May 3, 2010 at 04:50 PM in Economics, Unemployment | Permalink  Comments (9) 


                                                                  Are Tax Cuts Good or Bad?

                                                                  When Republicans complain about all the people who aren't paying federal income taxes, and they've been doing this a lot lately, I get confused. And that confusion extends beyond the obvious fact that almost everyone who is employed pays payroll and other taxes so the charge that they don't pay any taxes is misleading.

                                                                  I thought Republicans liked tax cuts, and the more the merrier. If taxes were zero on, say, capital gains or dividend payments, would they be whining and complaining? I don't think so. If inheritance taxes were cut to zero, would there be an uproar? We know there wouldn't be, Republicans want these taxes to be zero. But when income taxes on the poorest among us are zero -- and not all taxes, these workers pay plenty in payroll taxes, sales taxes, and the like, just federal income taxes -- they get quite upset.

                                                                    Posted by on Monday, May 3, 2010 at 03:42 PM in Economics, Politics, Taxes | Permalink  Comments (73) 


                                                                    FRBSF Economic Letter: Is the “Invisible Hand” Still Relevant?

                                                                    Steven LeRoy asks if "free markets", i.e. markets free of government intervention, generally perform better than markets where government intervenes:

                                                                    Is the “Invisible Hand” Still Relevant?, by Stephen LeRoy, FRBSF Economic Letter: The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.
                                                                    The single most important proposition in economic theory is that, by and large, competitive markets that are relatively, but generally not completely, free of government guidance do a better job allocating resources than occurs when governments play a dominant role. This proposition was first clearly formulated by Adam Smith in his classic Wealth of Nations. Except for some extreme supporters of free markets, today the preference for private markets is not an absolute. Almost everyone acknowledges that some functions, such as contract enforcement, cannot readily be delegated to market participants. The question is when and to what extent—not whether—private markets fail and therefore must be supplanted or regulated by government.
                                                                    The answer to that question is something of a moving target, with views of the public and policymakers tending to ebb and flow. In much of the latter part of the 20th century, support for Smith’s pro-private-market verdict gained favor, as reflected in the partial deregulation of financial and nonfinancial markets in the 1980s and subsequent decades. The financial and economic debacle of the past few years, however, has led many to revisit this question, particularly in Europe, but also in the United States and elsewhere. To many, financial markets in the last several years appeared dysfunctional to an extent that was never imagined possible earlier. Did Adam Smith get it wrong about private markets?
                                                                    This Economic Letter discusses two versions of the argument in favor of private markets: that of Adam Smith in the 18th century and that formulated in the 19th century by the Italian sociologist and economist Vilfredo Pareto. The discussion in this Letter points to the key assumptions in the arguments. Differing views on the degree of applicability of those assumptions underlie a good deal of the debate over the appropriate balance between relying on markets versus government intervention. Also important are views on the effectiveness of government involvement.
                                                                    Competitive markets work: Adam Smith
                                                                    In 17th and 18th century England prior to Smith it was taken for granted that economic and political leadership came from the king, not from private citizens. If the king wanted to initiate some large economic project, such as expanding trade with the colonies, he would encourage formation of a company to conduct that project, such as the East India Company. The king would grant that company a monopoly, usually in exchange for payment. Smith thought that these monopoly grants were a bad idea, and that instead private companies should be free to compete. He called on the king to discharge himself from a duty “in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it toward the employments most suitable to the interests of the society.” (Smith 1776 Book IV, Chapter 9)
                                                                    Thus, Smith’s conclusion was that private markets worked better if they were free from government supervision, and for him it was just about that simple. Smith’s idea received its biggest challenge when the Soviet Union achieved world power status following World War II. In the 1960s, reported gross national product grew at much higher rates in the Soviet Union than in the United States or western Europe. Such authorities as the Central Intelligence Agency estimated that, before long, Soviet gross national product per capita would exceed that in the United States. To many, it looked as though centrally planned economies could achieve higher growth rates than market economies.
                                                                    Economists who saw themselves as followers of Smith took issue. To them, it was simply not possible for centrally planned economies to achieve higher standards of living than market economies. As Smith put it, government could not be expected successfully to superintend the industry of private people. Too much information was required, and it was too difficult to structure the incentives. G. Warren Nutter, an economist at the University of Virginia, conducted a detailed study of the Soviet economy, arguing that the CIA’s estimates of Soviet output were much too high (Nutter 1962). At the time, those findings were not taken seriously. But, by the 1980s, we knew that Nutter had been correct. If anything, the Soviet Union was falling further and further behind. By 1990, this process came to its logical conclusion: the Soviet empire disintegrated. Score a point for Adam Smith.
                                                                    Competitive markets work: Vilfredo Pareto
                                                                    By the 19th century, economists had largely abandoned the informal and literary style of Smith in favor of the more precise—if less engaging—style of today’s economics. Increasingly, economists came to appreciate the role of formal mathematical model-building in enforcing logical consistency and clarity of exposition, although that development did not get into high gear until the 20th century. Under the leadership of Pareto and others, Adam Smith’s argument in favor of private competitive markets underwent a major reformulation.
                                                                    Pareto’s version of the argument is usually taken to be a refinement of Smith’s. But, for the present purpose, it’s best to emphasize the differences rather than the similarities. First, Pareto provided a more precise definition than Smith of efficient resource allocation. An allocation is “Pareto efficient” if it is impossible to reallocate goods to make everyone better off. Or, to put it another way, you cannot make someone better off without making someone else worse off. This idea captures part of what we usually mean by “good performance,” but not all of it. For example, attaining a reasonably equal income distribution is often taken to be part of what we mean by good performance, but an equal income distribution is not an implication of Pareto efficiency. Indeed, public policies designed to reduce the degree of income inequality can involve redistribution of income, making some better off and others worse off. (See Yellen 2006 for a discussion of income inequality.)
                                                                    Pareto reached the remarkable conclusion that competitive markets generate Pareto-efficient allocations. In competitive markets, prices measure scarcity and desirability, so the profit motive leads market participants to make efficient use of productive resources. The English economist F.Y. Edgeworth made a similar argument at about the same time as Pareto. Economists Kenneth Arrow and Gérard Debreu presented precise formulations of the Pareto-Edgeworth result in the 1950s and 1960s.
                                                                    A mathematical proof that competitive allocations are Pareto efficient required a characterization of a competitive economy that is more precise than anything Smith had provided. For Pareto, unlike Smith, it was not enough that the economy be free of government intervention. The essential characteristic for Pareto was that a buyer’s payment and a seller’s receipts from any transaction be in strict proportion to the quantity transacted. In other words, individuals cannot affect prices. This assumption is satisfied, to a close approximation, by the classical competitive markets, such as those for corn, wheat, and other agricultural commodities. The assumption rules out monopoly and monopsony, in which individual sellers and buyers are large enough to be able to manipulate prices by altering quantities supplied or demanded. When monopolists and monopsonists can distort prices in this way, allocations will not be Pareto efficient.
                                                                    Pareto’s efficiency result was first formulated in mathematical models of economies that were static and deterministic—that is, models in which time and uncertainty were not explicitly represented. In the 20th century, economists realized that the validity of the Pareto-efficiency result does not depend on these extreme restrictions. Arrow and Debreu showed that allocations will be Pareto efficient even in economies in which time and uncertainty are explicitly represented. They showed that, in any economy, there is an irreducible minimum level of risk that somebody has to bear. In a competitive economy with well-functioning financial markets, this risk will be borne by those who are most risk tolerant and who therefore require the least compensation in terms of higher expected return for bearing the risk. This is exactly as one would expect—risk-tolerant participants use financial markets to insure the risk averse. These aspects of equilibrium are discussed in standard texts on financial economics (such as LeRoy and Werner 2001).
                                                                    However, demonstrating these results mathematically depends on assuming symmetric information—that is, assuming that everyone has unrestricted access to the same information. Such an assumption is less unrealistic than excluding uncertainty altogether, but it is still a strong restriction. The advent of game theory in recent decades has made it possible to relax the unattractive assumption of symmetric information. But Pareto efficiency often does not survive in settings that allow for asymmetric information. Based on mathematical economic theory, then, it appears that the argument that private markets produce good economic outcomes is open to serious question.
                                                                    Nonmathematical economists such as Friedrich Hayek proposed an argument for the superiority of market systems that did not depend on Pareto efficiency. In fact, Hayek’s argument was the exact opposite of that of Arrow and Debreu. For him, it was the existence of asymmetric information that provided the strongest rationale in favor of market-based economic systems. Hayek emphasized that prices incorporate valuable information about desirability and scarcity, and the profit motive induces producers and consumers to respond to this information by economizing on expensive goods. He expressed the view that economies in which prices are not used to communicate information—planned economies, such as that of the Soviet Union—could not possibly induce suppliers to produce efficiently. This is essentially the same as the argument against socialism discussed above.
                                                                    Reevaluating the balance between markets and the government
                                                                    The financial crisis that we have just experienced puts the question about the appropriate balance between reliance on markets and government intervention on center stage. Those who believe that unregulated markets generally work well express the view that misconceived interference by the government was the major cause of the crisis. In contrast, those who take a more critical view about the functioning of private markets believe that the crisis stemmed mainly from the destructive consequences of factors such as information asymmetries in financial markets and distortions to incentives that encouraged excessive risk-taking. The problem was not government involvement per se, but rather government’s failure to place checks on destructive market practices.
                                                                    This latter view dominates most of the recent proposals for financial reform. And, while the particulars of financial reform are still to be determined, it appears that current sentiment is less supportive of Adam Smith’s verdict on the efficiency of markets than was the case prior to the financial crisis. At the same time, it seems clear that neither extreme view of the causes of the financial crisis is accurate. Reforms based only on one of these views to the exclusion of the other will not lead to a set of changes that will guarantee improvement of the performance of financial markets and prevent recurrence of financial crisis. The problems are complex, and sweeping changes in the regulatory structure could do more harm than good. A better strategy may be to identify specific problems in the financial system and introduce regulatory changes that address these clearly defined weaknesses, such as executive compensation practices that encourage excessive risk-taking.

                                                                    In response, I'll point, once again, to Markets Are Not Magic which makes the point that for all of the nice properties identified by Pareto and others to hold, having markets that are free of government intervention is not enough. To obtain optimality, markets must be competitive, and a competitive marketplace requires some fairly restrictive assumptions to hold, assumptions that, in many cases, can only be satisfied with government intervention.

                                                                    When it comes to government intervention, the one thing I wish people would understand is the difference between free markets and competitive markets. Markets that are free of government oversight are also free to exploit consumers in a variety of ways, from fraud to higher than necessary prices. Markets that are free, but not competitive, do not necessarily result in the best possible outcome.

                                                                    When problems do exist, we should still ask if government intervention will actually help, but I believe we have been far too cautious in intervening to solve market failures. For example, as I've discussed many times, obvious market failures exist at almost every stage of mortgage markets, from the real estate agent, appraisers, and loan originators all the way through the securitization process. Somehow, we were led to believe that these failures that were so profitable to those able to exploit them would fix themselves. But they don't, and didn't, and the belief that they would caused us to stand by and do nothing as these markets departed further and further from the competitive ideal.

                                                                    Hopefully we've learned something about the need for government oversight and intervention to correct problems, but it's not yet clear that we have. In coming months, we will see an attempt by market fundamentalists to tell a story about the economy recovering on its own despite government intervention. We'll hear all about the miraculous self-healing properties of the economy, and we will be told that it would have been even more miraculous if the government would have stayed out of the way.

                                                                    When they try to sell you this story, remember that these are many of the same people who went to the government, hat in hand, begging for the government to give them the help they needed to save their too big to fail bank (OK, maybe the hats weren't in hand, maybe they demanded a bailout with the economy held hostage, but the point is that they wanted and needed the bailout). Their arguments are self-serving, just as Adam Smith said they'd be, and your interests are not the primary concern of the people trying to resist stricter government regulation and oversight of the financial industry. You'd be well advised not to buy the market fundamentalism they'll be selling.

                                                                      Posted by on Monday, May 3, 2010 at 11:34 AM in Economics, Market Failure | Permalink  Comments (44) 


                                                                      "Obama Tax Increase Misperception Grows"

                                                                      Brendan Nyhan provides evidence of false beliefs about taxes:

                                                                      Obama tax increase misperception grows, by Brendan Nyhan: Earlier this year, I noted a CBSNews.com post showing that 24% of Americans thought President Obama had raised taxes for most Americans and 53% believed taxes had been kept the same. The numbers, which were drawn from a CBS/New York Times poll conducted February 5-10, were even worse among Tea Party supporters -- 44% thought taxes had been increased and 46% thought taxes were the same. In reality, Obama cut taxes for 95% of working families.

                                                                      The latest CBS/New York Times poll, which was conducted April 5-12, asks the same question:

                                                                      So far, do you think the Obama Administration has increased taxes for most Americans, decreased taxes for most Americans, or have they kept taxes about the same for most Americans?

                                                                      The findings show that misperceptions about changes to taxes under Obama have gotten worse. The percentage of respondents who think taxes have gone up under Obama has increased from 24% to 34% among the general public and from 44% to 64% among Tea Party supporters:

                                                                      It's the all-too-predictable result of combining misleading rhetoric suggesting Obama has raised taxes with people's biases toward their pre-existing beliefs.

                                                                      This is partly the administration's own doing. There is a theory that says people will spend more of their tax cuts if they are unaware that they have happened, so the administration decided not to publicize the tax cut portion of the stimulus bill.

                                                                      This was successful in that people were (and are) generally unaware that 40% of the stimulus package came as tax cuts. And some of this money was spent and that helped to stimulate aggregate demand. But it was politically unsuccessful for two reasons. First, as documented above, many people believe taxes have increased when, in fact, they have decreased for most taxpayers. Second, the administration has not been able to take credit for the stimulus that resulted from the tax cuts (and the criticism over the government spending portion of the stimulus package generally fails to recognize the large component of the package due to tax cuts).

                                                                      My view is that the attempt to hide the tax cut from consumers wasn't needed. This was a balance sheet recession -- consumers took huge hits to the value of their houses and retirement savings -- and consumers aren't going to go back to their usual consumption habits until the balance sheets are repaired. The faster that balance sheets are repaired, and tax cuts can help with that, the faster that consumers will return to normal levels of consumption. That means saving is needed, not consumption, and attempts to hide tax cuts from consumers and fool them into doing the opposite, consuming rather than saving. That would not be their first choice if they were fully informed.

                                                                      I think it would have been better to use tax cuts to help households repair their balance sheets as quickly as possible so that, once that was done, they could go back to more normal levels of consumption. That is, use tax cuts to allow balance sheet rebuilding (including paying credit bills), and use other means such as government spending to stimulate aggregate demand. Note, however, that if the tax cut portion is going to be saved rather than consumed, then the other part of the stimulus package, i.e. the government spending portion, must be correspondingly larger (which, unfortunately, it didn't happen).

                                                                      Paul Krugman has a different view:

                                                                      The Augustine Economy, by Paul Krugman: The good news from the consumer spending release is that consumers are, in fact, spending. The bad news is that they’re not saving: personal savings are now back down to 2.7 percent of income.

                                                                      This can’t go on; American households have to bring their debt levels down. And yet …

                                                                      We’re still in a liquidity trap, with Fed policy constrained by the zero lower bound. And a liquidity trap world is a paradox-of-thrift world, in which the virtuous individual decision to save more is a vice from the point of view of the economy as a whole. For now, it’s actually a good thing that consumers are behaving irresponsibly.

                                                                      So my wish is that we be made chaste, continent, and thrifty — but not yet.

                                                                      Again, my preference is different. Let consumers bring debt levels down and do the balance sheet rebuilding they need to do, and use government spending (or tax cuts of a different kind, say, business investment tax cuts) to provide the stimulus to aggregate demand (though the latest consumer spending release does suggest that consumers will return to higher levels of consumption before their balance sheet problems are completely repaired).

                                                                      There are different types of recessions, and this one hit balance sheets hard. Another type of recession, one where household balance sheets aren't destroyed to the extent they were in the present case, would call for a different policy, one that induced consumers to spend rather than save. But in this case, I think we have to use policy to both stimulate the economy and to repair the damage to balance sheets, and that requires a two-pronged strategy.

                                                                        Posted by on Monday, May 3, 2010 at 09:45 AM in Economics, Taxes | Permalink  Comments (52) 


                                                                        Paul Krugman: Drilling, Disaster, Denial

                                                                        Will the photogenic oil spill in the gulf revive environmentalism?:

                                                                        Drilling, Disaster, Denial, by Paul Krugman, Commentary, NY Times: It took futuristic technology to achieve one of the worst ecological disasters on record. Without such technology, after all, BP couldn’t have drilled the Deepwater Horizon well in the first place. Yet for those who remember their environmental history, the catastrophe in the gulf has a strangely old-fashioned feel, reminiscent of the events that led to the first Earth Day, four decades ago.
                                                                        And maybe, just maybe, the disaster will help reverse environmentalism’s long political slide — a slide largely caused by our very success in alleviating highly visible pollution. ...
                                                                        Environmentalism began as a response to pollution that everyone could see. The spill in the gulf recalls the 1969 blowout that coated the beaches of Santa Barbara in oil. But 1969 was also the year the Cuyahoga River ... caught fire. Meanwhile, Lake Erie was widely declared “dead,” its waters contaminated by algal blooms. And major U.S. cities ... were often cloaked in thick, acrid smog.
                                                                        It wasn’t that hard, under the circumstances, to mobilize political support for action. The Environmental Protection Agency was founded, the Clean Water Act was enacted, and America began making headway against its most visible environmental problems. Air quality improved... Rivers stopped burning, and some became swimmable again. And Lake Erie has come back to life, in part thanks to a ban on laundry detergents containing phosphates.
                                                                        Yet there was a downside to this success..., as visible pollution has diminished, so has public concern over environmental issues. ... This decline in concern would be fine if visible pollution were all that mattered — but it isn’t..., greenhouse gases pose a greater threat than smog or burning rivers ever did. But it’s hard to get the public focused on ... pollution that’s invisible, and whose effects unfold over decades rather than days.
                                                                        Nor was a loss of public interest the only negative consequence of the decline in visible pollution. As the photogenic crises of the 1960s and 1970s faded from memory, conservatives began pushing back against environmental regulation.
                                                                        Much of the pushback took the form of demands that environmental restrictions be weakened. But there was also an attempt to construct a narrative in which advocates of strong environmental protection were either extremists — “eco-Nazis,” according to Rush Limbaugh — or effete liberal snobs trying to impose their aesthetic preferences on ordinary Americans. ...
                                                                        And let’s admit it: by and large, the anti-environmentalists have been winning the argument... Then came the gulf disaster. Suddenly, environmental destruction was photogenic again. ... For the gulf blowout is a pointed reminder that the environment won’t take care of itself, that unless carefully watched and regulated, modern technology ... can all too easily inflict horrific damage on the planet.
                                                                        Will America take heed? It depends a lot on leadership. In particular, President Obama needs to seize the moment; he needs to take on the “Drill, baby, drill” crowd, telling America that courting irreversible environmental disaster for ... a few barrels of oil, an amount that will hardly affect our dependence on imports, is a terrible bargain.
                                                                        It’s true that Mr. Obama isn’t as well positioned to make this a teachable moment as he should be: just a month ago he announced a plan to open much of the Atlantic coast to oil exploration, a move that shocked ... supporters and makes it hard for him to claim the moral high ground now.
                                                                        But he needs to get beyond that. The catastrophe in the gulf offers an opportunity, a chance to recapture some of the spirit of the original Earth Day. And if that happens, some good may yet come of this ecological nightmare.

                                                                          Posted by on Monday, May 3, 2010 at 01:08 AM in Economics, Environment | Permalink  Comments (110) 


                                                                          Sunday, May 02, 2010

                                                                          links for 2010-05-02

                                                                            Posted by on Sunday, May 2, 2010 at 11:01 PM in Economics, Links | Permalink  Comments (27) 


                                                                            "The 'Real' Causes of China’s Trade Surplus"

                                                                            Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti argue, based upon their forthcoming AER article, that although China has accumulated nearly two and a half trillion in reserves in the last two decades, "it is wrong, and even dangerous, to blame this on a manipulation of the exchange rate." They argue that the existence of credit market imperfections leading to the need for high levels of internal savings provides a better explanation:

                                                                            The “real” causes of China’s trade surplus, by Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti, Vox EU: Over the last two decades, China has run large trade surpluses. Its foreign reserves swelled from $21 billion in 1992 (5% of its annual GDP) to $2.4 trillion in June 2009 (close to 50% of its GDP). The effect of this gigantic build up of reserves has been a source of growing public attention in the context of the debate on global imbalances. This debate has gained momentum during the global crisis. Lobbyists and politicians voice the popular concern that by swamping western markets with its products, China contributes to the failure of domestic firms and job losses. The call for protectionism is mounting.

                                                                            Did China engineer a trade surplus?

                                                                            A common argument, especially in the US, is that the culprit of global imbalances is the exchange rate manipulation carried out by the Chinese authorities, who peg the renminbi to the dollar at a low value. According to Fred Bergsten, head of the Peterson Institute for International Economics, the renminbi is undervalued by at least 25% to 40%. This "hostile" policy raises calls for robust retaliation.

                                                                            While economists have so far opposed any measure that might ignite a vicious cycle of trade retaliations and protectionism, even their front is cracking. Krugman (2010) advocated using the threat of a 25% import surcharge to force China to revalue. Last month, 130 lawmakers signed a letter asking the US Treasury to increase tariffs on Chinese-made imports. On 12 April 2010, Barack Obama openly criticized the Chinese exchange-rate policy in front of Hu Jintao, arguing that currencies should "roughly" track the market so that no country has an advantage in trade. Meanwhile, Senator Charles Schumer called for high tariffs against Chinese imports in order to force Beijing to revalue its currency.

                                                                            The exchange rate manipulation premise

                                                                            The manipulation thesis rests on the simple postulate that the imbalance itself is evidence of a misalignment of the exchange rate. Letting market forces determine the exchange rate would restore trade balance.

                                                                            This argument has weak foundations. What matters is the real exchange rate, not the nominal one. While the Chinese surplus has persisted for almost two decades, the real exchange rate has remained as flat as a pancake (see McKinnon 2006, Figure 3). A misaligned real exchange rate should feed domestic inflation, e.g., by increasing the demand of non-traded goods and stimulating domestic wage pressure. Yet, until very recently it does not appear as if China has experienced any major inflationary pressure – between 1997 and 2007 the inflation rate was on average about the same as in the US. Moreover, wages have grown slower than output per worker (see Banister 2007).

                                                                            In a recent article on this site, Helmut Reisen (2010) shows that a large part of the alleged undervaluation of the renminbi can be attributed to the Balassa-Samuelson effect (i.e., the fact that non-traded goods do not follow the law of one price and are relatively cheap in developing countries). He concludes that "the undervaluation in 2008 of the renminbi was only 12% against the regression-fitted value for China's income level." This is by no means a large number: “Both India and South Africa (which had a current-account deficit) were more undervalued in 2008.” In summary, while it is reasonable to expect some appreciation of the real exchange rate in the years to come (through either inflation or adjustments in the nominal exchange rate), the government manipulation of the nominal exchange rate is unlikely to be the primary cause of the two-decades-long imbalance.

                                                                            A “real” explanation: Growing like China

                                                                            What, then, can account for the Chinese surplus? We believe that the answer lies in real (i.e., structural) factors rather than in nominal rigidities. Let us look at the imbalance from an asset flow perspective: 

                                                                            Continue reading ""The 'Real' Causes of China’s Trade Surplus"" »

                                                                              Posted by on Sunday, May 2, 2010 at 01:32 PM in China, Economics, International Finance, Market Failure | Permalink  Comments (34) 


                                                                              "Reputational Capital and Incentives in Organizations"

                                                                              Rajiv Sethi notes that if "the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong."  Rajiv argues there are two ways to get employees to avoid pursuing strategies that are profitable for the individual, but may put the firm's reputation at risk. One is to create the proper financial incentives, and the other is to "hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so." He goes on to argue that the first solution, the use of financial incentives, is infeasible. Thus, firm's ought to hire people "who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character."

                                                                              But how do we find such irrational individuals? After all, putting the interests of the firm ahead of your own interests sounds like a departure from the rational self-interest seeking behavior assumed in economic models. In fact, it sounds anti-capitalist to assume that individuals will work for the common good first and foremost rather than for what's best individually. Rajiv argues that this type of behavior may not be irrational after all. The absence of self-interested behavior can result in payoffs that are larger than when individuals maximize individual gains, and hence such behavioral traits -- the traits necessary for allegiance to what's best for the group even if it comes at the expense of individual incentives -- is rational:

                                                                              Reputational Capital and Incentives in Organizations, by Rajiv Sethi: The following passage, jarring in light of recent revelations, appears in the opening pages of Akerlof and Kranton's recently published book on Identity Economics:

                                                                              On Wall Street, reputedly, the name of the game is making money. Charles Ellis' history of Goldman Sachs shows that, paradoxically, the partnership's success comes from subordinating that goal, at least in the short run. Rather, the company's financial success has stemmed from an ideal remarkably like that of the U.S. Air Force: "Service before Self." Employees believe, above all, that they are to serve the firm. As a managing director recently told us: "At Goldman we run to the fire." Goldman Sachs' Business Principles, fourteen of them, were composed in the 1970s by the firm's co-chairman, John Whitehead, who feared that the firm might lose its core values as it grew. The first Principle is "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow." The principles also mandate dedication to teamwork, innovation, and strict adherence to rules and standards. The final principle is "Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards in everything they do, both in their work for the firm and in their personal lives."

                                                                              If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong. Consider, for example, Chris Nicholson's report on the manner in which the bank managed to shed its holdings of mortgage backed securities shortly before they collapsed in value, allegedly serving itself "at the expense of its clients." ...

                                                                              This is a form of tail risk that is not unlike that taken by the folks at the AIG financial products division when they sold vast amounts of credit protection in the mistaken belief that they would never be faced with significant collateral calls. ... As in the case of tail risks arising from the sale of credit protection, damage to the firm's franchise value does not appear in standard compensation benchmarks. The problem in Goldman's case was not that such damage was "a hit worth taking" but rather that the incentives faced by its employees did not adequately reflect the value of the firm's reputation in the first place. To the extent that employee behavior is responsive to such incentives, the sacrifice of reputation for immediate profit will be made regardless of whether or not, in the broader scheme of things, the damage to franchise value exceeds the short term gains.

                                                                              How, then, might a firm accomplish the subordination of short term goals to long term objectives in practice? There are two possibilities: one could hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so, or one could design compensation schemes that adequately reward actions that preserve or enhance reputation. Economists, being fervent believers in the power of incentives, usually tend to favor the latter approach. But in this particular context, there are two possible problems with this. First, the contribution of any given transaction to the reputation of the firm is generally much more difficult to ascertain and quantify than any contribution to the firm's balance sheet. This makes it difficult to assign reward appropriately. Second, in order to serve as credible commitments to clients and customers, compensation schemes must be easily observable and not subject to renegotiation after the fact. This is seldom the case.

                                                                              The alternative is to hire individuals who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character. But would this not create incentives for potential employees to simply misrepresent their values? As Groucho Marx famously said: "The secret of life is honesty and fair dealing... if you can fake that, you've got it made." 

                                                                              Fortunately, the consistent misrepresentation of personality traits is often infeasible or prohibitively costly. There is an interesting line of research in economics, dating back to Schelling and continuing through Hirshleifer and Frank, that explores the commitment value of traits that are costly to fake. Hirshleifer went so far as to argue that the "absence of self-interest can pay off even measured in terms of material selfish gain, and... the loss of control that makes calculated behavior impossible can be more profitable than calculated optimization... we ought not to prejudge the question as to whether the observed limitations upon the human ability to pursue self-interested rationality are really no more than imperfections -- might not these seeming disabilities actually be functional?" 

                                                                              One could take this a step further: not only might limitations on the unbridled pursuit of material self-interest be functional for individuals, they may also be functional for the organizations to which they belong. And in the long run, firms that manage to identify and promote such individuals will prosper at the expense of those who are unable or unwilling to do so.

                                                                              Update: More on business reputation from Richard Green:

                                                                              What Milton Friedman got wrong, by Richard Green: Friedman had two fundamental problems with business regulation. His first is that the business would capture the regulator, and therefore use regulation to establish monopoly power. My field leads me to find this line of argument compelling: real estate developers love (regulatory) barriers to entry that keep competitors from building.

                                                                              His second, though, is just wrong. He argues that in order to preserve their reputations, businesses will self-regulate. Among other things, this ignores that managers often have short-term horizons. It also ignores that when large businesses implode, they leave victims with whom they never engaged in a transaction in their wake. BP did nothing illegal--how's that reputation thing working out? And having now read a whole lot on Goldman-Abacus (including the SEC complaint, the response on GS's web site, the offering circular, and excellent commentary from James Surowiecki, Yves Smith and others), it is not clear to me that Goldman did anything illegal or actionable (but I could be persuaded to change my mind). It is just that what it did (including investing long in CDS) should be unambiguously illegal and actionable. I can't think of anyone who had a bigger reputation franchise than Goldman.

                                                                              As Rajiv notes, "If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong."

                                                                                Posted by on Sunday, May 2, 2010 at 11:52 AM in Economics, Methodology | Permalink  Comments (49) 


                                                                                "Consumer Credit: More than Meets the Eye"

                                                                                This analysis of consumer credit from Michael Hammill, an economic policy specialist in the Atlanta Fed's research department, makes two important points. First, the biggest source of the recent decline in consumer credit has occurred for lending involving finance companies and securitized assets. Credit from commercial banks has remained relatively steady. Second, once "charge-offs" are considered, consumer loan growth is positive. This is in contrast to the negative growth in the as-reported series.

                                                                                The bottom line is that although it is true that banks have tightened some -- it's harder to get a loan now than before -- the focus of policy of stimulate consumer credit ought to be directed at finance companies and securitized assets. But it's also worth asking whether we want consumers to go back to their old credit habits. I would prefer polices that increase business lending (i.e. investment) to compensate for declines in consumer credit rather than trying to revive the free-wheeling credit ways that households have displayed in the recent past:

                                                                                Consumer credit: More than meets the eye, by Michael Hammill, macroblog: A lot has been made (here, for a recent example) of the idea that banks have shown a surprising amount of reluctance to extend credit and to start making loans again. Indeed, the Fed's consumer credit report, which shows the aggregate amount of credit extended to individuals (excluding loans secured by real estate), has been on a steady downward trend since the fall of 2008.

                                                                                Importantly, that report also provides a breakdown that shows how much credit the different types of institutions hold on their books. Commercial banks, which are the single largest category, accounted for about a third of the total stock in consumer credit in 2009. The two other largest categories—finance companies and securitized assets—accounted for a combined 45 percent. While commercial banks have been the biggest source of credit, they have not been the biggest direct source of the decline.

                                                                                042910a
                                                                                (enlarge)

                                                                                The chart above highlights a somewhat divergent pattern among the big three credit holders. This pattern mainly indicates that credit from finance companies and securitized assets has been on a relatively steady decline since the fall of 2008 while credit from commercial banks has shown more of a leveling off. These details highlight a potential misconception that commercial banks are the primary driver behind the recent reduction in credit going to consumers (however, lending surveys certainly indicate that standards for credit have tightened).

                                                                                Continue reading ""Consumer Credit: More than Meets the Eye"" »

                                                                                  Posted by on Sunday, May 2, 2010 at 10:17 AM in Economics, Financial System | Permalink  Comments (15) 


                                                                                  Saturday, May 01, 2010

                                                                                  links for 2010-05-01

                                                                                    Posted by on Saturday, May 1, 2010 at 11:04 PM in Economics, Links | Permalink  Comments (62) 


                                                                                    "Flying Blind in Policy Reforms"

                                                                                    Jeff Sachs says "our political system regularly puts around the table people who are not the best equipped to find deep solutions to our problems." He wants outside experts to have more influence in the formulation and execution of major policy changes:

                                                                                    Flying Blind in Policy Reforms, by Jeffrey D. Sachs, Commentary, Scientific American: The long and divisive fight over U.S. health care reform exposed basic weaknesses in the processes of governance. As is so often true in American politics these days, politicians and lobbyists kept complex subjects to themselves, pushing expert discussion and systematic public debate to the sidelines. ...
                                                                                    During 14 months of debate over health care, the administration did not put forward a clear, analytical policy white paper on the aims, methods and expected results of the proposed reforms. ... The actual health consequences of the legislation were never reviewed or debated coherently. ...
                                                                                    One might think that the real action had all happened earlier, in congressional hearings, in brainstorming sessions and in the bargaining sessions with key stakeholders. Yet the earlier process was relentlessly driven by political and lobbying calculations and without the informed participation of the American people, who were left to vent at Tea Parties and on blog sites. The mammoth legislation is impenetrable... Experts were never invited systematically to comment or debate about it so as to help the public and politicians understand the issues. The lack of clear policy documents from the administration meant that the public had little basis for reaction other than gut instincts and fearful sentiments fanned by talk-show hosts.
                                                                                    In general, our political system regularly puts around the table people who are not the best equipped to find deep solutions to our problems. Certainly it has also done so on climate change... As with health care, the outcome has been House and Senate draft legislation that lacks public support. The same has been true on Afghanistan: the “war cabinet” has lacked real expertise on that country’s culture, economy and development challenges, and the U.S. public has remained uninformed of true options.
                                                                                    As a start toward better policy making, the administration should put forward a detailed analysis justifying each major proposed policy change. That white paper could form the basis for coherent public debate and reflection, along with Web sites where outside experts would be invited to share opinions accessible to the public. The public, too, would be invited to blog about that position paper. ... The administration and Congress would rely more heavily on external advisory panels to tap into the nation’s wealth of expertise...

                                                                                    I would not presume or recommend that decisions be left to the purported experts, who often represent special interests or have their own biases or narrow views. Still, a systematic vetting of policy options, with recognized experts and the public commenting and debating, will vastly improve on our current policy performance, in which we often fly blind or hand the controls over to narrow interests and viewpoints.

                                                                                    The problem I see, at least in economics, is not so much the absence of experts weighing in on issues. Instead, it's the inability of the press, and hence the public more generally, to distinguish between expert and non-expert opinion. All too often the two are given a false equivalence in a "he said, she said" journalistic construction that obscures and confuses people about the issue. This can even do more harm than good in terms of informing the public.

                                                                                      Posted by on Saturday, May 1, 2010 at 02:16 PM in Economics, Policy | Permalink  Comments (30) 


                                                                                      "The Economic Rewards of Virtue"

                                                                                      Maxine Udall continues the discussion of the usefulness of the utility maximization assumption used in economics:

                                                                                      The Economic Rewards of Virtue, by Maxine Udall: Foreword: This is a response to Nick Kraftt at Open Economics, where he follows up on his blog in which he "attacks" U Max or "old fashioned economics" by Parsing the Comments that resulted. For non-economists reading this, what follows is my attempt to draw a distinction between utility maximization, which is what economists have tended to assume best describes consumer behavior, and preference maximization, which is more likely to be what consumers are actually doing when markets fail, information is faulty, prices are distorted away from marginal social cost, or uncertainty (i.e., risk) cannot be or is not managed efficiently. We have tended to use the two terms as synonymous. I think the distinction is important. If preferences do not map accurately to something that can objectively be called utility, there is no guarantee that market allocations are efficient in any meaningful sense of that term. (Obey, if you're out there, this one's for you. :-))

                                                                                      Uncertainty, norms, institutions all matter and will shape consumer  preferences (more about this later). The real issue IMHO is whether or not individual preferences map accurately to something that could plausibly and objectively be regarded as individual utility. It’s JS Mill’s “better to be a human dissatisfied than a pig satisfied” problem. Mill implies that there is some objective state of the world that corresponds or “should” correspond to human happiness. Were we rational, it is the state of the world we would prefer to that characterized by satisfaction of irrational, short-term pleasures.

                                                                                      We economists have tended to ignore the normative aspect and assume that if someone is a “pig satisfied,” his/her preferences correspond to the highest utility that person can or would want to attain subject to the constraints of their income and prevailing prices (even if there is another feasible to attain (with a little rearranging of resources) state of the world in which the person could have health insurance, retirement security, and better nutrition). We also assume that in forming those preferences, the individual is 1) rational (defined rather narrowly as having preferences that don’t change or switch around at least in the short run and that are characterized by more always and everywhere being preferred to less); 2) self-interested (maximizing his/her own idea of what is best for him/her); and 3) fully-informed (s/he knows everything (and I mean everything) about the good and bad effects of consuming some good, the side effects to others of consuming or producing the good, and the future states of the world that will result from consuming or producing the good. And, finally, the prices s/he faces are assumed to reflect the marginal social cost of the goods and services s/he purchases. If any of these assumptions do not hold, then the consumer’s preferences most likely do not map directly and accurately to a state that could be characterized by JS Mill as a “human satisfied”, i.e., a state in which individual utility by some objective standard is being maximized.

                                                                                      When the assumptions do not hold, the consumer is a preference maximizer, not a utility maximizer. The effect will be to distort demand for things that maximize (uninformed, possibly irrational, maybe even bad in the long run) preferences (e.g., granite counter tops and large homes with en suite baths purchased with no money down and pick-your-payment mortgages) at the expense (opportunity cost) of things that would actually improve the long-term prospects and lives of both individual consumers, the economy, and society generally. In the extreme, we have a world of “pigs satisfied” and an economy with significant (inefficient) distortions in investments in and stocks of financial, human, and health capital.

                                                                                      Norms and institutions are important aspects of market exchange and individual behavior that should (there's that normative word again) act to align individual preferences with plausibly objective individual and societal utility. In so-called "free markets," they will embody and reinforce the "social" virtues of generosity, beneficence, fairness or justice as well as individual virtues such as prudence and temperance that lead individuals to take  broader and longer-term views of their own behavior and its impact on their own long-term objectives as well as on their community and the larger society. The result is that norms and institutions provide a moral counterweight to greed and other strong incentives to pursue short-term hedonistic "self-interested" objectives.

                                                                                      All policy solutions aimed at remedying or minimizing the divergence of preferences from utility will necessarily involve "paternalism" to a greater or lesser extent. The solution that is least paternalistic and that allows the most consumer autonomy is preferred. To minimize paternalism, it must include improved (and state-funded) education, improved consumer information, increased market transparency, some regulation, and some "nudging" in circumstances where uncertainty makes rationally, informed choice difficult. The more effective are societal norms and institutions at reinforcing virtues that promote long-term individual and societal well-being, i.e., at aligning individual preferences with individual and societal utility, the less paternalism will be required. For this reason alone, prevailing norms and beliefs in support of unfettered self-interest that are derived from misunderstanding the metaphor of Adam Smith's "invisible hand" and "self-interest" must be corrected.

                                                                                      Assuming virtue in economic models of individual decision making is much the same as assuming full-information. If the assumption is true, revealed preference probably approximates utility maximization. If it is false, then I believe we're in a second best world.

                                                                                      If individual virtue tempers our "piggy" desires and conditions our choices to something that is both individually and socially better, then the economic rewards of virtue as embodied in and promoted by societal norms and institutions are far greater than we have ever suspected. As economists, we would do well to recognize this when we teach U max.

                                                                                        Posted by on Saturday, May 1, 2010 at 11:01 AM in Economics, Methodology | Permalink  Comments (16)