As Paul Krugman Says, the Stock Market Is Not the Big Problem

The flow of finance to expanding companies--or, rather, the not-flow of finance to companies that ought to be expanding employment--is the problem.

Paul:

Dow 9,000!: Stock prices are, however, the least of our worries. The money markets are frozen; the TED spread is 4.14%. G7 meeting tomorrow, IMF-World Bank over the weekend. Now is the time for major action — an announcement of coordinated capital injections, liquidity measures, and more. If we’ve had nothing except vague assurances by Monday...

Let me repost this:

The Wrong Financial Crisis

J. Bradford DeLong
Professor of Economics, U.C. Berkeley
Research Associate, NBER

delong@econ.berkeley.edu

October 8, 2008

We—all of us from Nouriel Roubini to Lawrence Summers to John Taylor to Tim Geithner (except perhaps Ben Bernanke, who really did seem to believe in a long-run global savings glut)—were expecting a very different financial crisis. We were expecting the Balance of Financial Terror between Asia and America to collapse and produce chaos. We were expecting a free fall in the dollar’s value that would push and be pushed by large-scale capital flight from America that would produce high interest rates and a collapse of construction and investment. We were expecting a collapse of imports into the United States that would produce a free fall in employment and in political stability in Asia. We expected the Federal Reserve and the U.S. Treasury to be powerless—for we expected the safe asset that banks and investors would scramble for in the chaos to be anything but U.S. Treasuries and reserve deposits at the Fed. And for the avoidance of a catastrophic balancing-down of the world economy we expected the United States to have to depend on the kindness of, well, not strangers exactly but of a disorganized congerie of national Treasuries and central banks that were unused to a world without a Kindlebergian hegemon.

We are not having that financial crisis. And it looks like we will not have that financial crisis: if the past year’s financial chaos in New York has not provoked a run on the dollar, it is hard to envision a scenario that would. Instead we are having a very different financial crisis: catastrophic failures of risk management throughout the entire banking sector have caused a relatively minor—by the standards of the global economy—collapse in housing prices in Riverside County, CA, Dade County, FL, and a few other places to freeze up global finance to a degree that has not been seen since the Great Depression. The first good thing about this situation is that it does not call for different central banks and Treasuries to do different things, but rather for them all to do the same thing in unison without fouling each other’s oars.

That should be relatively easy to arrange.

What we need right now are:

• Coordinated fiscal expansions across the globe: if the world economy is not now in something close enough to a liquidity trap to make no difference, it soon will be.
• Coordinated monetary expansions across the globe: a bank is any organization that borrows or accepts investments short and lends long; the durations of its assets and liabilities are deliberately mismatched; when the entire banking sector is insolvent at current market prices, anything that reduces interest rates all along the yield curve helps reduce the magnitude of the insolvency.
• Coordinated banking sector recapitalizations across the globe: since at least 1844 there has been broad consensus that the short-term price of safe liquidity is too important to be left to the market; now there is growing consensus that the price of risk is too important to be left to the market as well. For the government to operate on the price of risk through Operations Twist on a Galatic scale is infeasible. That means that the aggregate degree of capitalization of the banking system must become the object of policy choice. Call it socialism in one sector.

We need these now.

In an ideal world, Richard Cheney would resign, George W. Bush would appoint Barack Obama vice president, George W. Bush would then resign, and President Barack Obama would recall the congress to set it to work. We don't live in an ideal world. In a less-ideal world, this would happen on November 5. I don't think we live in a less-ideal world. But we should do what we can.

What we need in the longer term are:

• Global rules to make outsized compensation incentive-compatible; the Princes of Midtown Manhattan and Canary Wharf need to know that their fortunes will be lost if their institution blows up within a decade of their handing over operational control—only such can you make them truly long the fortunes of their firms and of the global economy rather than simply long volatility.

• More progressive global tax systems: we wish we could build a better global economic system, but we do not know how to build one that does not contain a solid safety net for plutocrats, and the systems we do know how to build are politically unsustainable unless all voters know and believe that from those who have much will be taken away.

The global market economy continues to evade all our attempts to make it foolproof—in large part because our greater fools are so ingenious. But there is not yet any requirement that this global economic downturn reach the magnitude of 1982, or even 1975.

---

From:

Barry Eichengreen and Richard Baldwin, eds. (2008), Rescuing Our Jobs And Savings: What G7/8 Leaders Can Do To Solve The Global Credit Crisis (London: CEPR: VoxEU):

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---

J. Bradford DeLong (2008), "The Wrong Financial Crisis," VoxEU (October 9, 2008):

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Comments

[CSTAR]

Could I add one more suggestion?

We build a giant statue to Ronald Reagan in some highly visible place (The Mall or on an island next to the Statue of Liberty) and then tear it down, Saddam-Hussein-statue-in-Baghdad style. Except this time we would NOT need US marines to do the tearing down.

That revolution is so over.

[JobMan]

Why not make senior executives of these companies paid through a publically viewable trust which restricts withdrawals to inflows made n (say 4) or more years earlier while the executive is at the company and to m (say 2) or more years once the executive leave the company and make it illegal to use or pledge trust holdings for any (hedging or monetizing) contract not within the trust? This allow boards to pay executives whatever they want/the market requires; however, have all boards and seniors executives clearly show what those executives are being paid, make any hedging or monetizing trades of compensation publically viewable, and make sure that senior managements truly have long-term perspectives. The trust not only makes aggressive accounting techniques/tricks harder, it strongly incentizes management to grow strong "management benches," make good succession plans, and find good future replacements for themselves both for retirement and replacement.

[CSTAR]

Pricing risk: Let $X$ be a random variable whose interpretation is a payoff function 5 minutes from now (that should give you time to read this and think) What is the value of $X$ say 2 minutes from now?

There are two problems here (1) what is the distribution of $X$ (2) even if we knew what the distribution of $X$ was, what is the price of risk? Do we even know how to quantify risk (variance? Shannon entropy of the distribution?) Conceivably both the distribution (a kind of "market based subjective probability") and the cost of risk (that is the cost of distribution of income as opposed to a deterministic one) could be determined by a market mechanism. If we have "adiabatic changes" of an equilibrium situation this mechanism probably works. Right now the market for risk has collapsed, apparently, and Delong's suggestion is entirely reasonable.

[CSTAR]

If you're a holder of the risky asset, I certainly wouldn't trust your assessment of its value. For any other observer the value of risk in this situation is meaningless. Even if you're thinking about this problem as a dynamic game which is converging to a Nash equilibrium, there has to be initialization.

What is being suggested I think in the case of an independent observer, is some other "non-market based"criterion to establish an initial estimate, as an initialization of a kind of "tatonnement" process in which a market for risk is reestablished and after which movements in price are "adiabatic". At that point I'd be willing to let the market assess risk.

Could normal banker's do this risk initialization process?Maybe, but they sure as hell are taking a long time. In the meantime, we're all going to Hell.

I don't want to go there.

[Kaleberg]

The financial sector meltdown is only a symptom. The problem is indeed a surplus of money and a lack of investment opportunity because income has not been rising as fast as productivity. (Look how much money was mobilized for the real estate bubble. Low interest rates and lax standards gave everyone an effective raise. Unfortunately, some people expected the loans to be repaid.) We can throw trillions at the financial sector, but we will have at best a tepid recovery until we can figure out a way to increase wages, or at least increase spending power. It took WWII to provide an excuse last time. Let's hope it doesn't take such a drastic impetus this time.

[Paul Yarbles]

"Point me in their direction so that I can make my offerings to celebrate their god-like nature."

God-like central bankers or god-like markets (whatever that means here!). What a f-cking false dichotomized joke. We should all grow up and quit worshiping childish gods of all kinds.

[W. Raymond Mills]

Having the government purchase stock from banks is the latest idea for how to unblock the credit markets.

This is a good idea if it is used to benefit taxpayers. To maximize the benefits to taxpayers, the government would purchase shares from those banks that are in best shape, that need the money least. These are the banks that are most likely to succeed in the futue. That would be a smart investment. This would unclog the credit markets because all parties could see which banks are most likely to be able to pay back a loan.

By these shares on the open market from other investors so as to not dilute the value of the existing shares. Buy them anonomyously. This will encourage other investors to buy. It is OK to stop the slide in market value. Make public the purchases for the past week on a regular basis.

This is a bad idea if it is used to benefit banks. To maximize the benefits to banks, the government would purchase shares from those banks that are in the worst shape, that need the money the most. Money provided to banks that are near failure would most likely be used up paying debts to other banks. This money would be spread around the whole banking system. Many of the marginal banks will fail. When they fail, all the shareholders, including the Federal Government would lose their investment. Thus, taxpayers would be out the investment and the remaining banks still standing would have additional money and no debt to taxpayers. In addition, this procedure would not result in identifying which banks are trustworthy. It would not unclog the credit markets.

[Maynard Handley]

"And it looks like we will not have that financial crisis: if the past year’s financial chaos in New York has not provoked a run on the dollar, it is hard to envision a scenario that would."

Uh, it's perfectly easy to imagine a scenario that would --- the US government takes steps that make it especially clear that US govt paper is not worth anything. The obvious step is, of course, default, but I don't think it'll come to that. More relevant is the issue of what happens when the 30 yr anti-tax-jihad hits its limits and Congress has to choose between raising taxes and cutting popular programs. My guess is that at that point their choice is the stealth tax of inflation rather than admitting to real taxes. And once it becomes clear that the US govt would rather inflate its way out of debt than repay it, US paper will be rather less popular.

OK, then. IF this is likely to happen given our current course, AND, given that we have seen that chaotic financial markets are not pretty, do we expect the US government over the next 8 yrs to do anything about it? Interesting problem. Does an Obama administration play the Clinton game (and then get screwed over by the next GOP administration) or do they conclude that the only way to throttle the anti-tax insanity is to keep spending.
(The reverse of Reaganism --- Reagan theory was, so he claimed, reduce taxes so as to shrink govt. This will be expand govt so as to raise taxes.)

All in all, however, it would make sense to plan for this scenario rather than imaging it isn't going to happen.

[Michael Turner]

"In an ideal world, Richard Cheney would resign, George W. Bush would appoint Barack Obama vice president, George W. Bush would then resign, and President Barack Obama would recall the congress to set it to work."

Ideally, yes. But I'm willing to settle for a suboptimal scenario:

(1) George W. Bush is impeached, then resigns;
(2) Richard Cheney suffers a disabling coronary immediately afterward;
(3) Nancy Pelosi appoints Barack Obama vice president;
(4) Nancy Pelosi resigns and Barack Obama appoints somebody who can stick to a script as vice president.

Really, I don't ask for more. I'm easy that way. I don't even require that Obama be sworn in on a bible still warm from Pelosi's swearing-in, with no speech from Pelosi during the whole handoff. Such golden silence would be ideal, but in an imperfect world, you can't have everything.

[donna]

Tomorrow it's Dow 8000.....

[bigTom]

I want to try to get you to step back and look at this thing from a different perspective than money. Money is simply a human artifact, numbers which society has more or less agreed upon. From a more fundamental materials perspective the case can be made that our current situtation arose as a result of: (1) We had become accustomed to exponential growth (a few percent GDP per annum), and our human economic and political systems were designed for the situation where the exponential growth rates only varies by a nominal amount. (2) As the world started to approach malthusian limits to growth, it became impossible to sustain real growth at anything near the rate required by the systems (and human expectations) that evolved for state (1). The temptation to invent gimmicks to preserve the appearance of growth became overwhelming. The financial industry began inventing all sorts of perpetual motion machines (bubble fed real estate ATMs etc), inorder to satisfy the non-negotiable demand for continuous growth. (3) Finally, the unsustain-ability of these artificial gimmicks becomes apparent, and the Ponzi schemes collapse in short order. Now, we have economists, trying to rejigger the financial system in a vain attempt to restore the initial state (1). This is a fools errand, as we no longer have the nonrenewable resource base per capita that we had during the final glory days of (1). We must recognize, upfront, that physical resource constraints are going to be a primary limitation on the future economy. Perhaps a severe global recession will mask this fact for a few years, but once growth gets going again the looming resource constraints will threaten to stop it in its tracks. The key for the future then is to change our systems, so that they can function with limited -or even declining physical resources. This means that economic efficiency with respect to the consumption of critical resources, must be a top priority. It also almost certainly means that the new economic/political system must be able to live with low -or perhaps zero growth rates.

[bunbury]

I think remuneration is a red herring here:

*Dick Fuld had most of his wealth in Lehman shares.
*The crisis is new but the remuneration pattern isn't.
*Remuneration is like it is for some good reasons - it solves part of the agency problem which may become unsolved if remuneration patterns are changed.

I don't see why the dollar crisis won't happen. Is the balance of payments getting any better? Is the US less indebted? Is the budget deficit under control? Is the manufacturing sector healthy?

[Mitchell]

Brad, I think you are still going to get the "financial crisis you expected", in some form anyway. Bretton Woods II is not definitively over yet, and it has to end. China will lead America's creditors in negotiating a new relationship - that's my prediction. It's not in their interest for America to crash and burn, but neither are they just going to keep lending money in unlimited quantity; and yet it seems to me that none of the rescue plans even address the likelihood that America's line of credit is going to dry up. For that reason, I think that even the latest round of crisis management proposals will in the end be just another King Canute exercise, though they may buy time. Ultimately a new global currency regime will have to develop; and if recent experience is any indicator, it will happen more by necessity than by design.

[jason voorhees]

Brad - what's your opinions about McCain's plan of buying up the excess inventory of homes? In principle, would dealing with the direct problems in the housing market deal with the insolvency issues? For instance, if the government simply bought up houses and destroyed them, this would deal with the falling housing prices problems, and presumably get at some of the other issues being amplified by those problems. If you have time, I'd be interested in what your thoughts are on that.

[piotr]

bigTom: I would support your starting point, that money is a convention. However, I do not think that the current crisis has "malthusian" character. Instead, two classes of nations run systematic surpluss of goods exported over goods imported, (a) oil exporters, (b) manufacturing exporters like China that have much lower labor cost than the class of nations with systematic deficit, USA, UK and few others.

Thus USA, UK and few others had to somehow convince exporters to lend them money, by offering the opportinities to "invest". As industrial investment were stagnant, the new investements were basically consumption, either direct consumption credit like credit cards, or housing, which is basically durable consumption goods. And for years wise guys were remarking that this is not sustainable, while clever guys (Bernanke is one of them) were showing holes in such obsolete thinking. Why, with a wider notion of savings, Americans did not have a deficit of savings at all!

Now we are coming back to a dull world in which people consume less that they earn, because they save something for the future, and even manage to leave some unspent savings to their children. When everybody (roughly speaking) balances books, it is hard to see how to finance the international trade deficit, although manifestly we cannot sustain our lifestyle with domestic goods alone (or goods exchanged for the domestically produced one at the current prices).

What will happen I have no idea. Ideally, the contraction will be temporary, and it will affect imports more than domestic production, but how to get from where we are now to there, I have no idea. Luckily, about half of the deficit is due to energy imports, and we can substitute imports with domestic investment in alternative energy and alternatives to energy consumption (energy saving technologies and products). And the other half could be possible too.

[RealThink]

Given that one of the three basic elements in Baldwin and Eichengreen’s proposal is "coordinated macroeconomic stimulus", which is in line with one of the "urgent and immediate necessary actions" advocated by Nouriel Roubini in his October 9 piece "The world is at severe risk of a global systemic financial meltdown and a severe global depression":

"- a massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government;"

And given that, given the weight of the economists backing this proposed course of action, it is highly likely that it will be promptly heeded, either with current or new authorities;

It is painfully clear for anyone aware of physical limits to growth - particularly of the fact that fossil fuels are finite, exhaustible resources whose global extraction rate will peak shortly if it already hasn't - that the world is facing a most critical and urgent issue: how smart or dumb, from a Hubbert's Peak-aware perspective, the forthcoming massive public works, infrastructure spending, tax rebates, etc. will be? I.e., are governments going to:
- spend on airports or railways?
- build new roads or electrified urban rail networks?
- offer tax rebates for SUVs or for efficient PHEVs?
- finance residential construction in Las Vegas or wind farm projects?

In a word, using the Easter Island model, are governments going to start a massive moai construction program or a massive reforestation program?

So, this is "the" point, and this is "the" time for all good Hubbert's Peak-aware folks to come to the aid of their country (actually planet because this is global), by speaking out as loudly as possible to influence public thinking to ensure that the forthcoming stimulus packages will be conducive to helping society withstand the oncoming descent from Hubbert's Peak and not to accelerating its collapse, this time due to shortages of physical "liquidity" that no Central Bank can provide.

[RealThink]

BTW, I agree with bigTom's comment (Oct 9 at 10:40pm). Like-minded folks might want to read http://www.theoildrum.com/node/4617

[Blissex]

«If the government simply bought up houses and destroyed them, this would deal with the falling housing prices problems, and presumably get at some of the other issues being amplified by those problems» Ahhhh a homedebtor talking his book! Unfortunately the problem is not falling house prices -- that is the solution. The problem is that house prices have become so high that buyers cannot afford them, and therefore cannot afford to keep the rising-debt Ponzi scheme working. The collapse in finance is due to a collapse in the number of people buying new mortgages with which to pay off older mortgages, and the discovery that current mortgage holders counted on their own mortgage to be paid off with a sale to someone taking on a bigger mortgage. That scheme has broken down, and the only way to fix things is to get house prices down to a level where people can afford to buy again. That is about a third of the level reached during the peak, if only because real interest rates on mortgages will have to be around three times what they were at the peak.