Obama and Golf

Michele Cottle criticizes the President for playing golf, and Paul Kruman approves. This is one of the stupidest articles one can read. For example,

As a senator, John F. Kennedy scored political points on Eisenhower by mocking Ike’s golf obsession--while taking pains to keep his own golfing gifts under wraps. (As Van Natta recounts, JFK forbade the media from photographing him at play.) Bushes 41 and 43 were both slammed for golfing during wartime. It has been posited that W. quit the game in part because of the stinging coverage of comments he made on the golf course in August 2002, following a suicide bombing in Israel. “There are a few killers who want to stop the peace process that we have started, and we must not let them,” Bush told the assembled journalists. “I call upon all nations to do everything they can to stop these terrorist killers. Thank you. Now watch this drive.” The tone-deaf clip eventually made its way into Michael Moore’s Fahrenheit 9/11. It was not one of golf’s finer moments.

So JFK hypocritically criticized Ike for playing golf even though he was a golfer (don't even get me started on JFK sending Pierre Salinger to buy all the Cuban Cigars he could find before announcing his boycott of Cuban imports). And George W. Bush made stupid comments on a golf course. Obama should thus quit golf because he can be falsely accused by some hypocrite? Or because a stupid President made stupid comments on a golf course?

This is what happens to liberals when they consider golf. Their minds go numb. Then there must be the ritual comment that golf is a white elitist pastime. This can only be said by a non-golfer. I played today at Wilson Golf Course in LA. The course is a United Nations meeting. I doubt there is a place in America -- except on other public golf courses -- where you get Blacks, Whites, Jews, Hispanics, and Korean Americans interacting in such a friendly, equal, manner. Obama's natural constituency plays golf at public courses all over America.

Derman on Regulators

Emmanuel Derman dreams about the TSA and the FED trading places.

If a bank failed at 9 a.m. one morning and shut its doors, the TSA would announce that all banks henceforth begin their business day at 10 a.m.

And, if a terrorist managed to get on board a plane between Stockholm and Washington, the Fed would increase the number of flights between the cities.

That does sum it up pretty well.

Hamilton Channels Shiller

Jim Hamilton channels some Bob Shiller to explain why stocks have performed so poorly for the last decade. Worth reading.

Goldman Scandal?

Felix Salmon has a good discussion on NYT’s 3000-word story on Goldman and synthetic CDOs.

Great Article

I had not noticed this parody about our health care system by Jonathan Rauch until today (when David Brooks mentioned it here). Here is a bit of the flavor of it:

"Hello! Thank you for calling Air Health Care, the airline that works like the health care system. My name is Cynthia. How can I give you travel care today?"

"Hi. My name is Jonathan Rauch. I need to fly from Washington, D.C., to Eugene, Oregon, on October 23."

"Yes, I'd be happy to assist you with that. It does look like we can get you on a flight on January 23 at 1 p.m. or February 8 at 3 p.m. Which would you prefer?"

"Neither. I need to be in Eugene on October 23. As in, the 23rd of October."

"I'm sorry, we have nothing open on that date. You might try another carrier."

"I suppose I'd better. Who has availability?"

"I'm afraid I have no way to know that. I have no way to look into their systems."

"Who would know?"

"You can call them individually and ask. I'm sure you can find one."

"Look, I don't have time to call two dozen airlines. It's important that I get to Eugene on the 23rd. There must be something you can do."

"Well, it looks like maybe we could squeeze you in on October 26, if you don't mind departing Washington Dulles at 5:35 a.m."

"Good grief. All right, I suppose it will do."

It just keeps getting better.

Of course one reason for the difference between airlines and health care is that consumers pay directly for the former. So the airlines try to attract us. But insurers make decisions for consumers regarding health care. Of course we all pay for health care too, but we don't make choices and we don't individually pocket the savings. Not sure that health reform will fix this.

Health Bill

Paul Krugman criticizes those who are unhappy about the Senate's passage of health care. In the spirit of the holidays he updates Dickens:

It begins with sad news: young Timothy Cratchit, a k a Tiny Tim, is sick. And his treatment will cost far more than his parents can pay out of pocket.

Fortunately, our story is set in 2014, and the Cratchits have health insurance. Not from their employer: Ebenezer Scrooge doesn’t do employee benefits. And just a few years earlier they wouldn’t have been able to buy insurance on their own because Tiny Tim has a pre-existing condition, and, anyway, the premiums would have been out of their reach.

But reform legislation enacted in 2010 banned insurance discrimination on the basis of medical history and also created a system of subsidies to help families pay for coverage. Even so, insurance doesn’t come cheap — but the Cratchits do have it, and they’re grateful. God bless us, everyone.

Of course, one might also note that somebody must pay for the increased coverage. Perhaps as the tale proceeds, Cratchit loses his job as Scrooge goes out of business.

Krugman does not consider that because he has his own straw men to consider. He divides opposition to the health bill to three groups: irrational tea baggers; "Bah Humbug" fiscal scolds; and disappointed progressives. Obviously the only sensible reason to be unhappy is if you are disappointed that we are not enacting a single payer system, but you have to be realistic.

There are reasons to be unhappy with the bill that does not fall into his three categories. The fiscal impact of the bill that Krugman is so happy about depends on Congress carrying out commitments that all know they won't follow. Even supporters like Ezra Klein believe that the individual mandate in this bill is a sweetheart deal. The penalty for not buying insurance is so small that for many the best option will be to just pay the penalty and sign up for insurance only after you need it. But someone will have to pay the cost of this, will they not?

The most pressing problem, perhaps, is that the bill does not allow competition across state lines. Krugman never discusses this issue. The exchanges are set up on a state level, and private insurers cannot compete. Given that the bill limits administrative costs, small insurers will likely go out of business -- they cannot spread the fixed costs sufficiently -- so in some states the number of options will decrease under this bill. As Richard Epstein argues, the current bill turns health insurance into a regulated public utility.

I suppose that Krugman really approves of this but he never discusses it. He cannot. This argument does not fall into any of his straw man categories.

CO2 Emissions and Taxes

The big problem at Copenhagen was the difficulty in getting the US and China to agree on sharing the burden of reducing CO2 emissions. The problem is the difference between size of country and size of income. China produces slightly more CO2 than the US (data is for 2006), perhaps 9%, but in per-capita terms the US produces 4 times as much. But the US is also ten times wealthier in per-capita terms. So if we calculate tons of CO2 emitted per unit of per-capita GDP, the figure for the US is 133,680 and for China it is 1,358,217. That is, we emit about one-tenth that of China per unit of per-capita income. This means that if the US and China were to reduce emissions by one million tons, and if the efficiency of production is unchanged, then US per-capita income would fall by about 13 cents, and Chinese per-capita income would fall by $1.36. So the incidence of the "tax" on emissions would be ten times higher on the average Chinese person than on the average American.

If we think of this as taxation then a fair way to share the burden might be to have a flat tax per unit of per-capita income. Then we ought to face an emission target ten times higher than China. Of course, if we believe in progressive taxation our tax rate ought to be even higher.

Before setting tax rates one ought to consider where are the greatest gains for reducing emissions -- that is efficiency gains that do not reduce GDP. Is that in China or the US? This could go either way, I suppose. One could argue that China has less efficient plants, so easy fixes are available since they have regulated less. But it may also be the case that it is easier to implement many technological fixes in the US than in China. My guess is that the efficiency differences are unlikely to be of the same order of magnitude as these income differences.

Samuelson Appreciations

Here are three good Samuelson appreciations: Dixit, Krugman, and Warsh.

How Sausage is Made

The Health Bill passed the Senate, and this article in the NYTimes illustrates how legislation is passed, with all sorts of special deals for key Senators. Some highlights:

Another item in the package would increase Medicare payments to hospitals and doctors in any state where at least 50 percent of the counties are “frontier counties,” defined as those having a population density less than six people per square mile.

And which are the lucky states? The bill gives no clue. But the Congressional Budget Office has determined that Montana, North Dakota, South Dakota, Utah and Wyoming meet the criteria.

Another provision would give $100 million to an unnamed “health care facility” affiliated with an academic health center at a public research university in a state where there is only one public medical and dental school.

The latter may be in PA, though nobody seems to be sure. I wonder if the PSU Hershey Medical
Center qualifies as a public medical school?

This reminds me of a bill (in the 80's) that provided a certain tax break only to cities with an American League Baseball team and a population of more than one million people. This still left two candidates (pretty obvious), so another provision in the bill limited the tax break to States that had a Republican Governor in 1980. The two provisions were several hundred pages apart in the bill. Guess which city won?

More on Credit

The President told the bankers they have to start lending to help us get out of the recession, and that they owe us this:

“America’s banks received extraordinary assistance from American taxpayers to rebuild their industry,” Mr. Obama said. “Now that they’re back on their feet, we expect an extraordinary commitment from them to help rebuild our economy.”

The President argues that credit difficulties are hurting small business:

President Obama reiterated his call Monday for the nation's banks to increase lending, saying that he was getting too many letters from small businesses unable to borrow money.

The story seems to be that the recovery is now held back because of a lack of credit. It is hard to understand what model might suggest this. The normal story is that we suffer from a lack of demand. Many observers, like Paul Krugman, have been arguing that we need more stimulus to fuel the recovery. That seems like what we need is more demand. In a recession the demand for loans declines. That is why the yield curve steepens. The quantity of credit extended depends on supply and demand. Given how low interest rates are, it is hard to believe that the recovery is really being stifled by a lack of credit supply.

Sure, we hear a lot about the troubles small businessmen are having obtaining credit. And surely banks are busy improving their balance sheets. But it must primarily be a lack of demand which hinders credit from flowing. Banking is a competitive industry. If there were companies with good collateral that were trying to borrow it is hard to believe they could not get credit.

More likely, the problem is that the quality of collateral is quite poor right now. Banks don't need more real assets. What kind of paper can companies pledge in a recession? Given that bank regulators want banks to improve their balance sheets this pressure must be what is limiting loans.

Credit and the Bankers

President Obama called the big Bankers to DC today to tell them to make more loans. See here and this article from Bloomberg. The purpose of the meeting was to "to ratchet up pressure on banks to extend more credit to small businesses and ease opposition to his regulatory overhaul."

Meanwhile,

Federal Deposit Insurance Corp. Chairman Sheila Bair said she’s “concerned” that U.S. banks are making only the safest loans. “There needs to be well-managed risk-taking to get the economy going again,” Bair said today in a Bloomberg Television interview at the White House.

Now it seems clear that credit for small business is a problem. But does it really make sense for regulators to call on banks to make more risky loans when the financial crisis arose because of excessive lending and an asset bubble?

Moreover, the whole process seems backwards to me. It was only six months ago that the Treasury was assessing the health of individual banks because we were worried about their solvency. In the wake of the financial crisis prudence would suggest that they should be worried about the quality of their balance sheets.

But the questions arise why the banks don't lend given that we bailed them out. We helped them, why don't they help Main Street? Well, one problem might be the restrictions put on those banks that took TARP money. They are paying a large price to get out of TARP, as this article in the NYTimes about Citibank suggests.

The moves will result in a $10.1 billion hit to Citigroup’s fourth quarter results, because of accounting charges taken on the value of the repaid preferred shares and the cancellation of loss-sharing agreement. The new stock offering, meanwhile, will severely dilute the value of existing Citigroup shares.

Why do it then? Clearly to get out from under the Pay Czar. It is better for the big banks to raise capital costly and pay back Uncle Sam than to be subject to the restrictions mandated by Congress. And if you are raising money to pay back Uncle Sam it must be harder to lend to Aunt Main Street. Nobody wants to mention that connection, however.

Addendum: Wells Fargo has announced that it too will repay TARP funds.

Paul Samuelson passes away

Paul Samuelson, the father of modern economics, passed away. Here is the NYTimes obit. Samuelson is clearly the most influential economist of the last century, even including Keynes. While the Keynes may have made a revolution, Samuelson made contributions to so many basic areas of economics that it is hard to enumerate them all. Clearly, he could have won several additional Nobel Prizes if these were given for specific contributions rather than lifetime achievements in the early days.

Tobin Taxes

Paul Krugman argues for extending Tobin taxes not just to currency transactions but also to repo transactions as well:

As Gary Gorton and Andrew Metrick of Yale have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period — often a single day. Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”

And a financial transactions tax, by discouraging reliance on ultra-short-run financing, would have made such a run much less likely. So contrary to what the skeptics say, such a tax would have helped prevent the current crisis — and could help us avoid a future replay.

Would a Tobin tax solve all our problems? Of course not. But it could be part of the process of shrinking our bloated financial sector. On this, as on other issues, the Obama administration needs to free its mind from Wall Street’s thrall.

Tyler Cowan argues against Krugman and makes several good points, most notably, that capital requirements are more effective than a Tobin tax to deal with excessive risk taking.

It seems to me that one big problem with a Tobin tax is that it is a tax on arbitrage transactions, and in particular, on short selling. It seems to me that asset bubbles are caused by the difficulties of arbitrage and short selling. If we had more of it then skepticism about bubbles could be priced and this would be valuable. Taxing financial transactions raises the cost of an already costly activity. So the unintended consequence could be severe.

Ethanol Woes

The NYTimes reports about the projected excess of ethanol mandated by Congress. Two years ago Congress mandated more use of ethanol for obvious political reasons:

To please the farm lobby and to help wean the nation off oil, Congress mandated that refiners blend a rising volume of ethanol and other biofuels into gasoline. They are supposed to use at least 15 billion gallons of biofuels by 2012, up from less than seven billion gallons in 2007.

But the recession and reductions in fuel consumption make these targets hard to fulfill:

At the maximum allowable blend, in which gasoline at the pump contains 10 percent ethanol, updated projections suggest that the country is unlikely to be able to use all the ethanol that Congress has ordered up. So something has to give.

When Congress wrote the rules, in 2007, gasoline consumption had been growing for years, and it looked as if the nation would be able to use considerably more ethanol in the future. Gasoline consumption hit a peak of 3.4 billion barrels that year.

But gasoline demand fell in 2008, after soaring gas prices early in the year were followed by the economic crisis. Consumption was slightly less than 3.3 billion barrels last year, and it could end 2009 at about the same level.

Congress could lower the targets but this would anger farmers. It could raise the amount of ethanol blended in gasoline, but this would ruin catalytic converters.

Perhaps the best solution would be for Congress to just buy the excess ethanol and store it. Cars would be saved and the subsidies would be maintained. But this would make transparent the fact that ethanol is a political subsidy to farmers, not a beneficial program to deal with global warming or energy needs. And making this transparent would make the subsidy program less sustainable over time. So this is unlikely. So more of our cars are likely to be rendered clunkers, but the cash will only be for the farmers this time.

Makes you kind of wonder what Congressional created health care will be like.

Reserve Currency

The Economist has an article that makes sense discussing the role of the dollar as a world currency. The basic point is that there is no good alternative right now. A very nice discussion of this issue also appeared in the Economic Report of the President, which had this graph:



This appendix made the important point that although the Euro zone is large, there is no unified European debt, only the debt of individual countries. This makes it harder to hold reserves in euros than in dollars. Depth of our capital markets is what makes the dollar a reserve currency.

Strong Dollar

Once again a US Treasury Secretary has affirmed support for the strong dollar.

U.S. Treasury Secretary Timothy Geithner said a strong dollar is in the nation’s interest and the government recognizes the importance it plays in the global financial system.

“I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,” Geithner told reporters in Tokyo today.

This despite the fact that the dollar fell to a 15-month low against major counterparts (click here for a picture of the DXY index) and will continue to slide as the US adjustment to our large current account deficits continues. This ignores any slide due to fears of inflation from large budget deficits. As the economy recovers imports will rise and thus we will need more dollar depreciation for the current account to adjust. If those who fear that deficits will lead to future inflation are correct then the dollar's slide will be even larger.

But at least we love that strong dollar!

Protection Rackets

The NYTimes reports about Oleg Deripaska suing Vedomosti over disclosure of financial information. The key points:

Rusal, the world’s largest aluminum company, is closely held by wealthy Russian businessmen, including Oleg Deripaska, once Russia’s richest man. As a private company, few details of its business are public.

The company hopes to raise $2.5 billion in an initial public offering in Hong Kong that will be an important test of international investor interest in Russian equities.

A series of articles in the business newspaper Vedomosti at the end of October detailed Rusal’s dismal financial results for 2008 and included other facts about the company. The articles cited documents given to bankers at a conference closed to the public.

That scoop is evolving into a legal test for business publications in Russia, a country where the political press is already kept on a tight rein.

Something appears to be missing in this story. Why is Deripaska doing this? Clearly, this lawsuit threat can have nothing to do with RUSAL’s impending IPO. The information that Vedomosti published is already published! A lawsuit, even if successful, is not going to put that genie back in the bottle. Moreover, Deripaska’s hypersensitivity about this can only serve to heighten suspicions that RUSAL really does have something to hide. In short, threatening a lawsuit is not in Deripaska’s immediate interest at all. So why is he making the threat?


The answer is that Deripaska is acting here not primarily on his own behalf but on behalf of all the members of the small club of oligarchs in Russia who – like Deripaska - participate in Vladimir Putin’s “protection racket.” Clifford Gaddy and I are writing in detail about this scheme in our new book, Russia’s Addiction. Beginning in the year 2000, when he entered office as Russia’s president, Putin has had a deal with the most powerful business owners. In that deal, the oligarchs agreed to abide by a few clear rules about their behavior inside and outside Russia; in return, Putin guaranteed them not only protection against expropriation by the state but also, and even more important, protection against each other. To be able to deliver on that latter guarantee, Putin has since 1999 at the latest preserved a monopoly on damaging financial information about the oligarch-controlled companies. That is, he and only he (along with one or two key associates) possesses the information, and he protects it from any leaks. Financial information is the nuclear weapons of Russia’s thoroughly opaque corporate elite. When Putin took over, the oligarchs were on the verge of all-out and all-destructive war against one another using such information. He ended the era of proliferation and brinksmanship and enforced a peace that has lasted to this day.


But if Putin’s power over the oligarchs rests on a monopoly of financial information, what could be more threatening to him and his system than independent collection – and release – of financial information? If independent media seek out the goods on the oligarchs, Putin's authority is dissipated. Ending internecine warfare among the oligarchs was the key event in the formation of the protection racket. The main terrain on which that war had been fought was ... the "independent media." Independent in quotes because, of course, the oligarchs owned the media and used it as weapons against each other. That is how kompromat was disseminated prior to Putin's accession. Putin took the media over to insure the oligarchs against each other. Deripaska’s threat against Vedomosti is intended to send the message to the press today not to upset the system Putin established a decade ago.

Craziest Quote of the Day

This would count for the year and probably the decade too. It is from Dick Armey, former House Majority Leader from Texas, and former Department Chair at North Texas State University:

“I don’t consider Larry Summers a serious economist,” Armey said. “You can get a Ph.D. from Harvard without ever having seriously considered the subject.”

I wonder if you can get the John Bates Clark Medal without seriously considering the subject? Here is the article it came from.

Summers list of publications is at least 10 pages long (his cv is here).

Links for today

Ned Phelps has an interesting article in the FT that criticizes both Keynesians and neoclassicals. He blames speculation for the housing crisis, not incentives.

The WSJ has an article (subscription required) on John Geanokopolos's work on leverage. I think that theorists will be interested to learn that they were on the margins:

Mr. Geanakoplos is among a small band of academics offering new thinking about those cycles. A varied group ranging from finance specialists to abstract theorists, they are moving to economic center stage after years on the margins.

Hard to see what margins they were on, but then we also learn that traditional macroeconomics had been relegated to second class status:

Traditional macroeconomics, such as practiced by John Maynard Keynes and Milton Friedman, was relegated to second-class status.

So I guess any comment about economics is possible in the WSJ. But despite these complaints, the article is interesting.

Everyone wants to make their work seem more revolutionary than it was, and reporters need it to be so, else why report it.

Mortgage Finance

This article by John Krainer of the San Francisco Fed has lots of information about the evolution of mortgage finance. This is important for thinking about the financial crisis of course. This is especially relevant for thinking about the relative importance of Government Sponsored Enterprises (GSE's) like Fannie Mae and Freddie Mac versus the non-agency securitizers. We can see, for example, that as the housing bubble proceeded the share of mortgages supplied by the GSE's declined:


We can also see that the non-agency lenders were more highly represented in the more risky types of mortgages at the height of the boom. For 2006 we have this picture:


Thus:

Compared with mortgages purchased by the GSEs, non-agency securitizations were much more likely to involve adjustable-rate mortgages, including option ARMs, to be rated as subprime, and to have less-than-full documentation of borrower income and assets. The median FICO credit score for the non-agency securitizations was about 30 points lower than for the mortgages held or guaranteed by Fannie Mae or Freddie Mac and much closer to the credit scores typically associated with loans guaranteed by Ginnie Mae.

These pictures are not consistent with the view that the housing bubble was the fault of the GSE's alone. Deteriorating standards seemed to accelerate as the GSE share fell.

Real Costs

The Brazilian Real has been appreciating significantly since last March. This rally has pushed the price of Big Mac up dramatically, according to this story in Bloomberg:

Buying McDonald’s Corp.’s flagship hamburger costs 8 reais in Sao Paulo, or $4.62, compared with $3.99 in New York and 2.29 pounds in the U.K. capital, or $3.74.

This is the counterpart to the dollar's weakening of course. But Brazil's President has not taken this lying down. As the Economist reports:

Brazil has gone for the direct approach. Foreign capital has flooded in, attracted by the healthy prospects for economic growth and high short-term interest rates. That has pushed up local stock prices, as well as the real, Brazil’s currency. To stem the tide, the government this week reintroduced a tax on foreign purchases of equities and bonds. Though many doubt the long-term efficacy of such measures, it had an immediate effect. The real, which had risen by more than one-third since March, fell by 2% (before regaining some ground). Brazil’s main stockmarket dropped by almost 3%.

This seems like quite a costly way to prevent currency appreciation -- cause your own stock market to fall. Perhaps a useful move to prick a bubble, but Brazil's appreciation versus the dollar does not seem to be driven by much other than fundamentals.

It's the fault of smart guys

Calvin Trillin explains how the financial crisis was caused by the migration of smart guys to Wall Street. Wall Street used to be populated by the lower third of the class. Then smart guys started going too. That is what caused the invention of complex securities:

“Did you ever hear the word ‘derivatives’?” he said. “Do you think our guys could have invented, say, credit default swaps? Give me a break! They couldn’t have done the math.”

“When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that. All of that easy money had eaten away at their sense of enoughness.”

Maskin on the Crisis

Nobel Laureate Eric Maskin discusses what he sees as essential reading on the financial crisis. Here is one tidbit:

I don’t accept the criticism that economic theory failed to provide a framework for understanding this crisis. Indeed, the papers we’re discussing today show pretty clearly why the crisis occurred and what we can do about it. The sort of economics that deserves attack is Alan Greenspan’s idealized world, in which financial markets work perfectly well on their own and don’t require government action. There are, of course, still economists – probably fewer than before – who believe in that world. But it is an extreme position and not one likely to be held by those who understand the papers we’re talking about.

Nobel Prize

Okay, so everybody now knows that Elinor Ostrom and Oliver Williamson won the Nobel Prize. A good day for Berkeley Economics! Williamson paid 82-1 in our pool, and nobody bet on Ostrom. here is the Nobel Prize committee announcement. Michael Spence talks about it here. And here and here are discussions at Marginal Revolution.

Nobel Update

Here are the latest odds for our lottery:

Economist	Payoff to a Dollar Bet
Diamond	5.2222222	to	1
Mortensen	7.6153846	to	1
Sims	7.6153846	to	2
Pissarides	10.2	to	1
Hansen	13	to	1
Nordaus	17.666667	to	1
Shiller	17.666667	to	1
White	27	to	1
Fehr	36.333333	to	1
Dreze	55	to	1
Feldstein	55	to	1
Hausman	55	to	1
Hendry	55	to	1
Jorgensen	55	to	1
The Field	55	to	1
Tirole	55	to	1
Williamson	55	to	1
Arthur	111	to	1
Barro	111	to	1
Broom, John	111	to	1
Dasgupa	111	to	1
Fama	111	to	1
Hart	111	to	1
Holmstrom	111	to	1
Kornai	111	to	1
Krueger	111	to	1
Nelson	111	to	1
Romer	111	to	1
Sachs	111	to	1
Sargent	111	to	1
Wilson	111	to	1
Winter	111	to	1

Strong Dollar

Treasury Secretary Geithner said, as recently as October 3, that “it is very important to the United States that we continue to have a strong dollar,” as reported by Bloomberg. Yet, the dollar continues to slide: 12 percentfrom its peak this year in March as measured by the Federal Reserve’s trade- weighted Real Major Currencies Dollar Index.

As of this point, investors no longer believe this rhetoric, which is standard for Treasury Secretaries:

“Since the dollar has been weak and weakening for years, Geithner was using a code phrase, a carry-over from the Bush administration,” said David Malpass, president of research firm Encima Global in New York. “It means that the U.S. approves of a constantly weakening dollar but doesn’t want a disruptive collapse,” said Malpass, the former chief economist at Bear Stearns Cos. and deputy assistant Treasury secretary from 1986 to 1989.

The government has used the phrase for so long that “I don’t think it has much meaning left for the markets,” said Vassili Serebriakov, a currency strategist at Wells Fargo Bank in New York. “Once you have this policy in place I don’t think there’s any possible choice but for the Treasury to stick to what it’s been saying all this time.”

The problem is that the desire for the dollar to be strong is in conflict with the need to adjust to the large current account deficit. US economic recovery requires an increase in exports, and current account adjustment requires that plus reduced imports, and that requires a weak, rather than a strong dollar. Economic policies pursued to combat the recession do not induce expectations of a stronger dollar in the future.

The problem, of course, is the fundamental conflict between internal and external objectives of economic policy. To be the world's reserve currency requires sacrificing internal concerns for external ones, so that confidence in the currency is maintained. This is hard to do when we are in a deep recession.

Nobel Prize

The Nobel Prize in economics will be announced on Monday. Our annual lottery (which tends to be more accurate than all other pools and lotteries in the profession) is underway. Here are the latest odds.

Economist	Payoff to a Dollar Bet
Diamond	5.5	to	1
Mortensen	7.6666667	to	1
Pissarides	7.6666667	to	1
Shiller	12	to	1
Sims	12	to	2
Nordaus	18.5	to	1
Fehr	25	to	1
Hansen	25	to	1
Dreze	38	to	1
Hausman	38	to	1
Hendry	38	to	1
The Field	38	to	1
White	38	to	1
Williamson	38	to	1
Arthur	77	to	1
Barro	77	to	1
Broom, John	77	to	1
Feldstein	77	to	1
Hart	77	to	1
Holmstrom	77	to	1
Jorgensen	77	to	1
Kornai	77	to	1
Krueger	77	to	1
Nelson	77	to	1
Sachs	77	to	1
Sargent	77	to	1
Wilson	77	to	1
Winter	77	to	1

Lehman Again

Richard Robb has an interesting counter to the argument that the impact of Lehman's failure was overblown. His main point is that the looking only at Libor and the overnight swap market was misleading at that time:

The latest contribution by John Cochrane and Luigi Zingales, like others before them, rests partly on misunderstanding of the data. The authors deduce that Lehman wasn’t the main cause of last autumn’s turmoil by inspecting the daily movements in the spread between Overnight Interest Rate Swaps and three-month Libor, which they define as “the rate at which banks can borrow unsecured for three months.”

But a better definition of Libor under the circumstances was “the rate at which banks said they can borrow”. Libor is the result of a survey, not a measure of actual transactions. In the week of September 15 last year, big banks refused to settle foreign exchange with each other. They were not lending interbank for three month terms, so Libor during that week tells us little.

We could say the same thing for OIS. Volume was light to nonexistent in the week of September 15 last year. What we do know is that three-month T-bills traded at 0.04 per cent on September 17, down from 1.47 per cent on Friday September 12. These are real data that ought to impress the professors that the market was breaking down as fast as it knows how.

In addition to this argument there is the additional point that Lehman's collapse led to the run on money markets because the Reserve Primary Fund held lots of Lehman debt. This cause them to break the buck, and this led to a run on other money market funds. Since money market funds are the main purchasers of commercial paper, this spread the crisis to the rest of the economy. This is the amplification mechanism that was crucial in generating such a large impact from the failure of a relatively small bank failure.

Fiscal Multipliers

Here are some links, courtesy of Mark Thoma and Econbrowser, for discussion on the size of fiscal multipliers.

New Summers Profile

The New Yorker has a profile of Larry Summers. The focus in on how the Obama team dealt with the economic crisis, and how Summers has evolved.

Securitization and Beef

One argument against regulation is that private companies have an incentive to conform to the highest standards to maintain their reputation. They won't shift risks even when the opportunity arises because this will hurt them in the future. Yet, this argument does not always work, as this article in the New York Times on E Coli in ground beef explains.

Ground beef is combined together from different suppliers, much like a collateralized debt obligation. This makes it very hard to identify the source of an outbreak.

Ground beef is usually not simply a chunk of meat run through a grinder. Instead, records and interviews show, a single portion of hamburger meat is often an amalgam of various grades of meat from different parts of cows and even from different slaughterhouses. These cuts of meat are particularly vulnerable to E. coli contamination, food experts and officials say. Despite this, there is no federal requirement for grinders to test their ingredients for the pathogen.

Self regulation does not work here very well:

Unwritten agreements between some companies appear to stand in the way of ingredient testing. Many big slaughterhouses will sell only to grinders who agree not to test their shipments for E. coli, according to officials at two large grinding companies. Slaughterhouses fear that one grinder’s discovery of E. coli will set off a recall of ingredients they sold to others.

Given how often I eat hamburgers this is a most important story. It seems incentives for self-regulation here are much worse than in the financial industry. Notice that with securitization the problem is that it is very difficult to disentangle the loans that make up the security. But in hamburgers it is impossible to distinguish which producers supplied the tainted meat. This is due to the lack of testing at the source, a result of an inadequate regulatory structure and the failure of self-regulation in this industry.

Goolsbee: funniest DC celebrity

Austan Goolsbee is the funniest celebrity in Washington according to Politico. See his standup routine here.

Executive Compensation and the Crisis

Rene Stulz has a new working paper which studies the impact of CEO pay on the economic crisis. Studying CEO. The conclusions are interesting:

There is no evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse both in terms of stock returns and in terms of accounting return on equity. Further, option compensation did not have an adverse impact on bank performance during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis; further, there is no evidence that they hedged their equity exposure. Consequently, they suffered extremely large wealth losses as a result of the crisis.

This is an important study. Perhaps it is not all that surprising, since competition across banks in an asset bubble leads to herding behavior.

This article in the New York Times discusses the controversy. This study is not going to head off reforms on CEO pay. Still, it is important to think about unintended consequences:

“neither bank C.E.O.’s nor regulators thought that banks were taking excessive risks.” So if the risks were viewed as small, he adds, “compensation incentives would not induce them to avoid those risks.”

He points out that in 2006, a collateralized-debt obligation with a triple-A rating didn’t look like a huge risk. “On the contrary, it looked like an extremely low-risk asset,” he says. “Yet, banks incurred extremely large losses on such C.D.O.’s.”

Regulations that would have encouraged executives to take on less risk, he adds, might have made matters worse because executives “might well have chosen to invest even more in AAA-rated C.D.O.’s and other asset-backed securities.”

One could argue, I suppose, that if CEO pay has a common structure, then differences in CEO schemes may not show up in differences in importance, yet the structure is still problematic. That is, all CEO incentive packages could induce risk taking, the differences being less important than the structure itself.

The Financial Bailout will not Impoverish America

Last night I participated in a debate here at PSU on the subject of bailouts. The motion was that bailouts will impoverish America, and I argued against. Here are my remarks (I only had five minutes for the presentation).

Meanwhile, Daniel Gross at Slate makes some important similar points, especially that many of the bailed out banks have actually paid income back to the government, and that the expenditures actually made are very small compared with the commitments. For example,

After the failure of Lehman Bros., the Treasury Department agreed to guarantee the $3.8 trillion industry for money-market funds. In so doing, taxpayers assumed a massive liability. Managers of money-market funds were charged a tiny fee for this insurance. On Sept. 18, the government lifted the guarantee, reporting that it had collected $1.2 billion in fees without having made any payments.

This seems to be the experience with most of the bailouts. Large commitments, much smaller expenditures, programs being wound down. Emergency actions paid off, at least so far.

Mundell calls for fixed dollar-euro rate

Robert Mundell, Nobel Laureate and intellectual father of the euro, calls for a fixed exchange rate between the dollar and the euro. See this article.

Posner becomes a Keynesian

Richard Posner writes in the New Republic about how he became a Keynesian. Worth reading, despite his confusion over the difference between savings and investment. Perhaps the problem is Posner's inability to use the word equilibrium condition. For Keynes point was that savings equals investment in equilibrium and that changes in income bring this about. Without this the article is confusing about passive and active investment and so on.

I need to write more about the contribution of Keynes to understanding this crisis.

Global Public Debt

The Economist has a nice interactive tool for looking at public debt across countries.

What's Wrong with Macro

Mark Thoma has collected as many links on this as anybody.

Predictability of the Crisis

Alex Tabarrok weighs in on the argument that no macro model could predict the crisis.

...the word timing is misleading. Let's accept that a crisis cannot be predicted to the day or even to the year. Nevertheless, it is perfectly reasonably and fully consistent with rational expectations to predict an increased probability of a crisis.

If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur. If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten. Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis. Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.

All of this is true even in the context of stock markets. Efficient markets theory implies that any two stocks will have similar risk-adjusted returns it does not imply that the risk of bankruptcy is the same for any two firms. It is perfectly reasonable to say that Google revenues are going to have to increase at a historically unprecedented rate or the stock will plummet. It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).

Thus the "we could not have predicted the crisis even in theory" argument is a weak defense--even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models.

It seems to me, however, that once you define the problem as one of predicting increased risk of a crisis then the charge against macroeconomics is lessened. Many economists argued that the risk of a crisis had increased after 2006.

The notion that economists should be able to isolate periods of increased risk is a good one. The IMF has tried to do that with early warning indicators. The BIS was warning of increased risks from at least 2006.

The Role of Keynes

David Warsh has an interesting column on Keynes. Read to the bottom to see Lucas's appreciation, which is most interesting.

Meanwhile, Mankiw reviews Skidelsky's new book on Keynes in the Wall Street Journal (subscription required). He notes:

In his preface, Mr. Skidelsky says that he is a historian, not an economist. The book bears out the claim, in both its strengths and weaknesses. Mr. Skidelsky is most engaging when he draws on his biographical work. Keynes, we are reminded, had a fascinating life. He was a widely read intellectual who wrote accessibly for the general public. He advised world leaders on the crucial issues of the day and socialized with the artists and writers of the Bloomsbury group. But most of "Keynes" is devoted to ideas, not history, and here Mr. Skidelsky is not playing his strong suit. To economists his discussion of macroeconomic theory will seem pedestrian and imprecise. To laymen it will seem abstract and hard to follow.

I also liked this line:

This brings us to the biggest problem with "Keynes." Mr. Skidelsky admits to being poorly trained in the tools that economists use: "I find mathematics and statistics 'challenging,' as they say, and it is too late to improve. This has, I believe, saved me from important errors of thinking."

Has it, really? Mr. Skidelsky would like to think that his math-aversion allows him to focus on the big ideas rather than being distracted by mere analytic details. But mathematics is, fundamentally, the language of logic. Modern research into Keynes's theories—I have conducted such research myself—tries to put his ideas into mathematical form precisely to figure out whether they logically cohere. It turns out that the task is not easy.

I enjoyed Skidelsky's 3 volumes on Keynes, and I will probably enjoy this book too. But I know the Mankiw is right about Skidelsky's weaknesses, and that is all the more important for the claim that Keynes is what is needed now.

Securitization and the Crisis

Here is an article discussing some recent research concerning the role of securitization in the financial crisis.

Macro and Finance

I keep arguing that macroeconomics needs to incorporate finance more fully. I think this is the major criticism that is made of macro models that actually holds up to scrutiny. People nonetheless ask me what I mean. Here is an article by BIS Chief Economist Steve Cecchetti and colleagues on precisely this subject.

Unitended Consequences: Egypt

Talk about unintended consequences. Egypt slaughtered all of its pigs and is now suffering from uncollected trash. The story is here.

For more than half a century, those collectors were the zabaleen, a community of Egyptian Christians who live on the cliffs on the eastern edge of the city. They collected the trash, sold the recyclables and fed the organic waste to their pigs — which they then slaughtered and ate.

Killing all the pigs, all at once, “was the stupidest thing they ever did,” Ms. Kamel said, adding, “This is just one more example of poorly informed decision makers.”

The whole story is worth reading for sure, and the lesson is very important. Especially in societies where informal arrangements are crucial.

Levine Responds to Krugman

David Levine writes an open letter to Paul Krugman on the state of Macroeconomics. At one point he notes:

our models don't just fail to predict the timing of financial crises - they say that we cannot. Do you believe that it could be widely believed that the stock market will drop by 10% next week? If I believed that I'd sell like mad, and I expect that you would as well. Of course as we all sold and the price dropped, everyone else would ask around and when they started to believe the stock market will drop by 10% next week - why it would drop by 10% right now. This common sense is the heart of rational expectations models. So the correct conclusion is that our - and your - inability to predict the crisis confirms our theories. I feel a little like a physicist at the cocktail party being assured that everything is relative. That isn't what the theory of relativity says: it says that velocity is relative. Acceleration is most definitely not. So were you to come forward with the puzzling discovery that acceleration is not relative...

Read more at: http://www.huffingtonpost.com/david-k-levine/an-open-letter-to-paul-kr_b_289768.html

Levine is being coy here. Without mentioning it, he is trying to outline Krugman's own model of first-generation exchange rate collapses. But not exactly. For in Krugman's model there is a fundamental that is driving the currency collapse. Excessive money growth is driving down reserves, so in Krugman's rational expectations model, investors do not wait for all reserves to be evaporated before selling the currency, they do so at the first moment that an attack is feasible. Krugman's model ties down the timing of the attack exactly, even though it is based on rational expectations (indeed that is the novel point). Thus, I suppose one could argue that with better models of fundamentals we would know more about the timing of crashes.

I should have linked earlier to John Cochrane's response to Krugman. It is long, but well worth reading.

Meanwhile, Gilles Saint-Paul provides a modest defense of the economics profession.

The Future of Global Finance

Liaquat Ahamed, author of the fine history of the international financial system in the 1920's and 1930's (Lords of Finance: The Bankers Who Broke the World), has an interesting essay on the future of global finance.

International finance has always been one of the more elusive areas of economics, in part because the channels through which capital moves around the world are so tortuous that the system looks as if it had been thought up by Rube Goldberg. It’s not surprising, therefore, that among all the various forces and factors to be blamed for the current global economic crisis — deregulation, Alan Greenspan, credit-default swaps, the power of the financial lobby, excessive leverage, securitization, Wall Street greed — the most difficult to get one’s head around is the international monetary system.

The rest is a well written essay worth reading.

More on Lehman's Failure

John Cochrane and Luigi Zingales have an interesting article on the impact of the closure of Lehman. They argue that it is a mistake to single out Lehman. Many other phenomena were occurring in that period:

Two weeks prior, on Sept. 7, the government took over Fannie Mae and Freddie Mac, wiping out much of their shareholder equity. On Sept. 16, the government bailed out AIG, lending it $85 billion. On Sept. 25, Washington Mutual, the nation's sixth-largest bank, was seized by the FDIC. On Sept. 29, Wachovia, the nation's seventh-largest bank, was sold to avoid a similar fate. All this would have happened without Lehman. Meanwhile, the Federal Reserve and the Treasury Department went to Congress to ask for $700 billion for the Troubled Asset Relief Program (TARP).

Which, they ask was pivotal?

The nearby chart shows that the main risk indicators only took off after Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke's TARP speeches to Congress on Sept. 23 and 24—not after the Lehman failure.

The risk of Citibank failure (the Citi-CDS spread) and the cost of interbank lending (the Libor-OIS spread) rose dramatically after Ben Bernanke and Hank Paulson spoke to Congress. (In basis points.)

On Sept. 22, bank credit-default swap (CDS) spreads were at the same level as on Sept. 12. (CDS spreads are the cost of buying insurance against default.) On Sept. 19, the S&P 500 closed above its Sept. 12 level. The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman's collapse, while it shot up more than 60 points from Sept. 23 to Sept. 25, after the TARP testimony. (Libor—the London Interbank Offer Rate—is the rate at which banks can borrow unsecured for three months.)

Their argument is that these speeches were announcements that we had a real financial crisis, we are in desperate shape and we need emergency help. So investors believed banks were in even worse shape than they turned out to be. As I noted in a previous post, Lehman was Pearl Harbor. We wanted to fight the Germans, but we needed the Japanese to bomb Pearl Harbor before we could attack. Cochrane and Zingales are arguing that the speeches of Bernanke and Paulson were like FDR announcing the attack and calling for a declaration of war.

Obama's Speech to Wall Street

The Economist (magazine) did not like Obama's speech. I have to say I agree with their criticism. It must say something when you get compared unfavorably to George Bush's analysis:

"THIS sucker could go down.” George Bush’s verdict during the worst of the financial crisis a year ago was crude but penetrating. Barack Obama, delivering a speech in New York on September 14th to mark the anniversary of Lehman Brothers’ failure, managed the opposite trick. He produced plenty of elegant phrases but little that was new, and quite a bit that was confusing.

How can one argue for both extending financial services to those unserved and for regulations to prevent this sort of thing? How can one argue that future bailouts will not cost taxpayers? The tone is serious but the arguments are not.

The intricacies of bank reform were never likely to get a thorough airing in a set-piece political speech. But the casual listener to Mr Obama’s oratory might conclude that the crisis occurred because there were no regulations, that big banks would be allowed to fail in the future and that the proposed constraints of finance will create a new age of prosperity. (They would also think that the incomprehensible decision on Friday to impose tariffs on Chinese tyre imports was designed to save free trade.) The truth is far messier. Reform is badly needed, but people will still be greedy, banks will still need saving and a more stable system will entail less credit flowing through it. Mr Obama is eloquent but too often he does not tell it like it is.

That last part just about says it.

The Real Lehman Shock

The real Lehman shock, according to Dan Gross, is the impact it had on the rest of the world. By its impact on the commercial paper market, Lehman's collapse had a devastating effect on world trade.

Yes, the United States had been in recession since the beginning of 2008. But world trade had held up quite well. But after the Lehman shock, all world trade began to shrink rapidly. Starting in September 2008, the volume of world trade began to plummet sharply. As the World Trade Organization reported in March, "the months since last September have seen precipitous drops in global production and trade, first in the developed economies, then in developing ones as well." In late 2008, world trade was contracting at a 40 percent annual rate. In Japan, exports, which had held up well in 2008, fell 57 percent between August 2008 and January 2009. (Go here and click on "exports.") Through the first half of 2009, they were down nearly 40 percent from the first half of 2008. In Germany, exports in July 2009 were 25 percent below the level of July 2008. China's exports have fallen, too, although less dramatically.

Also, interesting is this report that bankruptcy courts in England are still working on the Lehman collapse.

Lehman Brothers' European clients and creditors could have to wait another two years before they get back billions of dollars of assets tied up in the bank when it collapsed a year ago.

Tony Lomas, partner at PwC and administrator for the bank's European operations, said he had hoped to have "broken the back" of the case by this time next year, substantially reconciling claims, returning assets to clients and putting in place a process for paying dividends to unsecured creditors.

As Tyler Cowen notes, one should think about this delay when arguing that a bankruptcy of a large interconnected bank would be superior to the bailout.

The Economist has an interesting article on how the post-Lehman world of finance may shape up.

Lehman and Pearl Harbor

Joe Nocera writes in the NYTimes that the failure of Lehman Brothers, one year ago, actually saved the global financial system. Basically, the consequences shocked the authorities so much they made sure that AIG and then Citigroup were bailed out.

Part of the explanation is that the aftershock of Lehman's failure jarred Paulson and Benanke sufficiently that any worry about moral hazard was pushed away. More important, however, was the impact on Congress, which made it possible to get the TARP passed.

In the months between Bear Stearns and Lehman Brothers, Mr. Paulson and Mr. Bernanke had approached Congressional leaders about the need to pass legislation that would give them a handful of additional tools to help them deal with a larger crisis, should one ensue. But they quickly realized there was simply no political will to get anything done. After Lehman, however, Mr. Paulson and Mr. Bernanke were able to persuade Congress to pass a bill that gave the Treasury Department $700 billion in potential bailout money — which Mr. Paulson then used to shore up the system, and help ease the crisis. Even then, it wasn’t easy; it took two tries in the House to pass the legislation. Without the crisis prompted by the Lehman default, it would have been impossible to pass a bill like that.

In a sense, Lehman's collapse was like Pearl Harbor. Despite the Nazis trying to take over the world Congress would not allow the US to enter the war. Pearl Harbor shocked the political system sufficiently to get the US to enter in time.

Social Insurance

Uwe Reinhardt has an interesting article which discusses financial bailouts in the context of social insurance. There are many different types of social insurance that we benefit from, but some types are more "politically acceptable" than others. As he notes:

Why is it the American way that I in New Jersey should feel obliged to give financial help to a family whose beach house in Mississippi was blown down by a hurricane, but it is socialist and un-American to help a Mississippi woman struck by breast cancer?

When financial institutions got in trouble -- think Bear Stearn, Bank of America, Citigroup -- they ran to the government for a bailout.

The financial markets had prided themselves on their expertise in pricing and managing financial risk prudently. But left on their own, they proved that they could not even manage properly as simple a transaction as a mom-and-pop mortgage loan, let alone fancy derivatives such as the collateralized debt obligations (C.D.O.’s) that were based on sloppily-written mortgage loans and the credit-default swaps (C.D.S.’s) meant to insure the value of these C.D.O.’s, but without adequate reserves to back up that credit insurance.

In the end, like teenagers who hate Mother’s strictures when all is well, but run to Mommy whenever they get in trouble, the swashbuckling oligarchs of the financial sector ran to government for cover, owning up once again to the time-honored mantra of this country’s legendary rugged individualists:

When the going gets tough, the tough run to the government.

Another term for “government risk management,” of course, is “social insurance.”

Why are some forms of social insurance more acceptable than others? Is it just politics?

From Financial Crisis to Debt Crisis?

Ken Rogoff wonders if government efforts to ameliorate the financial crisis will lead us to a debt crisis. He makes an important point that even economies with unsustainable levels of debt can plod along for a while before the sudden stop occurs:

Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning.

It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible.

A good analogy is the prediction of heart attacks. A person who is obese, with high blood pressure and high levels of cholesterol, is statistically far more likely to have a serious heart attack or stroke than a person who exhibits none of these vulnerabilities.

Yet high-risk individuals can often go decades without having a problem. At the same time, individuals who appear to be ``low risk" are also vulnerable to heart attacks.

Of course, careful monitoring yields potentially very useful information for preventing heart attacks. Ultimately, however, it is helpful only if the individual is treated, and perhaps undertakes a significant change in lifestyle.

The large debts we are incurring are reducing the negative consequences of the financial crisis, but these were emergency measures. Will be able to unwind them successfully?

Will Global Imbalances Return?

Barry Eichengreen discusses whether global imbalances will return. The recession has reduced the US current account deficit through two channels. The income decline has led to reduced imports, and the destruction of household wealth has led to an increase in savings. This offset the longer-term forces that were generating current account deficits. The key question, however, is what happens after we emerge from the crisis. This is especially concerning given the large fiscal stimulus and large monetary stimulus that have been policy reponses to the crisis. He notes:

...once American households rebuild their retirement accounts, they may return to their profligate ways. Indeed, the Obama administration and the Federal Reserve are doing all they can to pump up US spending. The only reason the US trade deficit is falling is that the country remains in a severe recession, causing US imports and exports to collapse in parallel.

With recovery, both may recover to previous levels, and the 6%-of-GDP US external deficit will be back. In fact, there has been no change in relative prices or depreciation of the US dollar of a magnitude that would augur a permanent shift in trade and spending patterns.

The answer depends a lot on decisions outside the US. For example, will China continue to lend to the US. A disaster could arise if China turns away from holding US assets. He concludes:

There are two hopes for avoiding this disastrous outcome. One is relying on Chinese goodwill to stabilize the US and world economies. The other is for the Obama administration and the Fed to provide details about how they will eliminate the budget deficit and avoid inflation once the recession ends. The second option is clearly preferable. After all, it is always better to control one’s own fate.

Capitalism After the Crisis

A very interesting article by Luigi Zingales on capitalism after the crisis. He discusses a broader problem than we usually consider:

The nature of the crisis, and of the government's response, now threaten to undermine the public's sense of the fairness, justice, and legitimacy of democratic capitalism. By allowing the conditions that made the crisis possible (particularly the concentration of power in a few large institutions), and by responding to the crisis as we have (especially with massive government bailouts of banks and large corporations), the United States today risks moving in the direction of European corporatism and the crony capitalism of more statist regimes. This, in turn, endangers America's unique brand of capitalism, which has thus far avoided becoming associated in the public mind with entrenched corruption, and has therefore kept this country relatively free of populist anti-capitalist sentiment.

This is, indeed, an issue of long run concern.

Housing Again?

A new wave of housing defaults is in the offing according to this article in the New York Times.

Experts predict a steady drumbeat of defaults over much of the next decade as these interest-only loans mature. Auctioned off at low prices, those foreclosed houses could help brake any revival in home prices.

Interest-only loans are not the only type of exotic mortgage hanging over the housing market. Another big problem is homeowners with “pay option” loans; in many of these loans, principal balances are actually increasing over time.

Still, interest-only loans represent an especially large problem. An analysis for The New York Times by the real estate information company First American CoreLogic shows there are 2.8 million active interest-only home loans worth a combined total of $908 billion.

The interest-only periods, which put off the principal payments for five, seven or 10 years, are now beginning to expire. In the next 12 months, $71 billion of interest-only loans will reset. The year after, another $100 billion will reset. After mid-2011, another $400 billion will reset.

In a sense people with interest-only loans were really renters. They had no real equity in their homes. They were renting with an option to buy if the appreciation of home prices made their gamble pay off. But with housing prices tanking the option is no longer in the money. The problem for such people is that with the option out of the money their rent goes way up. Normally, if the rent is raised dramatically a household can move. But these people are locked in to a much greater extent, at least to the worth of their credit reputation, which will be destroyed when they default.

I guess the unknown here is how large the impact of these defaults will be on the economy as a whole. Presumably most of the shocks to the financial system have already been taken. All securitizations in the housing sector have taken hits. The major impact would be on a recovery in home prices.

Dollar Falls Some More

Improved investor sentiment about the world economy seems to be leading to the dollar falling in value.

You can see here that the initial rally happened after Bear Stearns collapsed, and that it accelerated after Lehman's collapse, really after the TARP legislation was first rejected by Congress.

If the world economic crisis is receding then the value of the dollar as a safe haven is less important, and long-term fundamental factors begin to drive investor behavior.

Economics and the Crisis

Paul Krugman has a long article discussing the role of economists in the crisis. Krugman argues that macroeconomics has gotten it very wrong. His basic indictment:

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, thatstocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

The explanation is becoming fairly conventional. The problem is that mathematization of the field.

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.

The article is worth reading in full, but Krugman's attack lacks focus I think. His attack is too broad, and thus the worthy parts are offset by the desire to blame everything he does not like.

For example, it is just not fair to argue that economists accepted the efficient markets hypothesis or the belief in market efficiency for personal gain:

The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

What about the evidence from financial markets that demonstrates the difficulty of beating the market? Most empirical studies, especially the early ones, were quite clear on this (see, for example, here). This is especially true for the weak form of the hypothesis that says that asset prices incorporate all publicly available information.

Krugman also mis-characterizes why fresh-water and salt-water economists reconciliated. He writes:

Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed.

This misses the story. What happened is that fresh-water economists started to incorporate market frictions in their models, especially those that come from search. Meanwhile, salt-water economists adopted the methodology, using dynamic models with optimizing agents to study economies with other types of market frictions. An agreement to study the quantitative effects of policies made it easier for macroeconomists to talk. This is much closer to what happened.

How about Krugman's claim that macroeconomists should have predicted the crisis?

In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst.

Of course it is not really clear that Shiller actually predicted that housing prices would decline nationally, as Falkenblog has noted. Moreover, a bubble continues precisely because the belief that asset prices follow a bubble is not common knowledge. Once it becomes common knowledge traders sell against the bubble. The bubble continues precisely because nobody knows when enough agents realize this. This is the important lesson from Abreu and Brunnermaier (the latter is Krugman's colleague, so he should be aware of this). Now suppose that there is a difference of opinion concerning the likelihood we are on a bubble path. What are policymakers to do? If they try to prick the bubble they will be blamed for the consequences. There is a political agency problem here.

The person who gets the most credit for predicting the crisis is Nouriel Roubini. He did predict crisis, the one that many economists did expect. But that was a currency crisis due to our excessive current account deficits. This was quite a rational fear. As for the excessive risk in the banking system, it seems that Raghuram Rajan was the only major economist who talked about this (there was some very good work at the BIS that was also ignored). And as Krugman notes in his article, when Rajan made these warnings even Larry Summers belittled him. Why was this the case? I suspect that most economists understood the basics of securitization, but could not believe how much of the CDO's banks were keeping on their books or in special investment vehicles they were responsible for. Since the latter are off-balance sheet, they are precisely organized to fool analysts.

What economists did miss is an important point made by Posner in his book, A Failure of Capitalism. Suppose we have regulations that prevent some type of crisis. Over time, if the policies are successful, the likelihood of seeing a crisis will recede. So the benefits of the regulations will be less apparent. But the costs of the regulation will not be reduced. So a cost-benefit analysis of beneficial regulations will seem to signal inefficiency. This increases the political support for eliminating the beneficial regulations. And this will make a crisis more likely.

This leads to another interesting point about economics. Normally economics works through negative feedback loops. When demand for a good falls so does its price. The fall in the price reduces the extent of the fall in sales and signals producers to produce other things. Negative feedback is what makes the equilibrium hypothesis useful. But what happens when the economy is so far out of kilter that we have positive feedback loops? This is what happened when the housing bubble burst. The fall in asset prices led to a deterioration of bank balance sheets and less lending. This hurt investment and production and incomes declined. So people could not purchase homes that were much cheaper. This is positive feedback, and it is what turned the asset bubble into the great recession.

Notice that after many asset bubbles burst negative feedback loops operated. Think of the 1987 crash or the end of the tech bubble. These had little economy-wide effects because of negative feedback. But in rare cases we do get positive feedback. Yet if these cases are so rare most of the data we operate with will not display it. So most of our experience, and most of our analysis will be conducted using data generated by negative feedback behavior. It is not surprising that we are not well-prepared for positive feedback loops. If we were it would mean we had experienced many more crises.

One could then blame economists for focusing so much on normal times and ignoring how the economy works outside the corridor (see my previous post on the Corridor hypothesis). But given how rare depressions have been was this such an unwise strategy?

Another important point Krugman makes is that macro failed to incorporate finance sufficiently. This is an important criticism, but I doubt the reason is the efficient markets hypothesis. It stems much more from the use of representative agent models. These make it hard to model finance. I think it is the complexity rather than the obtuseness of economists that led to this result.