Dark Ages of Macro

Krugman has a piece on the Dark Age of Macro that must be linked to. So here goes.

It is partly a comment on John Cochrane's essay. The critics focus on John for this comment:

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both¹ . This is just accounting, and does not need a complex argument about “crowding out.”

But if you read the whole essay you see that there is a lot of very good stuff in here. Including a very important diagnosis of what the real cause of the crisis -- essentially an excess demand for US Govt Debt (bonds and money). People have fled private debt for public debt because of a sudden explosion of risk aversion. In this setting aggregate demand is low precisely because people want to hold more public debt. Cochrane argues that fiscal stimulus potentially could work in this situation, but he points out that once people's preference return to normal we are going to have a lot more public debt outstanding than we can handle. So his preference is for policies that can be reversed when needed:

In sum, there is a plausible diagnosis and a logically consistent argument under which fiscal stimulus could help: We are experiencing a strong portfolio and precautionary demand for government debt, along with a credit crunch. People want to hold less private debt and they want to save, and they want to hold Treasuries, money, or government-guaranteed debt. However, this demand can be satisfied in far greater quantity, much more quickly, much more reversibly, and without the danger of a fiscal collapse and inflation down the road, if the Fed and Treasury were simply to expand their operations of issuing treasury debt and money in exchange for high-quality private debt and especially new securitized debt.

This is a much more subtle argument than the first quoted paragraph suggests. It shows that one should always read the whole essay.

More on TARP

Joe Nocera argues that the first formulation of the TARP was correct. The basic problem is to get the bad assets out of the banking system. Recapitalization made Gordon Brown a hero, and it prevented a deepening of the crisis, but lending will not start till the toxic assets are removed. I thought that this was the lesson we learned from Japan in the 90's.

The only quibble is that what we have to do is not the original TARP. The problem there was that they wanted to buy toxic assets. The correct solution is to take over the problem banks and corral the assets in a new RTC. Nocera actually argues this. But the important point seems to be that nobody was comfortable with an RTC-type solution in September. That is because there was not a wide enough recognition of the size of the losses.

Now that Nouriel Roubini has further revised upwards his estimate of total writedowns it may finally convince the powers that be that RTC is the way to go. Here is the money shot:

We have now revised our estimates and we now expect that total loan losses for loans originated by U.S. financial institutions will peak at up to $1.6 trillion out of $12.37 trillion loans . Our estimates assume that national house prices will fall another 20% before they bottom out some time in 2010 and that the unemployment rate will peak at 9%. If we include then around $2 trillion mark-to-market losses of securitized assets based on market prices as of December 2008 (out of $10.84 trillion in securities), total losses on the loans and securities originated by the U.S. financial system amount to a figure close to $3.6 trillion.

Will people start to believe Dr. Doom now?

Fiscal Stimulus

Paul Krugman is annoyed at the opposition to fiscal stimulus plans that are couched in bad macro. I have to agree with him. As he notes:

There are certainly legitimate arguments against spending-based fiscal stimulus. You can worry about the burden of debt; you can argue that the government will spend money so badly that the jobs created are not worth having; and I’m sure there are other arguments worth taking seriously.

What’s been disturbing, however, is the parade of first-rate economists making totally non-serious arguments against fiscal expansion. You’ve got John Taylor arguing for permanent tax cuts as a response to temporary shocks, apparently oblivious to the logical problems. You’ve got John Cochrane going all Andrew-Mellon-liquidationist on us. You’ve got Eugene Fama reinventing the long-discredited Treasury View. You’ve got Gary Becker apparently unaware that monetary policy has hit the zero lower bound. And you’ve got Greg Mankiw — well, I don’t know what Greg actually believes, he just seems to be approvingly linking to anyone opposed to stimulus, regardless of the quality of their argument.

It seems very weird that such excellent economists would make such bad arguments. Why not just argue political economy or corruption or debt. But to argue that fiscal stimulus cannot have an impact on aggregate employment in a deep recession when monetary policy is tapped out seems bizarre to me.

Mark Thoma has had some good columns on this too, and Brad DeLong has a nice web paper.

Citigroup Value

Felix Salmon has a chart that shows the decline in the market capitalization and book value of Citigroup. The key point is:

The problem is that the blue bar (book value per share) can't fall much further, without Citigroup breaking minimum capital adequacy requirements. In fact, Citi is skating so close to its regulatory minimums right now that it's almost impossible not to suspect that a large part of where it's marking its assets is a function of where the CFO needs the company's book value to be.

It looks like only a matter of time before it becomes insolvent.

TARP Distributions and Politics

The Wall Street Journal reports on how TARP funds have been disbursed based on political influence. A bank that Rep Barney Frank had ties to received funds even though much larger banks did not.

The Treasury had said it would give money only to healthy banks, to jump-start lending. But OneUnited had seen most of its capital evaporate. Moreover, it was under attack from its regulators for allegations of poor lending practices and executive-pay abuses, including owning a Porsche for its executives' use.

Nonetheless, in December OneUnited got a $12 million injection from the Treasury's Troubled Asset Relief Program, or TARP. One apparent factor: the intercession of Rep. Barney Frank, the powerful head of the House Financial Services Committee.

Alabama banks have done well because of political connections as well. This is hardly a surprise. A better solution has to be found. This will be some type of RTC-bank that takes over all the bad assets and wipes out the shareholders of the banks with toxic assets. Nationalization and then privatization seems in the offing.

Saving the Banks

Some ideas for a comprehensive solution for the banking crisis are discussed in this article by Joe Nocera in the NYTimes. An important point is that until we know the extent of the losses in the banking system it will continue to rely on government funding. But banks are reluctant to recognize losses until they know they will be able to survive the shock. One type of solution is then an RTC type bank to buy all the bad assets. Sounds like TARP? But how to determine the value?

Bank Bailouts and Losses

Representative Barney Frank and many others complain that recipients of TARP funds have hoarded funds rather than issue new loans. I find this argument perplexing. If there was a huge demand for credit that is going unfulfilled, perhaps it makes sense. But as we spiral into a Keynesian recession the demand for credit, at least by able borrowers, has fallen significantly. De-leveraging is taking place because banks are not sure if anybody else is credit-worthy. Since the banks got in trouble by lending too much it is not surprising that they hold reserves to maintain some semblance of solvency.

And then we read, in today's Post for example, that unexpectedly large bank losses are complicating the federal government's rescue plans. As they note:

The problems are intensifying the pressure on the incoming Obama administration to allocate more of the $700 billion rescue program to financial firms even as Democratic leaders have urged more help for distressed homeowners, small businesses and municipalities. Senior Federal Reserve officials said this week that the bulk of the money should go to banks.

This should hardly be a surprise. Given the massive de-leveraging we are experiencing, and the fact that a new wave of foreclosures are coming. Moreover, it is not clear that all of the troubled banks have recognized their losses yet. Under these conditions would you lend?

Lena Goldfields in Venezuela

Today's NYTimes has an article about Hugo Chavez welcoming western oil companies back, and the oil companies hurrying to get in. It smacks of Lena Goldfields all over again. See my previous post on that episode.

Nature of the Financial Crisis

Axel Leijonhufvud has a very insightful article on the causes of the financial crisis. The basic point of departure is the difference between positive and negative feedback systems. Typically markets display negative feedback: when demand exceeds supply price tends to rise. This restores equilibrium. A thermostat is a negative feedback system, it stabilizes the temperature in your house. Positive feedback systems can lead to bubbles. Leijonhufvud explains how the monetary system and the financial system took on features of positive feedback.

Leijonhufvud also has important things to say about the process of deleveraging. His conclusion is not rosy:

American households are also fairly highly levered at this time and virtually the only way for them to reduce debt is to increase their saving. The fall in business investment combined with the increase in attempted saving by households will, under present financial conditions, produce the kind of recession that John Maynard Keynes theorised about. The automatic adjustment tendencies of free markets are peculiarly ineffective in producing a recovery from a recession of this type.

Fiscal Stimulus

In the NYTimes David Brooks discusses the Romer's research showing that monetary policy, not fiscal policy, is the preferred solution to recessions. This is a consistent theme in recent discussion. But what this discussion all ignores is Leijonhufvud's corridor hypothesis, which I discussed in an earlier post. The key point is that the economy works differently when inside the corridor of normal behavior. Then neoclassical relations hold. In depression-like circumstances, on the other hand, we are outside the corridor. It is not at all clear that relationships that hold inside the corridor hold outside as well.

The point of Keynesian economics is thus really about Depression conditions. Then monetary policy is relatively useless because businesses fail to invest not because of the cost of capital but because of fear of the future. It is crucial to keep the corridor analysis in mind these days. Ignoring it is ignoring the Lucas Critique.

Acemoglu on the Financial Crisis

Daron Acemoglu has written an essay on the financial crisis and what it means for economics. Always important to read what he says. Comments will appear later.

Simon Johnson talked about the financial crisis in his Presidential Address to ACES in San Francisco. Here he comments on Acemoglu's paper. Johnson's paper will appear in Comparative Economic Studies. This address is a very important event, especially as I gave the first Presidential Address to ACES.

India's Ponzi Scandal

Joe Nocera reports on an Indian version of the Madoff scandal. A respected entrepreneur is forced to reveal that his company has no assets. When credit was cheap he could borrow against shares to fund the company. With the credit crisis this is no longer possible and he has to report the fraud. The common thread is that easy credit allows one to cover up holes in balance sheets. The credit crisis -- which is trully global -- prevents this.