Grasping Reality with Both Hands

But the Economics Profession Right Now *Is* Useless...

The Economist gives us economists too much credit. It writes:

In... the idea that economics as a whole is discredited... backlash has gone far too far.... Economics is less a slavish creed than a prism through which to understand the world...

I would like to draw a distinction between economics as a way of thinking--the way good economists think, at least--and academic economics as a profession. Economics as a way of thinking is, I believe, still very valuable. But academic economics as a profession has proven itself to be not valuable at all in this financial crisis. As the Economist writes later on:

the financial crisis has blown apart the fragile consensus... [about] monetary policy... [because] in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness...

In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.

And I for the life of me cannot see what the arguments of the "purists" are. The basic quantity theory of money:

(M/P) * V(i) = Y

tells us that output depends on (a) the real money stock M/P, and (b) the velocity of money V, which (c) is an increasing function of the short-term nominal interest rate on government securities i. Fiscal policy--government deficits--change the quantity supplied of government bonds, and by supply-and-demand things that change the quantity of something change its price, and the price of government bonds is this interest rate i. It is true that Robert Barro has an argument that deficits caused by tax-law changes create offsetting changes in desired savings that neutralize the effect of increasing the supply of government bonds, but I know of no argument that claims the same for deficits caused by government-spending changes unless the goods the government buys and distributes with its spending are perfect substitutes for private consumption expenditures.

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Some more context:

Economics: What went wrong with economics: OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. And on the public stage, economists were seen as far more trustworthy than politicians. John McCain joked that Alan Greenspan, then chairman of the Federal Reserve, was so indispensable that if he died, the president should “prop him up and put a pair of dark glasses on him.”

In the wake of the biggest economic calamity in 80 years that reputation has taken a beating.... [T]heir pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”...

[T]wo central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined.... There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it. The first charge is half right. Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments were built on these ideas.

But economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the “efficient market hypothesis”. A recent ranking of academic economists was topped by Joseph Stiglitz and Andrei Shleifer, two prominent hole-pokers. A newly prominent field, behavioural economics, concentrates on the consequences of irrational actions.... But as insights from academia arrived in the rough and tumble of Wall Street, such delicacies were put aside. And absurd assumptions were added.... The charge that most economists failed to see the crisis coming also has merit. To be sure, some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of New York University and the team at the Bank for International Settlements are now famous for their prescience. But most were blindsided. And even worrywarts who felt something was amiss had no idea of how bad the consequences would be....

Macroeconomists also had a blindspot.... Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis--the sort used in many central banks--incorporate imperfections in labour markets (“sticky” wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy’s financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it.

What about trying to fix it? Here the financial crisis has blown apart the fragile consensus between purists and Keynesians that monetary policy was the best way to smooth the business cycle. In many countries short-term interest rates are near zero and in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness....

[T]here is a clear case for reinvention, especially in macroeconomics.... [A] broader change in mindset is still needed. Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.

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The other-worldly philosophers: [M]acroeconomists were not wholly complacent. Many of them thought the housing bubble would pop or the dollar would fall. But they did not expect the financial system to break. Even after the seizure in interbank markets in August 2007, macroeconomists misread the danger. Most were quite sanguine about the prospect of Lehman Brothers going bust in September 2008.

Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.... For Mr Krugman, we are living through a “Dark Age of macroeconomics”, in which the wisdom of the ancients has been lost.

What was this wisdom, and how was it forgotten? The history of macroeconomics begins in intellectual struggle. Keynes wrote the “General Theory of Employment, Interest and Money.”... [The] classical mode of thought held that full employment would prevail, because supply created its own demand... whatever people earn is either spent or saved; and whatever is saved is invested in capital projects. Nothing is hoarded, nothing lies idle. Keynes... [thought] investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity-preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply.... The Keynesian task of “demand management” outlived the Depression, becoming a routine duty of governments... aided by economic advisers.... [T]heir credibility did not survive the oil-price shocks of the 1970s. These condemned Western economies to “stagflation”, a baffling combination of unemployment and inflation, which the Keynesian consensus grasped poorly and failed to prevent.

The Federal Reserve, led by Paul Volcker, eventually defeated American inflation in the early 1980s, albeit at a grievous cost to employment. But victory did not restore the intellectual peace. Macroeconomists split into two camps.... The purists... blamed stagflation on restless central bankers trying to do too much. They started from the classical assumption that markets cleared, leaving no unsold goods or unemployed workers. Efforts by policymakers to smooth the economy’s natural ups and downs did more harm than good.... [P]ragmatists... [saw] the double-digit unemployment that accompanied Mr Volcker’s assault on inflation was proof enough that markets could malfunction. Wages might fail to adjust, and prices might stick. This grit in the economic machine justified some meddling by policymakers. Mr Volcker’s recession bottomed out in 1982. Nothing like it was seen again until last year. In the intervening quarter-century of tranquillity, macroeconomics also recovered its composure. The opposing schools of thought converged.... For about a decade before the crisis, macroeconomists once again appeared to know what they were doing....

[Willem] Buiter... believes the latest academic theories had a profound influence.... He now thinks this influence was baleful... a training in modern macroeconomics was a “severe handicap” at the onset of the financial crisis, when the central bank had to “switch gears” from preserving price stability to safeguarding financial stability. Modern macroeconomists worried about the prices of goods and services, but neglected the prices of assets. This was partly because they had too much faith in financial markets....

Before the crisis, many banks and shadow banks... believed they could always roll over their short-term debts or sell their mortgage-backed securities, if the need arose. The financial crisis made a mockery of both assumptions. Funds dried up, and markets thinned out. In his anatomy of the crisis Mr Brunnermeier shows how both of these constraints fed on each other, producing a “liquidity spiral”. What followed was a furious dash for cash, as investment banks sold whatever they could, commercial banks hoarded reserves and firms drew on lines of credit. Keynes would have interpreted this as an extreme outbreak of liquidity-preference.... But contemporary economics had all but forgotten the term....

In the first months of the crisis, macroeconomists reposed great faith in the powers of the Fed and other central banks.... Frederic Mishkin... presented the results of simulations from the Fed’s FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model... [because] the Fed would respond “aggressively”, by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a “manageable level”. Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists’ faith in monetary policy. Unfortunately, they are also horribly divided about what comes next.

Mr Krugman and others advocate a bold fiscal expansion... stimulating resources that might otherwise have lain idle.... Mr Barro thinks the estimates of Barack Obama’s Council of Economic Advisors are absurdly large. Mr Lucas calls them “schlock economics”, contrived to justify Mr Obama’s projections for the budget deficit....

Economists were deprived of earthquakes for a quarter of a century. The Great Moderation, as this period was called, was not conducive to great macroeconomics. Thanks to the seismic events of the past two years, the prestige of macroeconomists is low, but the potential of their subject is much greater. The furious rows that divide them are a blow to their credibility, but may prove to be a spur to creativity.

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Financial economics: Efficiency and beyond: IN 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them. And trying to beat the market was a fool’s errand for almost everyone. If the information was out there, it was already in the price.

On such ideas, and on the complex mathematics that described them, was founded the Wall Street profession of financial engineering. The engineers designed derivatives and securitisations, from simple interest-rate options to ever more intricate credit-default swaps and collateralised debt obligations. All the while, confident in the theoretical underpinnings of their inventions, they reassured any doubters that all this activity was not just making bankers rich. It was making the financial system safer and the economy healthier.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics. That verdict is too simple. Granted, financial economists helped to start the bankers’ party, and some joined in with gusto. But even when the EMH still seemed fresh, economists were picking holes in it.... Academia thus moved on, even if Wall Street did not.... The EMH, to be sure, has loyal defenders. “There are models, and there are those who use the models,” says Myron Scholes, who in 1997 won the Nobel prize in economics for his part in creating the most widely used model in the finance industry—the Black-Scholes formula for pricing options. Mr Scholes thinks much of the blame for the recent woe should be pinned not on economists’ theories and models but on those on Wall Street and in the City who pushed them too far in practice.

Financial firms plugged in data that reflected a “view of the world that was far more benign than it was reasonable to take, emphasising recent inputs over more historic numbers,” says Mr Scholes. “Apparently, a lot of the models used for structured products were pretty good, but the inputs were awful.” Indeed, the vast majority of derivative contracts and securitisations have performed exactly as their models said they would. It was the exceptions that proved disastrous.... Even as financial engineers were designing all sorts of clever products on the assumption that markets were efficient, academic economists were focusing more on how markets fall short....

Behavioural economists were among the first to sound the alarm about trouble in the markets. Notably, Robert Shiller of Yale gave an early warning that America’s housing market was dangerously overvalued. This was his second prescient call. In the 1990s his concerns about the bubbliness of the stockmarket had prompted Alan Greenspan, then chairman of the Federal Reserve, to wonder if the heady share prices of the day were the result of investors’ “irrational exuberance”. The title of Mr Shiller’s latest book, “Animal Spirits” (written with George Akerlof, of the University of California, Berkeley), is taken from John Maynard Keynes’s description of the quirky psychological forces shaping markets. It argues that macroeconomics, too, should draw lessons from psychology. “In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. Mr Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”...

One task, also of interest to macroeconomists, is to work out what central bankers should do about bubbles—now that it is plain that they do occur and can cause great damage when they burst. Not even behaviouralists such as Mr Thaler would want to see, say, the Fed trying to set prices in financial markets. He does see an opportunity, however, for governments to “lean into the wind a little more” to reduce the volatility of bubbles and crashes. For instance, when guaranteeing home loans, Freddie Mac and Fannie Mae, America’s giant mortgage companies, could be required to demand higher down-payments as a proportion of the purchase price, the higher house prices are relative to rents. Another priority is to get a better understanding of systemic risk, which Messrs Scholes and Thaler agree has been seriously underestimated. A lot of risk-managers in financial firms believed their risk was perfectly controlled, says Mr Scholes, “but they needed to know what everyone else was doing, to see the aggregate picture.” It turned out that everyone was doing very similar things. So when their VAR models started telling them to sell, they all did—driving prices down further and triggering further model-driven selling...

Global Imbalances Continue...

Lex:

FT.com / Lex / Finance & governance - China’s $2,000bn foreign reserves: It appears the great unwinding of global imbalances and the dollar’s ensuing demise are notions that belong up there with the tooth fairy. China added $178bn to its foreign reserves in the second quarter, taking its total booty past $2,000bn, the equivalent of twice the annual economic output of New York

Although there are no official statistics on how China has apportioned these new reserves, US data supports the thesis that China is not yet jettisoning the dollar, however antsy Beijing gets about the greenback’s global dominance. Even so, the pattern of China’s reserve accumulation is changing. While China is still buying more US debt, it is not necessarily doing so with cash recycled from American consumers. The sum of China’s trade surplus and foreign direct investment, the usual driver of reserve accumulation, was the lowest in three years. At about $60bn, it was also almost half last year’s quarterly average of $100bn, according to Royal Bank of Scotland. Rather, China’s hoarding is being driven by hot money.

After all, China, the world’s favourite green shoot, is back in bubble land; its reserve growth is just one indication of this. Estimates vary widely, but between $30bn and $70bn of speculative capital flowed into China in the second quarter. Some of that may be anticipating a possible revaluation of the renminbi. More likely are flows into real assets such as property or the stock market, where volumes are running at as much as three times last year’s levels. Hong Kong residents, having spent much of the past year grinding down their renminbi deposits, added more funds in May.

To mop up some of this liquidity, Beijing has started selling one-year sterilisation bills again (so far this year, the central bank has actually injected net cash into the system). Last year, it issued an estimated $170bn of these bills. Roaring reserves, a bubbly stock market and the tentative start of monetary tightening: all these recall the glory days of 2007-08. Still, don’t expect everything to return full cycle. Exports, for one, are weak. While that remains the case, renminbi appreciation is off the cards.

What, Me Worry?: Few Expected Green Shoots in the Bond Market

Paul Krugman has a chart:

and writes:

Bond panic subsiding?: Over the course of the spring there was a substantial rise in long-term interest rates; it was fed partly by talk of green shoots, but also, I suspect, by all the yelling about deficits and inflation. And, of course, the rise in rates was itself taken as evidence that inflation fears etc. were justified.

But the panic seems to be subsiding. Rates are still well above their post-Lehman lows, when credit markets were completely frozen and everyone was piling into govt. debt. But they’re low by historical standards, and not giving much ammunition to the worriers these days.

On the contrary, they are giving a significant amount of ammunition to the worriers--my brand of worriers, a different kind of worriers. We worry that the next two years are going to bring what happened after the end of the 2001 recession: something like this:

A recovery in which unemployment is higher two years later than when the recovery began is not much of a recovery. And I don't see what is going to keep the probability of such an eventuality low.

The lower are ten-year Treasury interest rates, the more are people trading in the bond market willing to bet their money that the future holds that kind of non-recovery recovery. And so I worry.

Retiring TARP Warrants: Obama's Treasury Makes a Significant Mistake

Whether or not you think that it is good for the system for banks to buyback the preferred-stock investments that the Treasury has made through the TARP program, there is no argument at all that it is good for the system to buy back the equity warrants: we want banks to have more equity capital right now, not less. If you don't want the U.S. government holding them, sell them on the open market. But don't retire them until the financial crisis is two years past.

There's at least one chance in ten that the banks will hit the wall again sometime in the next couple of years if the recession turns out to be worse than forecast, and we may once again be desperate to have the banks have as much equity as possible.

And I haven't even reached the issue of what price the warrants should be valued at: just don't do it.

David Mildenberg:

U.S. TARP Warrant Plan Favors Banks, Professor Says: Policy makers want to speed the withdrawal of the government from the banking industry, rather than attempt to maximize returns for the taxpayers by waiting for share prices to rise, Washington banking lawyer William Sweet of Skadden, Arps, Slate, Meagher & Flom said last week. “The president has clearly stated that his objective is to dispose of the government’s investments in individual companies as quickly as is practicable,” the Treasury statement said. The Obama administration gave approval in June for 10 of the biggest U.S. banks, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley, to repay $68 billion of TARP funds. When the money was first obtained, banks had to give the Treasury preferred stock plus warrants to buy stock at a future date at a specific price, called the strike price.

Wilson values JPMorgan’s warrants at $1.55 billion using the traditional method of determining how much the stock may gain in the next decade, compared with $1.33 billion set by Treasury, he said. The strike price for JPMorgan is $42.42, about 25 percent higher than yesterday’s closing price of $34.11 in New York Stock Exchange composite trading. Banks will have 15 days after retiring government stakes to propose a “fair-market value” for the warrants, the Treasury said last week. Should officials object to the estimate, up to three “independent advisers” will help set a price. If lenders don’t make an offer, the warrants will auctioned.

Negotiations as planned by Treasury open the door to political favoritism and corruption, Simon Johnson, an economist at Massachusetts Institute of Technology, said in an interview. Johnson favors public auctions. “The question is why wouldn’t you sell these on the open market and the answer is that the banks would probably lose,” he said. Treasury is bound by contracts with the banks that set out a specific negotiating process, spokesman Andrew Williams said.

Valuing the warrants may rile Congress because lawmakers including Sen. Jack Reed, a Rhode Island Democrat, have warned Treasury Secretary Timothy Geithner not to let banks buy back government stakes at discount prices. “I will be watching closely to ensure Treasury’s pricing system works both fairly and efficiently for the benefit of taxpayers,” Reed said in a June 26 statement. At least 10 smaller banks have negotiated warrant buybacks with Treasury, including First Niagara Financial Group Inc., which paid $2.7 million, according to a statement this week. It’s among the best prices Treasury has received so far, equal to 65 percent of what the warrants were actually worth, compared with an average of 48 percent for the 10 previous repurchases, Wilson said.

Burning Chrome...

Greg Farrell:

Former Goldman employee accused of cyber-theft: Law enforcement officials in the US arrested a former Goldman Sachs employee over the July 4 holiday weekend, accusing him of stealing sensitive automated trading codes and uploading them to a server based in Germany. Sergey Aleynikov, a computer programmer who joined Goldman in May 2007 and resigned last month, was arrested late Friday as he disembarked from a flight at Newark International Airport and charged the next day with theft of trade secrets and transfer of stolen property.

According to an affidavit filed by a Federal Bureau of Investigation agent in the matter, Mr Aleynikov – who held the title of vice-president at Goldman before leaving June 5 – was part of a team that developed and improved the software codes used in the firm’s computerised trading programs. Mr Aleynikov was bound by Goldman’s standard confidentiality agreements. The FBI affidavit alleges Mr Aleynikov, after accepting the offer from his new firm – which has yet to be identified – downloaded approximately 32 megabytes of proprietary trading platform data from his desktop computer at work as well as his laptop at home on four separate occasions between June 1 and June 5, his last day at Goldman.

Robert Shiller, Jeff Madrick, Teresa Ghilarducci, Brad DeLong: Animal Spirits

1. Introduction3 min 25 sec
2. Robert Shiller: Why People Didn't Foresee the Crisis4 min 8 sec
3. Comparing the Current Crisis to The Depression3 min 5 sec
4. International Economic Fears2 min 38 sec
5. Obama's Economic Challenge2 min 13 sec
6. Tracking Changes in Home Prices6 min 26 sec
7. The Psychology of Bubbles2 min 15 sec
8. Analyzing Obama's Stimulus Plans5 min 39 sec
9. Implementing Long-Term Financial Solutions4 min 27 sec
10. Strategies for Keeping People in Homes4 min 47 sec
11. Brad DeLong: The Purpose of Financial Markets2 min 25 sec
12. Problems with Financial Markets2 min 55 sec
13. Vindicating Shiller's 'Animal Spirits' Theory5 min 9 sec
14. Why Government Intervention is Necessary6 min 3 sec
15. Teresa Ghilarducci: Rethinking Retirement Planning2 min 45 sec
16. The Origins of 41(k) Plans4 min 19 sec
17. Rethinking Obama's Stance on Retirement Plans3 min 58 sec
18. Implementing 'Guaranteed Retirement Accounts'2 min 26 sec
19. Commentary by Jeff Madrick5 min 29 sec
20. Robert Shiller's Response11 min 48 sec
21. Q 0 min 8 sec
22. Q1: Increasing the Size of the Stimulus1 min 53 sec
23. Q2: Avoiding Another Bubble0 min 49 sec
24. Q3: Rethinking Housing Subsidies2 min 35 sec
25. Q4: Implementing Countercyclical Regulation1 min 52 sec
26. Q5: Regulating Shadow Banks3 min 47 sec
27. Q6: Nationalizing Banks3 min 41 sec
28. Q7: Problems with the Auto Bailout5 min 39 sec

Paying the Piper and Dancing the Tune

The investment banks want the Federal Reserve's lender-of-last-resort support without wanting its regulatory oversight. Sorry guys, it doesn't work that way.

Emanuel Derman, via James Wilmott:

Emanuel Derman's Blog: Are you bicestrian? You don't look bicestrian.: "So many riders in the Tour de France have been tossed out because of drugs, the overall leader is now a delivery guy from Empire Szechuan," joked David Letterman in 2007. Anyone who lives on the Upper West Side of Manhattan knows what it's like to walk across Broadway when the sign says WALK and then narrowly escape being hit by a delivery guy coming through on a bicycle. Or riding the wrong way down a one-way street.

There's a simple explanation. The delivery guys have been given the right at any time to regard themselves as either cyclists or a pedestrians. When the traffic light is green, they regard themselves as vehicles and ride. When the light is red they define themselves as a pedestrian who just happens to have wheels. They can choose whatever is advantageous at any time. Who can blame them? Life is short and they need the money.

I am reminded of this when I read rumors that some of the investment banks want to give up their bank holding company status now that their funding crisis is over.

Origins of the Current Financial Crisis

In which Barry Ritholtz encounters the unreliable Stan Liebowitz saying very strange and very false things about the mortgage market:

Zero Down Is a Foreclosure Factor: There is a kind of weird OpEd in today’s WSJ by Stan Liebowitz. The professor makes the incredible discovery that zero down payments, 100% LTV financings tend to slide in great numbers into foreclosure.... This is analysis by gross over-simplification. Not quite reductio ad absurdum, but close. Unfortunately, it leads to conclusions that are at best only partially correct. And that conclusion? The problem has been Prime, not sub-prime loans....

Here is where things get weird: I can’t verify many of [Liebowitz's] data points. They don’t square with the data I review via RealtyTrac or Mortgage Bankers Association or Bloomberg. (I assume the professor meant we had 4.3m foreclosures since Q3 2006, not during). As to prime versus sub-prime, it appears the Mortgage Bankers Association, data dispute the professor’s. Jay Brinkmann, chief economist for the MBA, noted in May 2009 that in 2008, prime, fixed-rate loans were only 19% of foreclosure starts nationwide, while Subprime adjustable-rate mortgages were 39%. More recently, the two levels have come together: prime loans are up to 29% of foreclosure starts while subprime adjustables came down to 27%.

But reporting only in percentages can be misleading. As Floyd Norris noted in August of 2008, “There are far more prime mortgages than subprime, of course, and subprime loans are much more likely to get into trouble. But this does show how the foreclosure problem is spreading.” Agreed. But the claim that during this crisis it has been Prime and not Subprime is simply unsubstantiated by the timeline or data. Subprime went bad first, then Alt-A, and then prime followed it later. Sub-prime and Alt-A went bad due to poor lending standards; Prime went bad in part due to job losses and as the economy got worse...

Krishna Guha: Please Discipline Your Headline Writers!

Krishna Guha to the orange courtesy phone, please.

The headline over your article is:

Romer Upbeat on US Economy

The quotes from the Hon. Christina D. Romer are:

• We do not want to repeat the mistake Japan made in the 1990s, when the moment things started to improve they tightened policy...

• [Stimulus spending is] going to ramp up strongly through the summer and the fall. We always knew we were not going to get all that much fiscal impact during the first five to six months. The big impact starts to hit from about now onwards...

• [Stimulus spending] should make a material contribution to growth in the third quarter...

• I am more optimistic that we are getting close to the bottom...

• I still hold out hope it will be a V-shaped recovery. It might not be the most likely scenario, but it is not as unlikely as many people think. We are going to get some serious oomph from the stimulus, there is the inventory cycle, and I believe there is some pent-up demand by consumers...

If that is what the FT calls "upbeat," what would be "downbeat"? "CEA Chair Romer advised Americans to stockpile bottled water, ammunition, gasoline, and sewing needles; and to start training for the Thunderdome"?

FT.com / US / Economy & Fed - Romer upbeat on US economy: The US economy will feel a substantial boost from the Obama administration’s emergency spending package over the next few months, says Christina Romer, a senior White House official, who has warned against tightening monetary and fiscal policy before recovery is well established. Ms Romer, chairman of the US president’s council of econ omic advisers, told the Financial Times in an interview she was “more optimistic” that the economy was close to stabilisation. But while hopeful that America could yet experience a V-shaped recovery, she said it was much too soon to begin tightening policy: “We do not want to repeat the mistake Japan made in the 1990s, when the moment things started to improve they tightened policy.”

Meanwhile, David Axelrod, a senior White House adviser, told NBC Television on Sunday the administration would be open to further stimulus if needed. “Let’s see in the fall where we are, but right now we believe what we have done is adequate to the task. If more is needed, we’ll have that discussion.”

Ms Romer’s comments come as opposition Republicans step up their attacks on the $787bn fiscal stimulus, pointing out that it has not prevented unemployment from hitting a quarter-century high of 9.4 per cent. Ms Romer said stimulus spending was “going to ramp up strongly through the summer and the fall. We always knew we were not going to get all that much fiscal impact during the first five to six months. The big impact starts to hit from about now onwards,” she said.

Ms Romer said that stimulus money was being disbursed at almost exactly the rate forecast by the Office of Management and Budget. “It should make a material contribution to growth in the third quarter.” But she acknowledged that cutbacks by states facing budget crises would push in the opposite direction. Ms Romer said the latest economic data were encouraging, following a weaker patch a month ago. “I am more optimistic that we are getting close to the bottom,” she said.

The CEA chairman, who has forecast a sharper rebound in 2010 than most economists, said she had lowered her estimates for growth this year “and also for next year, a bit” since the start of the year. She said the consensus forecast that unemployment would continue to rise for the rest of this year and peak early next year was probably accurate. But she added: “I still hold out hope it will be a V-shaped recovery. It might not be the most likely scenario but it is not as unlikely as many people think. We are going to get some serious oomph from the stimulus, there is the inventory cycle and I believe there is some pent-up demand by consumers.”

Fifty Little Herbert Hoovers Watch

The Economist's free exchange:

Fifty little Hoovers, hoovering up stimulus: MATTHEW YGLESIAS makes a good point:

Reading Harold Meyerson’s column on the looming devastation of California public services was yet another reminder of the remarkable extent to which the terrible continuing economic situation has bizarrely dropped off the political agenda. Even the whole “green shoots” debate is really about whether we can expect things to be somewhat better or somewhat worse six months out from now. In either case, things really are really bad right now. And a whole bunch of states—including large ones like California and Pennsylvania—are soon to implement substantial cutbacks in services at just the time when the objective need for social services is going up.

The American economy appears to be nearing the end of contraction. That's good news, particularly when one considers that only about 10% of the funds authorised in this year's stimulus bill has been spent; the plan is only beginning to ramp up and outlays will peak in 2010. We should expect that injection to provide the economy with a nice boost at a critical time.

On the other hand, state budget policies are sharply contractionary at this point. Despite allocations of federal aid to states, services are being cut, state employees are being laid off, and taxes are being raised in order to balance the budgets of local governments constitutionally unable to run deficits. It's not at all clear that the federal stimulus will entirely compensate for state-level fiscal tightening, which means that American fiscal policy could, on net, be contractionary.

Easy money is doing its part, of course, but the bottom line is that the fiscal boost many are expecting may not actually materialise. This will end up causing a lot of human suffering, and it may make for a long and shallow recovery—or worse, a tipping back into contraction.

Nobody thinks that it's time to go back in the water yet. And we do need a bigger stimulus.

Has Martin Wolf Been Reading too Many Comic Books?

He writes:

The cautious approach to fixing banks will not work: With one bound the banks are free...

Please Allow Me to Introduce Myself: I'm a Central Banker of Wealth and Taste...

Now other people are weighing in. Here are a bunch of smart reactions to my "Sympathy for Greenspan" piece.

First, some scene-setting:

Knut Wicksell some eighty years ago argued that the purpose of a central bank like the Federal Reserve is to manipulate the money stock so that the "market" rate of interest is equal to the "natural" rate of interest. The natural rate of interest is the rate of interest at which intended savings is equal to intended investment--at which the rewards to saving call forth enough abstinence from consumption on the part of households to equal business desires to try to make additional profits by expanding capacity.

Why have the central bank manipulate the money stock? After all, won't the market eventually get it right? Wicksell said that the key was the "eventually": if the money stock was too low then the market rate of interest would be above the natural rate, and you would have a prolonged period of unanticipated deflation (because demand for consumption and investment goods together would be below the value of production, which is equal to households' incomes) that would cause lots of unemployment until the price level had fallen enough to make desired money holdings low enough to reduce the market rate to the natural rate; if the money stock was too low then the market rate of interest would be below the natural rate, and you would have a prolonged period of inflation (because demand for consumption and investment goods together would exceed the value of production, which is equal to households' incomes) that would cause lots of unjust wealth redistributions until the price level had risen enough to make desired money holdings high enough to increase the market rate to the natural rate. Better to aid the market in its job via activist central-bank monetary policy.

Thus Wicksell gave economists and central bankers:

• a goal for monetary policy: to set the market rate of interest equal to the natural rate.
• a rationale for monetary policy: to quickly carry out the adjustments to the real money stock that the unaided laissez-faire market would carry out only slowly and painfully.
• a way to judge the central bank: it was doing its job of setting the market to the natural rate if there was neither unanticipated inflation--which would mean the market rate was too low--or unanticipated deflation--which would mean the market rate was too high.

You can think of Wicksell's insights this way: In a credit economy the market interest rate would always be equal to the natural interest rate that balances desired saving and desired investment. However, we live not in a credit but in a monetary economy in which the interest rate has to both balance supply and demand for investment and balance desired increases in people's cash holdings to the increase in the money supply. It cannot do both of those--not and keep full employment--unless the increase in the money supply is of exactly the right magnitude. The job of the Federal Reserve is thus to change us back so that even though we live in a monetary policy interest rates are as if we lived in a credit economy.

That was what Alan Greenspan was trying to do in the first half of the 2000s: to set the market rate of interest equal to the natural rate. And he succeeded: there was neither unexpected inflation nor unexpected deflation.

But was it a mistake for Greenspan to have carried out the mission that Knut Wicksell assigned him? Should he have pushed the market rate of interest above the natural rate--pushed investment, production, and employment below their credit-economy laissez-faire levels--in the interest of avoiding the growth of a housing bubble?

I don't know: http://delong.typepad.com/sdj/2009/06/three-or-four-mistakes-in-american-monetary-policy.html. But other people are willing to venture an opinion:

Mark Thoma:

Economist's View: I have argued the Fed's decision to keep interest rates low contributed to the bubble, but was not itself the sole cause of it. As to whether the Fed made a mistake, I'll just note that the tradeoff wasn't quite as stark as Brad implies, i.e. there were other policy instruments that Fed could have used to limit the housing bubble. Regulation is certainly one means the Fed had to that end, but Fed communication could have helped too. If Greenspan had, for example, told people to stay away from mortgages because they were toxic rather than implicitly encouraging them to invest in housing, things might have been different.

Would limiting the bubble through regulation, communication, or other means have limited the employment response, the primary worry? I don't think so, at least not enough to matter. The money would have been invested somewhere, housing had an opportunity cost after all, so the next best alternatives would have been pursued to the extent that they were profitable (and many would have been, just not as profitable - apparently anyway - as investing in housing and mortgages). So people still would have been employed somewhere as the money was invested, just not in housing, and that would have helped to insulate us from the housing crash. (And a lot of them might still have those jobs, unlike the people who depended upon the housing markets for employment.)

So narrowly, keeping interest rates low and employment high was the right thing to do. The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing market in pursuit of profits based upon the misperception of risk. Those resources could have been redirected into other sectors and put to productive use rather than wasted building houses nobody wants, and achieving this result did not require the Fed to aggressively raise the target rate, it only needed to use the other tools it already had available.

Unfortunately, however, those tools were not used, and the ideology Greenspan brought to the Fed played a large role in this outcome.

Michael @ Bright Rights:

Bright Rights: The causes of the financial crisis: Brad Delong has a nice post outlining some of the mistakes the government made before or during the crisis. I agree with all of the three points listed at the beginning of his article, but I disagree with his comment on Greenspan's involvement. Brad DeLong states:

On Tuesdays and Thursdays I think that going forward central bankers must now also recognize that it is imprudent to lower interest rates in pursuit of full employment when doing so risks an asset price bubble. On Mondays, Wednesdays, and Fridays I think that even with the extra information about the structure of the economy we have learned in the past two years that Greenspan's decisions in 2001-2004 were prudent and committed us to a favorable and acceptable bet. And I am writing this on a Friday.

I think before explaining my point of view, let me explain something about Alan Greenspan. Alan Greenspan believed (I don't know if he still holds this view) that central bankers should not involve themselves in asset bubbles. According to Mr. Greenspan, it is too difficult to identify when something is actually a bubble, until after it blows up. I think this is an incredibly irresponsible opinion. But I think if you are going to take the view, as Brad DeLong does at the end of his post, that Greenspan's actions were reasonable at the time, you have to take into account how Greenspan would react if he lost this bet. If an asset bubble occurs, in my opinion a central banker needs to step in and try to deflate it before it creates a crisis. However, Greenspan didn't believe in deflating bubbles; he believed in dealing with them after they blew up. Taking this view into account, it seems unreasonable to me to say Greenspan's actions were correct. I think they were only correct if he would have been willing to deflate bubbles. But we know he wasn't.

David Beckworth:

Macro and Other Market Musings: Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake: Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s: not accelerating inflation but rather deflation threatened. The natural interest rate was very low because, as Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). You can argue--and on Tuesdays and Thursdays I will believe you--that Alan Greenspan's policies in the early 2000s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity.... [A] rise in productivity growth should lead to a rise in the natural interest rate and ultimately, a rise in the federal funds rate for monetary policy to stay neutral. However, this latter development did not happen. It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria. This interpretation of events has been borne out more rigorously in this ECB paper. One a more practical level, this disequilbria comes through in the Taylor rule which similarly shows the federal funds rate was below the neutral rate during this time.

It is also worth noting that these same rapid productivity gains were the source of the deflationary pressures in 2003 that Brad mentions. Thus, these deflationary pressures did not indicate a weakening economy. In fact, aggregated demand (AD) was growing at at rapid rate in 2003-2004 which, if anything, indicated an overheating economy. The figure below shows a measure of AD, final sales to domestic purchasers, relative to the federal funds rate and has the period 2003-2004 marked off by the dotted lines (click on picture to enlarge):

The productivity gains, apparently, were offsetting the upward pressure on prices being created by the robust growth in AD at this time. There simply was no real deflationary threat in 2003. By way of contrast, this figure shows for 2008-2009 what a real AD-induced deflationary threat looks like. Regarding the saving glut theory I would recommend Menzie Chinn's post here or my previous post here...

Greg Ip:

What the regulators did wrong | Free exchange | Economist.com: BRAD DELONG catalogues the consensus on three mistakes the Fed made leading up to and during this crisis, and also gives a balanced and anguished analysis of a fourth: whether Alan Greenspan erred in keeping interest rates as low as he did.

I agree with almost everything here, in particular that it was almost impossible at the time to believe the Fed was erring in holding rates too low. (If the error was so obvious, surely more people would have pointed it out at the time, even if not a majority of people, right?) That this does not look the right decision in hindsight is because the small risk of a catastrophic financial collapse was in fact realised.

Where I do disagree, however, is his faulting abandoment of principles-based regulation, which he says allowed the shadow banking system to grow as much as it did beyond the reach of regulation. In fact, the decision to let the shadow banking system grow as large as it did was a textbook example of principles-based regulation. In most of the markets that went awry, bank regulators ran the show, and in America bank regulation is principles-based.

Regulators pride themselves on closely monitoring banks' behaviour, often from inside the banks themselves. If they get worried, they quietly tap the bankers on the shoulder and suggest they do something differently. When troubles arise, they are often handled with a nonpublic order. And when an order becomes public it is devoid of useful information, such as what the bank did wrong.

Contrast this with the SEC, which is rules-based and will make an errant broker take a perp walk in front of the TV cameras as a lesson to his peers. This different approach is precisely why, during the 2008 debate about financial modernisation, people like Hal Scott wanted a single financial regulator to adopt the approach of the bank regulators rather than that of the SEC.

This principals-based approach can be very powerful: regulators can bar a merger, ban a banker or do any number of far-reaching things. But the fact of the matter is that the bank regulators choose which principles to live by. They had countless opportunities to rein in the shadow banking system and chose not to because the most important principle guiding their action was to safeguard the depository. The Fed oversaw bank-holding companies and in theory had oversight of the off-balance sheet and non-bank activities that got banks into trouble. It chose not to exercise that oversight as long as the rest of the entity was a “source of strength” to the depository. Regulators also did not force banks to keep full capital on hand for off-balance-sheet vehicles, because to do so would've frustrated the very purpose of them: to legally segregate risky assets from the depository. In both these instances bank regulators used a principals-based approach. They simply deprioritised the principles that would prove most important. They failed to look for potential sources of systemic risk and think creatively about how things that should not have threatened the bank in theory did in practice.

This is a cautionary tale to those who call for principles-based regulation. Just how it works in practice depends on the principles being observed.

Noam Scheiber:

Are We Too Hard On Greenspan? (Hint: Probably Not.) - The Stash: I guess my problem with this analysis is that I don't think it's right to lump the years 2001-2004 together. From early 2001 to early 2003, the economy was indeed very weak, and it's hard to quibble with Greenspan's decision to ease interest rates aggressively and stay easy. But by mid-2003, the economy was growing at a decent clip. It may not have been quite at full employment, but certainly stable. And yet Greenspan lowered the fed funds rate another quarter point to an eye-popping 1 percent in June of 2003, and kept it there through June of 2004. (And though the tightening began at that point, the fed funds rate was still at a mere 2.25 percent through January of 2005.) During the four quarters between June '03 and June '04, the economy grew at a real rate of 7.5 percent, 2.7 percent, 3 percent, and 3.5 percent. So when people talk about a monetary policy mistake, I think they're generally refering to that final year of easing, not the 2001 through mid-2003 period.

The stated reason for this continued easing was that Greenspan wanted to take out an insurance policy against deflation, of which there were some mild hints at the time, though even Greenspan referred to them as remote. In retrospect, this concern was probably unwarranted, as inflation chugged along either at or well-above the Fed's implicit target through all of 2004. Worse, all the easing appears to have resulted in a massive real estate bubble.

But, as DeLong says, the question isn't whether a policymaker is wrong in retrospect. The question is whether he or she made a reasonable bet at the time. DeLong thinks maybe. I lean the other way. Here's why: DeLong's defense of Greenspan hinges on the idea that, if it turned out the Fed was wrong about the necessity of easing--so wrong it created a bubble that later popped and threatened a deflationary spiral--the Fed had enough powerful tools at its disposal to prevent a depression at that point.

Three or Four Mistakes in American Monetary Policy?

http://www.project-syndicate.org/commentary/delong91

In the circles in which I travel, there is near-universal consensus that here in America our monetary philosopher-princes have made three serious mistakes. This consensus is almost always qualified by fervent declarations that we have been very well served by our Federal Reserve chairs and others since at least Paul Volcker's accession to the chair at the end of the table in the Eccles' Building's conference room, and that each of us who has not sat in that chair knows that he or she would have made worse mistakes, but nevertheless there is a consensus that mistakes were made when:

• the Federal Reserve and the Treasury decided to nationalize AIG rather than to support AIG's counterparties last fall, allowing financiers to pretend that their strategies were fundamentally sound rather than things that would have shut down their firms had the Feds not paid AIG's bills.

• the Federal Reserve and the Treasury decided to let Lehman Brothers go into an uncontrolled bankruptcy last fall in order to try to teach financiers that having an ill-capitalized counterparty was not riskless and that people should not expect the government to come to their rescue always.

• the long-ago decision was made to eschew principles-based regulation and allow the shadow banking sector to grow unregulated with respect to its leverage and its compensation schemes in the belief that government regulation of finance should be minimal and that the government's guarantee of the commercial banking system was enough to keep us out of messes like the one we are currently in.

As I said, there is near-universal consensus in the circles in which I travel that these were mistakes and serious mistakes--and it is as certain as it is that the sun will rise in the east tomorrow morning that monetary policymakers will not make these mistakes again.

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake. Should Alan Greenspan have kept interest rates higher and triggered a much bigger recession with much higher unemployment back then in order to head off the growth of a housing bubble? If we push interest rates up, Alan Greenspan thought, millions of extra Americans will be unemployed and without incomes to no benefit--they will not enjoy the prolonged "staycations" they will be taking, and the rest of us won't have the stuff they could make. If we allow interest rates to fall, Alan Greenspan thought, these extra workers will be employed building houses and making things to sell to all the people whose incomes come from the construction sector and making things to sell to the people whose incomes come from making things to sell to people whose incomes come to the construction sector. Full employment is better than high unemployment if both can be accomplished without inflation, Alan Greenspan thought. If a bubble does develop, and if the bubble does not deflate but crashes, and if the crash threatens to cause a depression--well, Greenspan thought, then will be the time to deal with that, and the Federal Reserve is a very powerful institution with policy tools that can short-circuit that chain leading to catastrophe at any point.

With hindsight Alan Greenspan was wrong. Catastrophe does stare us in the face. His policies have crapped out. But not every good policy is certain to have a good outcome. The question is: was the bet that Alan Greenspan made a favorable one? Whenever in the future we find ourselves in a situation like 2003 should we try to keep the economy near full employment even at some risk of a developing bubble?

I am genuinely not sure which side I come down on in this debate. Central bankers have long recognized that it is imprudent to lower interest rates in pursuit of full employment if the consequence is an inflationary spiral in wages, resource prices, or consumer prices. On Tuesdays and Thursdays I think that going forward central bankers must now also recognize that it is imprudent to lower interest rates in pursuit of full employment when doing so risks an asset price bubble. On Mondays, Wednesdays, and Fridays I think that even with the extra information about the structure of the economy we have learned in the past two years that Greenspan's decisions in 2001-2004 were prudent and committed us to a favorable and acceptable bet. And I am writing this on a Friday.

I do, however, know that the way the issue is usually posed is wrong. People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level." But what is the natural level of the interest rate? Swedish economist Knut Wicksell defined the natural rate of interest in the 1920s: it is the interest rate at which, economy wide, desired investment is equal to desired savings and hence in which there is neither upward pressure for consumer price, resource price, and wage inflation to accelerate as aggregate demand outruns supply nor downward pressure on those three inflation rates as demand falls short of supply. On Wicksell's definition--which is the best, in fact, to my knowledge the only definition--the market interest rate was if anything above the natural interest rate in the early 2000s: not accelerating inflation but rather deflation threatened. The natural interest rate was very low because, as Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency).

You can argue--and on Tuesdays and Thursdays I will believe you--that Alan Greenspan's policies in the early 2000s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level. Rather, Greenspan's mistake--if it was a mistake--was his failure to overrule the market and aggressively push the interest rate up above its natural rate, thus deepening and prolonging the recession that started in 2001.

It's Friday, and I don't think Greenspan's failure to push the interest rate up above its natural rate to generate high unemployment and head off the growth of a mortgage-finance bubble was a mistake. There were mistakes--other places where the chain that has generated the catastrophe that faces us should have been interrupted. But today at least I don't think Greenspan's unwillingness to overrule the market's choice of the natural interest rate was one of them.

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Open publication - Free publishing - More wicksell

DeLong: The Simplest Possible Behavioral Finance Bubble Model

There are, I think, two big questions in behavioral finance:

1. Under what circumstances will normal, human behavior by investors produce forces in financial markets that drive them to speculative excess?

2. Under what circumstances will arbitrageurs--smart, sophisticated investors who understand what is going on--fail to help the situation much?

A first whack at trying to answer (1):

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Download now or preview on posterous

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Can the Federal Reserve Shrink the Money Stock Rapidly Now that It Can Pay Interest on Reserves?

Tyler Cowen asks:

Marginal Revolution: Paying interest on reserves, and why it should be easy to disarm future inflationary pressures. Do I believe it?

The correct answer is "maybe."

If inflationary pressure comes because banks and others regain their confidence and seek to move their excess reserve deposits into higher-yielding dollar denominated assets, then the Federal Reserve can fix that with a flick of its wrist by raising the interest rate on deposits.

If inflationary pressure comes because banks and others fear a large dollar depreciation and seek to move their excess reserve deposits into non-dollar denominated assets, then the Federal Reserve is helpless, and the situation is dire--unless the Federal Reserve has gotten the authority to issue bonds and has preemptively used that authority to mop up the excess liquidity.

Paul McCulley of PIMCO:

PIMCO - Global Central Bank Focus June 2009 Exit Strategy: Most rational investors accept the dual proposition that a Fed funds rate pinned against zero and near-$800 billion of excess reserves sloshing around the banking system are not enduringly sustainable. This is the case despite the fact that most – though a smaller most – applaud the Fed for engineering these outcomes, so as to cut off the fat tail risk of deflationary Armageddon. The consensus overwhelmingly holds that once that fat tail has been cut off and then killed, borrowing from Colin Powell’s famous description of America’s strategy for running Iraq out of Kuwait, it will be necessary for the Fed to exit its extraordinarily accommodative strategy, hiking the Fed funds rate and soaking up all those excess reserves. It’s hard to argue with the basic thrust of this exit thesis. Because it’s basically right!

I must admit, however, that I’m perplexed that so many pundits put so much emphasis on the importance of the Fed soaking up excess reserves, as if it is a necessary condition for hiking the Fed funds rate. It is not. To be sure, it used to be, before the Fed had the legal authority to pay interest on reserves, which Congress granted last fall. Before then, the only way the Fed could achieve a meaningfully positive Fed funds rate target was to constrain the supply of reserves relative to the banking system’s demand for reserves, essentially required reserves. If there were excessive excess reserves, then the Fed funds rate would fall below the Fed’s target, as banks with excess would be willing to lend them out in the Fed funds market below the Fed funds target, given that if they simply left them at the Fed, they would earn nothing. But now, the Fed pays interest on banks’ excess reserves (presently at an interest rate of 0.25%, the top of the Fed’s 0% – 0.25% target band for the Fed funds rate). Thus, logic says that banks with excess reserves will not lend them in the Fed funds market at a rate appreciably lower than the Fed pays, but simply leave them on deposit at the Fed. Accordingly, the rate that the Fed pays on excess reserves should now act as a proximate floor for the Fed funds rate, even if there are huge excess reserves in the system. Thus, by hiking the rate it pays on excess reserves, the Fed now has the ability to enforce a rising Fed funds rate target – even before it “unwinds” its bloated balance sheet....

The Federal Reserve’s approach to supporting credit markets is... credit easing... focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions.... [C]redit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.... When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market.... [T]he stance of Fed policy in the current regime – in contrast to a QE regime – is not easily summarized by a single number....

Yes, I know that many of your eyes are probably glazing over about now, given my (and Ben’s) wonkishness. I’m sorry about that, but this is really, really important stuff to understand, given the widespread yammering about the need for the Fed to have an exit strategy to de-create all the excess reserves it has created, as if they are intrinsically the kindling for an (eventual) rip-roaring inflationary fire. They are not.... [W]e can categorically say that the near-zero Fed funds rate is not, for the moment, fueling an inflationary pace of aggregate demand growth.... And neither is the Fed’s Credit Easing.... Yes, in the fullness of time, zero Fed funds could conceptually re-ignite borrowers’ and lenders’ mojo. Indeed, that’s precisely the Fed’s objective. And if and when that objective is achieved, the Fed funds rate will need to be hiked.... But right now, the least of my worries, and I think the Fed’s, too, is the prospect for an overheated economy, putting too many idled resources, both labor and industrial capacity, back to work too quickly... it would be delightful if that were our primary worry! But it isn’t....

Chairman Bernanke and a number of his colleagues have talked about all these various tools, stressing they have plenty of potential doors in their exit strategy. And indeed they do, even though simply hiking the rate the Fed pays on excess reserves is the cleanest way to hike the Fed funds rate...

Martin Wolf on the Reform of Incentives as Part of Financial Regulation

Wolf:

FT.com / Columnists / Martin Wolf - Reform of regulation has to start by altering incentives: At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely....

[B]anks are special sorts of businesses: for them, debt is more than a means of doing business; it is their business. Thus limited liability is likely to have an exceptionally big impact on their behaviour.... In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal....

A solution seems evident: let creditors lose. Rational creditors would then charge a premium for lending to higher-risk operations, leading to lower levels of leverage. One objection is that creditors may be ill-informed about the risks being run by banks they are lending to. But there is a more forceful objection: many creditors are protected by insurance backed by governments. Such insurance is motivated by the importance of financial institutions as sources of credit, on the asset side, and suppliers of money, on the liability side. As a result, creditors have little interest in the quality of a bank’s assets or in its strategy. They appear to have lent to a bank. In reality, they have lent to the state.... [C]reditors are most at risk in a systemic crisis. But a systemic crisis is precisely when governments feel compelled to come to the rescue, as they did at the end of last year....

The well-known solution is to regulate such insured institutions very tightly. But an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the “shadow banking system” itself – was to find a way round regulation....

Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part. Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives.... Regulatory reform cannot end with incentives. But it has to start from incentives...

There are three players relevant here: shareholders of banks, lenders to banks, and managers and traders of banks.

Shareholders are already on the hook to some extent: they can lose their investment. Nevertheless, there is space for reform. The natural reform I would like to try--to see what happens--would be to make financial-institution stock into par-value stock. It would work like this: If you hold a share of a regulated bank, then in a crisis the bank can call on you for an additional capital investment of up to $X. As a condition of their licenses to do business, financial institutions would be required to have outstanding equity on such terms and conditions that they can always call for half their book net worth from their shareholders.

Lenders are now largely off the hook in the event of a systemic crisis. (They are on the hook for a one-off collapse.) I think lenders need to stay off the hook in a systemic crisis--what you gain in ex ante caution you more than lose in the additional likelihood of bank runs.

Managers and traders are, however, where I would focus most of my attention. I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out--reduced in assets to their last two cars and their last four-bedroom house--if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don't see how we do it.

In My Inbox: Public Economic Argument

A corresopondent writes:

Dear Professor DeLong:

This fall I am teaching a section of the required freshman writing course at Malefactor of Great Wealth University, a course that emphasizes the analysis of argument and other related rhetorical skills, as well as instruction and practice in academic writing. All sections are organized around a single issue, and I have chosen to focus on public argument on the economy leading up to and following the events of late 2008.

I have been enjoying your blog and the fine array of links. My main question for you is this: can you recommend any good, short primers that can provide my students with enough economic literacy to be able to follow the public arguments made by, say, Alan Greenspan or Paul Krugman?

I would also be curious to know your answer to the following: What would you as an economist say to a member of the public who did not have an extensive economic education but nevertheless was trying to decide, say, what public economic policies to support? Is it a matter of picking the right experts to trust?

Thanks very much for your time and consideration!

Candidate for MA in Rhetoric and Freshman Writing Instructor
Malefactor of Great Wealth University
Sunny City, USA

My answer:

Oyyyy...

The problem is that everything I can think of takes a side (the fact that I think one side is clearly right is not of much help for your purposes)...

I can think of three things to do:

1. Set them to read, as preliminary background, one nineteenth-century book, Walter Bagehot's Lombard Street, and one early twentieth century book, John Maynard Keynes's Tract on Monetary Reform. There is a possibility of some confusion: when people today say "Keynesian" they mean late Keynes, and the Tract is early Keynes. But if that is made clear, it should work well: those two lay out pretty much all the issues and do so in a historical context divorced from today...

2. Set them to read, as preliminary background, the paperback macroeconomics half of Krugman and Wells's introductory economics textbook...

3. Set them to read, as preliminary background, the macroeconomics half of Cowen and Tabarrok's forthcoming introductory economics textbook...

As to your second question, all I can say is that I am trying as hard as I can in lots of different forums, with as best as I can see no success...

Better suggestions, guys?

Yours,

Brad DeLong

More on the Romer Symposium at the Economist

I confess that I think Alan Meltzer's contribution to the Christie Romer symposium at the Economist ill-advised for two reasons. Meltzer writes:

Romer roundtable: Think, plan, and tell us the plan: CHRISTINA ROMER... like generations of policymakers before her... counsels "trust us"... [I]t was they who allowed banks to circumvent the Basel regulations, that permitted Fannie and Freddie to expand beyond any reasonable standard, that brought us too big to fail and, as John Taylor has shown, abandoned a policy that brought us almost 20 years of the Great Moderation....

[L]ike most other defenders of this inflationary, low productivity policy, Christina puts the choice as whether we act against recession now or against inflation now. That leaves out a multitude of options.... [Y]es, stimulate now to reduce unemployment, but avoid creating a big inflation in a year or two. And even announce in advance how you propose to reduce the high money growth rate and the excessive deficits. Don't just say you'll do it, think, plan, and tell us the plan.

The first reason that it is ill-advised is that Meltzer really should not be claiming that Christina Romer is one of the "they" who "allowed banks to circumvent the Basel regulations... permitted Fannie and Freddie to expand... abandoned a policy that brought us almost 20 years of the Great Moderation..." Christie has not been doing any of these things. She has been sitting in her southeast corner office on the sixth floor of Berkeley's Evans Hall lecturing about monetary policy before, during, and since the Great Depression. If Meltzer wants to blame the actions of the American conservative politicians he has consistently voted for and the officials they appointed for our current mess, fine. But to say that Christie Romer = Phil Gramm because both are "policymakers" is simply wrong.

The second reason that it is ill-advised is that Meltzer misleads when he implies that the Obama administration and the Federal Reserve have not "announce[d] in advance how [they] propose to reduce the high money growth rate and the excessive deficits..." The Obama administration wants, as OMB Director Peter Orszag explains every hour on the hour, to balance America's long-run budget by reducing the extraordinary economic inefficiency of the American health-care system via health care reform. The fact that the people staffing the executive branch are in large part those who in the Clinton administration did such great work at bringing America's public sector back toward fiscal balance in the 1990s (but whose work was then largely undone by the American conservative politicians Alan Meltzer has consistently voted for and the officials they appointed) should give observers some confidence that they will at least try to reduce excessive deficits. At the very least Alan Meltzer should not be claiming that they have not told us how they intend to do so.

The same applies to the Federal Reserve, which Meltzer implies needs to "tell us the plan." I have found the Federal Reserve extremely eager and anxious to explain how it intends to unwind the large increase in the money supply when monetary velocity starts to recover. The basic problem, I learned back in my first year of graduate school, is that the central bank's ability to soak up excess liquidity in an economy and reduce the supply of "monnaie" is limited by its balance sheet: it needs to be able to induce banks to part with their cash by offering them something else to hold, and the Fed cannot offer what it does not itself have to trade. The solution the Federal Reserve is proposing is to allow it to create additional kinds of liabilities on its balance sheet. If congress grants the Federal Reserve the power to accept not just interest-free but interest-paying reserve deposits (which it has) and the power to issue and sell its own interest-bearing bonds (which I hope it will), then the Federal Reserve will have no trouble reducing the transactions balances that make up our monetary base when it wishes to do so. Once again, we have already been told the plan--and it is unfair to claim that Bernanke and company have not told us.

Comment for the Economist on Christina Romer (2009), "The Lessons of 1937"

Five Lessons from 1937 and Otherwhen

J. Bradford DeLong
U.C. Berkeley and NBER
delong@econ.berkeley.edu

June 17, 2009

Comment on Christina Romer (2009), "The Lessons of 1937":

Let me make five points to eliminate or refute or at least to fight against or lay down a marker that there is--well, call it "confusion" about what the right state of American macroeconomy should be.

Last December’s Unemployment-Rate Forecast and Outcome to Date

Source: Romer and Bernstein (2009).

My first point is that over the past six months the economy has been a severe disappointment. Output and employment have fallen much faster than people were projecting last December. Romer and Bernstein (2009) projected at the very start of this year that unemployment in the U.S. would reach a peak of 7.9% in the summer of 2009. But unemployment now in mid-June is about 9.7%, with 10% baked in the cake and the possibility existing that it might go much higher. The signs that the cliff-dive of employment has come to an end are very few. The level of new unemployment claims is still consistent with a rapidly-collapsing labor market nationwide.

New Weekly Unemployment Claims (Red, Right Scale, Four-Week Average) and Monthly Fall in Payroll Employment (Blue, Left Scale, Thousands)

Source: Paul Krugman.

Six months ago a net federal fiscal stimulus of about $1 trillion--$400 billion each year for about 2.5 years--seemed appropriate: that seemed to balance the benefits of filling-in the hole in aggregate demand without running too great a risk of triggering worrisome inflationary fever further down the road. Now the hole in aggregate demand is greater than was thought likely last December--about twice as great--and the likelihood of heightened future inflation is less. Thus if it was appropriate to set a $1 trillion federal fiscal stimulus in motion last December given what we knew then, if we had known then what we know now it would have been appropriate to set a roughly $2.4 trillion fiscal stimulus--$800 billion for 3 years--in motion back then.

My first point is thus that the Obama administration's federal fiscal stimulus programs are on the low side of what is appropriate by a substantial margin: this is the largest economic downturn since the Great Depression and the standard tools of expansionary monetary policy are tapped out and broken right now.

My second--related--point is that the need for federal-level fiscal expansion is reinforced by what state governments are doing right now. The federal government's discretionary actions are expanding aggregate demand by about $400 billion over fiscal year 2010, but state governments are right now cutting their spending and raising their taxes in order to offset this federal fiscal expansion more or less completely. On net, the government sector will be on autopilot as far as discretionary policy moves to stimulate the economy are concerned: federal-level expansion is offset and neutralized by state-level fiscal contraction. This is not an appropriate macroeconomic policy stance: this is the largest economic downturn since the Great Depression.

My third--unrelated--point is that the policy innovations of the past year have created a potentially dangerous weakness in the Federal Reserve system. The Federal Reserve's balance sheet has more than doubled over the past year, as it has acquired an enormous and bizarre menagerie of assets. On the liability side, it has funded this acquisition by expanding the monetary base, and has increased private-sector willingness to hold this monetary base by paying interest on reserves. This has added a fourth motive--profit--to the three traditional motives for holding reserve deposits at the Fed: the transactions demand, the emergency liquidity demand, and the speculative demand.

As long as the dollar remains the safest currency in the world, as long as the dollar remains the linchpin of the global financial system, there is no problem in the Federal Reserve's funding by what is essentially overnight borrowing the expansion of its balance sheet and the purchase of private securities that will vary up or down in market price with an eye toward holding them to maturity.

However, at some future time the dollar will cease to be the linchpin of the world financial system, in which case the Federal Reserve's financing its balance sheet via overnight borrowing will leave it vulnerable to the mother of all bank runs. It would be very good to fix this now: to give the Federal Reserve now the option to borrow not in what are essentially demand but rather in time deposits--to grant the Federal Reserve the power to issue its own bonds. This diminishes the chance of a great financial crisis in 2050 or so, with no downside that I can see.

My fourth point is the obvious one that health care is the only thing tht matters for the long run budget. The other points that the Hon. Dr Christina Romer raises, are--as is almost always the case--accurate and important. America's long-run fiscal problems are caused by health care, and will not be appreciably made worse by this half-decade's federal fiscal stimulus. If restructuring the health care system can bend the curve on the rise in overall (and hence public as well as private) health care costs, then America has ample debt capacity to borrow whatever we wish in this crisis--and to borrow it at extraordinarily favorable rates as well. If the curve of rising health-care costs is not bent, then the government's long-term finances are in trouble and so is the growth of private-sector non-health living standards: health care costs that rise as fast as CBO is projecting in the baseline cause lots of long-run economic problems, of which government fiscal bankruptcy is not the worst. Health care reform to bend the long-run curve of costs is now just what it was back in 1993: the most important issue for the American political system to deal with.

Fifth, I have the sense that the Obama administration's economic policymakers have forgotten one of the most basic lessons taught by Robert Rubin during his stewardship of economic policy during the 1990s. The lesson is to think probabilistically: to project yourself forward into the possible futures, to ask in each one what would be the actions that you would then wish you hd undertaken today, and then to actually take the appropriate action today. Looking forward into the future, (a) I see a 10% chance that something happens to create renewed cliff diving--a recession that bottoms out not with an unemployment rate in the 10-12% range that we currently anticipate but an unemployment rate that blows through 12% and keeps on rising. (b) I see a 30% chance of a rapid recovery as confidence and asset prices recover, and firms take advantage of high unemployment to hire new workers in droves at wage levels that make increasing production very profitable. But (c) I see a 60% chance of the end of the current cliff-dive in employment being followed by what happened in Japan in the 1990s, in the U.S. after 1991, in the U.S. after 2001, and to some extent in the U.S. after 1933--a recovery that does not see the market exert sufficient upward pressure on employment to return the unemployment rate to normal levels in two or three years, but that instead sees a jobless or low-job recovery during which the unemployment rate continues to drift upward for years, or falls only then to rise again.

The Obama administration's policies appear to me to be the ones that would be adopted if we believed that there was a 75% chance of scenario (b) and a 25% chance of scenario (a). But I don't think those are the probabilities. And I wonder what the Hon. Dr. Christina Romer thinks the probabilities are. For she is the one who warns of how:

[t]he 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy following an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment. Financial crises, in particular, tend to leave scars that make financial institutions, households and firms behave differently [than in normal times]. If the government withdraws support too early, a return to economic decline or even panic could follow...

The blunt fact is that the economic recoveries that have been rapid and seen fast growth in employment are those that ended when a Federal Reserve following strongly restrictionary policies to fight inflation eased off and significantly lowered interest rates. No such lowering of interest rates is possible this time--interest rates are already as low as they can possibly go at the short end. So I can see no reason to anticipate a rapid recovery and employment when the cliff-diving stops. And I do not understand why the Obama administration is following policies that presume such a rapid recovery--a V rather than an L for the shape of the recession--is not just possible but probable.

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Posted via email from http://braddelong.posterous.com/comment-for-the-economist-on-christina-romer at Brad DeLong's Scrapbook

We Are Live at The Week with: A Wall Street Fairy Tale

A Wall Street Fairy Tale - THE WEEK: The story we tell ourselves about what happened to the financial markets last fall is vitally important. It will determine what form financial market regulation takes in the next few decades, and how vulnerable we will be to the next disruption. At this moment, a relatively calm one, a fictional version of last fall's events is gaining traction. So let's review a few foundational facts.

September, 2008 was a busy month. On Sunday, the 7th, the U.S. government nationalized the two large government-sponsored mortgage enterprises, Fannie Mae and Freddie Mac, which had been privatized in 1968. The following Sunday, the investment-banking house of Merrill Lynch was forcibly merged into Bank of America. The next day, Lehman Brothers simply did not open. The old-line investment bank went into an uncontrolled and unsupervised bankruptcy, and all financial-market expectations that the Federal Reserve and the Treasury would guarantee the unsecured debt of every substantial investment bank in America, as they had for Bear Stearns, went out the window. Wednesday, September 17, saw the nationalization of the American International Group, which, unlike Lehman, was deemed too big to fail. Government-injected cash went straight through AIG and out the other end—like grain through a goose. The forced feeding may total $300 billion before we are through.

The bankruptcies of Fannie, Freddie, Lehman, and AIG; the fall in the prices of risky assets worldwide; the shutdown of the flow of funds through financial markets as trust evaporated and everyone presumed that whoever they entrusted their money to might go bankrupt—this was September's harvest. Risk tolerance collapsed. People became much less willing to hold risky assets at any price. The interest rate on 30-year Treasury bonds fell to less than 3 percent. And it was presumed that every large bank in America would be bankrupt if they were forced to mark to market.

The banks' survival depended on their (a) not having to sell assets until asset prices rebounded, and (b) the availability of enough government money, at cheap enough prices, to enable them to avoid selling any assets at fire-sale prices.

This troubling tale led to the largest recession in post-war history. Yet if you go to the big banks of Wall Street right now, most of them will say: "What is the problem?" They will deny that any changes in the way they run their businesses are called for. "Sure there were a few scary moments," they say, "but big shocks cause scary moments. And our fundamental business model is sound."

Indeed, as Paul Kedrosky points out, if you look at the stock prices of Goldman, JPMorgan Chase, Barclays, and Morgan Stanley, they are back where they were in late August, 2008 before the worst unpleasantness began. (Citi, however, is still down 75 percent and Bank of America is off 67 percent.) So, they say, there is no need for government investments in, or control over, their businesses; no need for restrictions on how much they can pay whom or for what; no need to restrict how much leverage they assume or what they invest in or how much capital they must hold. The smart banks, they say, figured out that the mortgage market was headed for a crash and managed to profit from the boom without being destroyed by the bust. It was only the dumb banks, they say—Bear-Stearns, Lehman, AIG, Fannie, Freddie, and to a lesser degree, Citi and Bank of America—that suffered severely. That's how the market works.

This is a fairy tale.

Suppose for a moment, that things had been handled differently last September. Suppose that the Federal Reserve had announced not that it was buying up the stock of AIG and that it would make sure that all of AIG's debts were paid, but rather that AIG was bankrupt. Suppose the Federal Reserve said it would rescue AIG's bank clients by paying out cash at par for contracts with AIG-provided that it also got (a) upside warrants in the bank and (b) an illiquid, long-dated note, the value of which would be determined by formula after the crisis passed.

In that case, Goldman, JPMorgan, Barclays, Morgan Stanley, Citi, and Bank of America would still have been able to function—they would have had enough cash to pay their bills and enough assets to match their liabilities—but they would now be owned by the federal government. Because all the money passed through AIG to the banks would not be a loss for the government but would rather have been in the form of government investments in still-solvent banks. The resulting expansion of the banks' share issue would have left their stock prices today a shadow of their values last August.

When American high finance hedged its mortgage risk by buying derivatives from AIG, it did not perform due diligence to figure out if AIG could in fact meet its obligations. This failure cost American high finance an amount that may ultimately reach $300 billion. And it would have been fatal had the government not come to their rescue.

Had the government stepped in by discounting AIG paper in return for warrants and notes at fair market values, the banks' life support apparatus would have been obvious. It is only because the government stepped in by nationalizing AIG and guaranteeing its debts that American high finance now has healthy stock prices, and that the senior executives of the big banks—except Citi, Bank of America, Lehman, and Bear-Stearns—are congratulating themselves for their skillful navigation through the crisis.

The fact that the rescue of the banking system took the form of nationalization of AIG, and the honoring of its paper, rather than equity investments by the government in the banks, and the discounting of AIG paper, has encouraged a bout of revisionism in which most of Wall Street and at least a third of Congress now embrace a fairy tale. They tell themselves—and us—a story of a banking system that was fundamentally sound, that merely needed a little temporary liquidity to tide itself over a panic. But the true story is one of an overleveraged banking system that was insolvent save for a $300 billion gift from American taxpayers.

In September, Wall Street was overrun with bears. Now it seems Goldilocks has taken up residence there, too.

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Posted via email from http://braddelong.posterous.com/delong-a-wall-street-fairy-tale at Brad DeLong's Scrapbook

The Atlantic Monthly Crashes and Burns...

More lack of quality control at the Atlantic Monthly. Not as bad as highlighting Gregg Easterbrook's bizarre claim that the chances of a catastrophic mammoth meteor impact over the next five and a half centuries "could be" 50%, but still...

NOBODY SHOULD READ DR. MANHATTAN IN THE ATLANTIC MONTHLY AND BELIEVE HIM WHEN HE CLAIMS THAT THE FINANCIAL MARKETS DO NOT NEED MORE AND BETTER GOVERNMENT REGULATION:

Dr. Manhattan: Sentences That Don't Compute - The Atlantic Business Channel: Today's entry comes from Mark Thoma, who writes in a guest-blog at the Washington Post:

The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.

Which entities' failures and near-failures required TARP and other system-saving emergency programs again? 

I don't want to be too hard on Prof. Thoma: his second sentence is correct, assuming the definition of "shadow banking system" encompasses Subprime Mortgage-To-Go (which offers drive-thru!).  But unlike Long-Term Capital Management's meltdown in 1998, the systemic breakdowns we have been experiencing over the past 18 months have been caused by problems at the major banks (even the former investment-only banks which weren't regulated by the Fed or FDIC cannot be called part of the "shadow banking system"), AIG (regulated by the state insurance commissioners, even if they'd rather you didn't remember) and let's not forget Fannie and Freddie, which had their own regulator. (And the most acute phase of the crisis was touched off by the Reserve Primary Fund's "breaking the buck," even though money market funds are among the most stringently regulated entities on earth.) Only when the products of Subprime Mortgage-To-Go were thoroughly integrated into the activities of these heavily regulated institutions (and sometimes even acquired in full by them; just ask Wachovia and Merrill) was the stage set for the financial crisis.  By contrast, though numerous hedge funds have failed, some people are beginning to look longingly at the sector as one in which even major players can fail without touching off a systemic meltdown. This isn't necessarily an argument against extending regulation to the "shadow banking sector," but we should be on guard against any tendency to assume that the job has been done when a previously unregulated activity now has a regulation applied to it.  In reality, that is when the work begins.

It is hard to know whether being kept in ignorance of the world for decades as part of a secret government program has deprived Dr. Manhattan of his ability to understand the world in which we live, or whether the eldritch nuclear mishap that gave him his eight-foot stature, total lack of body hair, and blue skin tone also scrambled his brain. But i would advise all readers--and editors of the Atlantic Monthly as well--to take care: only one of the two pictured below is an economist worth listening to on the financial crisis:

Yes, it is the one on the right. Listen to University of Oregon Professor of Economics Mark Thoma. Do not listen to the weirdo on the left with his cheap imitation copy of the Fortress of Solitude on Mars, his irregular private life, and his propensity to murder long-time acquaintances and comrades to help billionaires cover up genocidal crimes.

Let's go through it slowly. The commercial banks were regulated. The government guaranteed their deposits. Savers who wanted to not have to worry about making sure that their money wasn't going to vanish and who were inertial in their behavior put their money into commercial banks. Regulators watched the leverage of commercial banks. And commercial banks--with their massive retail savings deposits--have for the most part come through this all right. In fact, the possession of lots of inertial commercial savings and checking deposits that they did not have to worry might flee provided JPMorgan (with the retail banking assets of Chase) and the bank formerly known as NationsBank (with the retail banking assets of Bank of America) with competitive advantages that allowed them to pick up the assets of Bear Stearns and Merrill Lynch at what they thought were bargain prices.

The non-commercial banks--those that did not have large retail banking deposits, did not have government guarantees, and were left less tightly regulated--have, by contrast, flamed out almost to an entity newly reincorporated as a bank holding company. Countrywide. Bear Stearns. Other hot money-financed mortgage lenders too numerous to name. Fannie Mae. Freddie Mac. Lehman. Merrill Lynch. AIG. All are now gone. Only Goldman Sachs and Morgan Stanley remain--and directors of both tell me that they really wish that they had some large retail banking businesses in their portfolio so that the entire liability side of their balance sheet was not hot money.

I think that Dr. Manhattan is just too ignorant of the world outside Area 51 to understand the point Mark Thoma was making--which is, after all, a commonplace. I hope it isn't that the high energy neutrons have permanently scrambled his brain. But given his irrational actions in the Veidt affair, you have to wonder.

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UPDATE: Mark Thoma defends himself:

Sentences That Don't Compute - The Atlantic Business Channel: Nice try, but the problems did begin just where I said they did, in the shadow banking sector:

Geithner: The shadow banking system has been implicated as significantly contributing to the financial crisis of 2007–2009. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the shadow banking system by their couterparties...

Nouriel Roubini: Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.... A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up. The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. "... [these are his five steps top the crisis - step one is, drum roll please, problems in the shadow banking system]...

Bill Gross: What we are witnessing is essentially the breakdown of our modern-day banking system... My Pimco colleague Paul McCulley has labeled it the "shadow banking system" because it has lain hidden for years, untouched by regulation, yet free to magically and mystically create and then package subprime loans into a host of three-letter conduits that only Wall Street wizards could explain.

Krugman: As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible--and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank.

It goes on and on - I'm comfortable with the assertion - most analyses say the same thing, it was the shadow banking system (with only a few exceptions). So it's the title of the post and your argument that doesn't compute.

On the one hand, strange blue guy who insists that "Fannie, Freddie, Lehman, AIG" are part of the "traditional, regulated [financial] sector." On the other side, Thoma, Geithner, Roubini, Gross, Krugman, and many others. Something is very wrong here.

You can do better guys. A lot better.

Warning: Socratic Dialogue

I have never seen this before. From the Economist:

The price of debt, and the cost | Free exchange | Economist.com: This is somewhat curious, as Brad DeLong points out today (warning: Socratic dialogue)...

Is there a standard warning sign that a Socratic Dialogue is ahead? What would it look like?

Department of "Huh?" (Eric Zitzewitz Department)

Justin Wolfers gives the keys to the freakonomicsmobile to Eric Zitzewitz:

Krugman vs. Ferguson: Letting the Data Speak: Why Have Long-Term Interest Rates Risen? There’s no debating that long-term interest rates on government debt have risen. But there’s a pretty fierce debate about what it means. Harvard historian Niall Ferguson interprets this as indicating that the bond market is worried about the U.S. deficit and the prospect of inflation. Princeton economist Paul Krugman thinks it indicates that worries about deflation have eased. It’s a high-stakes debate: Professor Ferguson is arguing that the stimulus package has counterproductively stimulated inflation fears, while Professor Krugman thinks the stimulus has worked as intended by reducing the likelihood of deflation. In fact, Krugman has argued for another dose of fiscal stimulus.

So who is right?... Resolving their debate requires measuring the likelihood of different inflation scenarios. Let’s do it. The graph below plots the probability of different outcomes for the yield on 25-year Treasuries on two different dates — late February and the end of last week.... The blue line shows that there was a lot of uncertainty about future Treasury yields in February, including a very large chance of very low interest rates, as in Krugman’s deflation scenario. But the green line shows that this deflation risk appears to have receded. In fact, the recent increase in Treasury yields is almost entirely due to a reduction in the probability of the deflationary (low nominal interest rates) scenario. Score this round for Krugman...

OK. Zitzewitz is out of the driveway and the car is still running. He has, how ever, run over the mailbox and crushed it into smithereens. The graph should, I think, say not "Option-Implied Probability Distribution" but instead "Risk-Neutral Option Pricing-Implied Probability Distribution." But the car is still rolling down the street because Zitzewitz does say--correctly--that Krugman is right and Ferguson is wrong: rates have risen because the fear of deflation has ebbed and not because the fear of inflation has grown (in fact, he claims the fear of inflation is less than it was in February).

But then Zitzewitz wraps the freakanomicsmobile around a tree:

While Ferguson wrongly diagnosed the cause of the rise in interest rates, he is right that the markets are spooked about the risk of an inflationary breakout. There’s about a 7 percent chance that 25-year interest rates will exceed 10 percent.... This is a fairly extreme scenario: long-term interest rates have not been above 10 percent since inflation was tamed in the mid-1980’s. So there’s a chance that Professor Ferguson may be right about the broader issue: now that deflationary worries seem to have eased, it might be time to start turning the fiscal policy battleship around...

No, no, and no. It is not that the market thinks that there is a 7% chance that the 25-year Treasury nominal rate will exceed 10% in January 2011. Rather, the probability that the 25-year Treasury will exceed 10% in Jaunary 2011 times the scaled marginal utility factor for how much you fear Treasury rates above 10% together equal .07 when you normalize values so that the sum over the entire probability distribution of the scaled marginal utility factors is equal to one. (I know that that is totally incomprehensible, but that does make sense.)

The chance that 25-year Treasury rates will be above 10% in January 2011 is more like 1% or maybe 2%: it is not 7%.

To say that there is a 7% chance that the 25-year Treasury rate will be above 10% in only 19 months is to say something bizarrely misleading.

Someone please call AAA...

Money Laundering

Is it illegal to carry forged large-denomination Treasury bonds across national borders without declaring their putative "value"?

Italian Police Ask SEC to Authenticate Seized U.S. Treasuries: By Sonia Sirletti and John Glover: June 12 (Bloomberg) -- Italy’s financial police said they asked the U.S. Securities and Exchange Commission to authenticate U.S. government bonds found in the false bottom of a suitcase carried by two Japanese travelers attempting to cross into Switzerland.

The bonds, with a face value of more than $134 billion, are probably forgeries, Colonel Rodolfo Mecarelli of the Guardia di Finanza in Como, Italy, said today. If the notes are genuine, the pair would be the U.S. government’s fourth-biggest creditor, ahead of the U.K. with $128 billion of U.S. debt and just behind Russia, which is owed $138 billion.

he seized notes include 249 securities with a face value of $500 million each and 10 additional bonds with a value of more than $1 billion, the police force said on its Web site. Such high denominations would not have existed in 1934, the purported issue date of the notes, Mecarelli said. Moreover, the “Kennedy” classification of the bonds doesn’t appear to exist, he said.

The bonds were seized in Chiasso, Italy. Mecarelli said he expects a determination from the SEC “within a few days.”

We Hicksian Economists Should Be Confident that We Know Something...

Looking at forthcoming U.S. Treasury bond issues:

I do understand why people who think about supply-and-demand expect this tsunami of bonds to push down the prices and push up the interest rates on Treasury bonds a lot.

The argument that it will not do so but will instead boost spending is an old argument--more than three-quarters of a century old--but it is somewhat subtle.

The fact that U.S. Treasury bond prices did not collapse the moment the magnitude of the U.S. government's 2009 and 2010 fiscal deficits became clear is the one thing that gives me substantial confidence that we Hicksian economists do actually know something about how the world really works.

A Sokratic Dialogue: Liquidity Preference, Loanable Funds, and European Hedge Funds that Fear the Collapse of U.S. Treasury Bond Prices

Meno: I haven't seen you since spring classes ended.

Adeimantos: I have been away: Paris. London. Frankfurt.

Meno: Oh. Pleasant? Interesting?

Adeimantos: Not really interesting--too jet-lagged, so I sit in my hotel room in my underwear, read the Economist and Financial Times,, and reflect on how if in my 20s I had been in a fancy hotel in central Paris with someone else paying I would have thought I was in heaven, but that now I am just tired. Thus not too pleasant either.

Meno: Middle age is a shipwreck?

Kephalos: It gets worse...

Adeimantos: However, it was somewhat lucrative: talking to European hedge funds.

Meno: And what do European hedge funds think?

Adeimantos: They look at things like this:

Then they demand that I tell them why U.S. Treasury bond prices have not already collapsed (and Treasury interest rates risen) in anticipation of this forthcoming tsunami of bond issues. Given that Treasury bonds have not yet collapsed they are very very bearish about U.S. Treasury bond prices and interest rates. Supply and demand. The supply of U.S. Treasury bonds is about to become huge, and when supply goes up price should go down.

Sokrates: But if that argument is correct, then rational profit-seeking traders should already have sold U.S. Treasury bonds and already have pushed their prices down in anticipation of the sudden increase in supply...

Meno: Are you Sokrates or Milton Friedman?

Kephalos: There are two supply-and-demand arguments that can be made here. The first is that the supply of U.S. Treasury bonds is about to jump enormously--and so by supply-and-demand the price will be low once the extra bond issues hit the market, and should be low now in anticipation of this low-price Treasury bond market equilibrium. The second is that the inverse of the price of U.S. Treasury bonds--the Treasury nominal interest rate--is the price of liquidity: the amount of interest income you forego by keeping your wealth in cash rather than in securities. According to this second argument, the supply-and-demand is the supply and demand for cash: when the supply of cash is high, the price of liquidity is low, and since the price of liquidity is the short-term Treasury interest rate the short-term Treasury interest rate should be very low.

Adeimantos: Which it is...

Kephalos: And the long-term Treasury interest rate is the average of expected short-term future Treasury interest rates. Since the Federal Reserve has flooded the economy with cash and will keep flooding it with cash for the foreseeable, Treasury interest rates should be low which means Treasury bond prices should be very high--which they are--and stay high.

Adeimantos: Loanable funds vs. liquidity preference.

Sokrates: So, Kephalos, with your impeccable logic and deep wisdom derived from a long career financing expeditions to the shores of the Black Sea, you have presented us with two different supply-and-demand arguments, one saying that Treasury bond prices should be low and hence are about to collapse, and the other saying that Treasury bond prices should be high and are likely to stay more-or-less where they are for some time to come.

Meno: Which argument is right? Is the price of bonds the price that balances the supply and demand for bonds in the bond market? Or is the price of bonds the inverse of the interest rate which balances the supply and demand for cash in the money market? Both cannot be true, can they?

Adeimantos: Ah. But both arguments are true...

Meno: Why do I get the feeling that I am being cast as the dumb straight man in this dialogue?

Sokrates: Because you are a sophist and we are philosophers. We write the dialogues, and we write them to make ourselves look good so that everyone thinks that philosophers are the roxxor and sophists are lame...

Meno: What have I ever done to you?

Glaukon: Tried to take our students and their fees, perhaps?

Sokrates: And we have won. There are now departments of philosophy everywhere. But when was the last time you saw a department of sophistry?

Meno: OK. I will take up my role: Kephalos: Can you explain to me how two perfectly-coherent supply-and-demand arguments lead to opposite conclusions? And if both arguments are coherent, why do European hedge funds all believe the first?

Kephalos: I can answer the second question but not the first: European hedge funds live in the bond market and they see the supply and demand of bonds all day, so that is the market they believe is most important...

Adeimantos: That is true about European hedge funds. But, Meno, the way you have posed the issue is somewhat misleading. It is not which supply-and-demand argument is correct--for both are: the price/interest rate on Treasury bonds clears both the bond and the money market, both loanable funds and liquidity preference. It is how does the economy adjust in order to make the Treasury bond price/interest rate clear both these markets.

Meno: And I have the feeling that you are about to tell me...

Adeimantos: Let's start with an economy in equilibrium--where Treasury bond prices are such as to satisfy both loanable funds and liquidity preference, so that everyone is happy to hold the bonds given their current price and everyone is happy to hold the economy's cash supply given the current interest rate. Now suppose the Treasury issues a huge honking tranche of bonds (and Obama spends the money hiring the unemployed to give people cholesterol screenings on the street and hand out statins). Now the supply of bonds is greater than demand at current bond prices. So what happens?

Kephalos: The prices of Treasury bonds fall--interest rates rise...

Adeimantos: And what happens in the money market as interest rates rise?

Kephalos: People are no longer happy holding the economy's cash--it's too expensive; it's burning a hole in their pocket. So they start spending it faster...

Adeimantos: And as they start spending it faster?

Kephalos: This puts upward pressure on prices and employment, as businesses find that they can charge more and make hire profits and so hire more people...

Adeimantos: Incomes rise, and as incomes rise savings rise because people don't spend all of their increased incomes, do they?

Sokrates: Very true, Adeimantos.

Adeimantos: And what happens as savings rise?

Kephalos: People want to park those savings somewhere. They want to park those savings in Treasury bonds. And so demand for Treasury bonds rises...

Adeimantos: And the economy settles back at its new equilibrium, with (a) somewhat higher interest rates and (b) higher spending and income so that (c) people are happy holding the economy's cash at the current interest rates and rate of spending, and (d) people are happy holding the bonds at the current bond prices and level of income.

Kephalos: So both supply-and-demand arguments are true...

Meno: And the way that they can both be true is that there isn't just one quantity--the bond price--that adjusts to match supply and demand in the bond and the money markets...

Sokrates: But there are two quantities that adjust: the bond price and the level of spending...

Adeimantos: Yes. You have just derived things that were well-known 72 years ago. See John Hicks (1937), "Mr. Keynes and the 'Classics': A Suggested Interpretation."

Sokrates: But which adjusts more?

Adeimantos: Once again back to Hicks (1937). When the unemployment rate is high and the nominal interest rate on Treasury bonds is very very slow, adjustment comes in the form mostly of changes in spending and only slightly in changes in interest rates--the world is then "Keynesian." But when the unemployment rate is normal or low and the nominal interest rate on Treasury bonds is near its normal levels, adjustment comes in the form mostly of changes in interest rates and only slightly in changes in spending--the world is than "Classical." That's why the title of the article is "Mr. Keynes and the 'Classics'."

Meno: So when European hedge funds predict the collapse of U.S. Treasury bond prices as the new issues hit the market and ask where is the extra demand to hold all these new bonds come from, the answer is...?

Adeimantos: That even as the government issues the bonds it is also spending the money, and as the money it spends is parked in the bank accounts of the businesses the government is buying things from, the banks in which the money is parked take it and use it to buy Treasury bonds.

Meno: That sounds like sophistry...

Sokrates: You should talk...

Glaukon: Actually, it's just general equilibrium...

Meno: But is this doctrine--that the government's issuance of a fortune in bonds and spending of a fortune in money will show up primarily not as a collapse in bond prices and a spike in interest rates but as an expansion of spending--true?

Sokrates: We will see. Keynesian--or maybe I should say Hicksian--economists would say that bond prices/interest rates and spending/income levels are the two quantities that together adjust to jointly clear the bond and the money markets, to satisfy both loanable funds and liquidity preference equilibrium; that sometimes the principal movement is in interest rates; that sometimes the principal movement is in spending levels; and that right now it is likely that spending will adjust by much more than interest rates.

Adeimantos: And there is a little bit of empirical evidence that the Hicksian economists are right. Tim Fernholz http://www.prospect.org/csnc/blogs/tapped_archive?month=06&year=2009&base_name=compare_and_contrast_economic sends us to Nelson Schwartz, who writes:

Europe Lags as U.S. Economy Shows Signs of Recovery - NYTimes.com: There was more evidence Thursday that the United States economy might be stabilizing, if not rebounding, even as economic reports in Europe remained gloomy. The American news — showing slight growth in retail sales and a dip in first-time jobless claims, as well as rising stocks — was not enough to end the disagreement between bulls and bears over how soon the economy would improve. But the apparent divergence of fortunes between America and Europe highlighted the different approaches to solving the financial crisis, and why some economists say the more aggressive American strategy may be working better, at least for now. It is a debate that is likely to be one of the issues dominating discussions when finance ministers from the eight largest economies meet in Italy this weekend.

Some private economists are even predicting that the American economy will resume growth in the fourth quarter, while Europe’s economy is expected to remain in recession well into 2010, after contracting an estimated 4.2 percent this year compared with an expected 2.8 percent decline in the United States. “The shock originated in the U.S., but Europe is paying a higher price,” said Jean Pisani-Ferry, a former top financial adviser to the French government who is now director of Bruegel, a research center in Brussels. Almost from the beginning of the crisis, the United States and Europe chose largely different paths to aiding their economies. The most stark was Washington’s willingness to commit hundreds of billions of dollars to stimulus spending — in addition to moving aggressively to shore up banks and keep credit flowing — versus Europe’s worry that similar spending would increase inflation in the future. Just as the policies pursued during the Great Depression have been dissected ever since by economists, the fate of the United States and Europe as the two regions emerge from the global crisis will be analyzed for decades to come.....

One crucial concern about America’s increased deficit spending — that it would lead investors to demand higher interest rates on United States debt, making it far more expensive to borrow and slowing the economy — has been allayed, for now. An auction on Thursday of $11 billion in 30-year Treasury bonds found enthusiastic buyers, helping to push the Standard & Poor’s 500-stock index to a seven-month high...

Meno: And the Chicago School economists who say that government borrow-and-spend logically cannot increase overall spending? The Robert Lucases who say: "[W]ould a fiscal stimulus somehow get us out of this bind...? I just don't see this at all. If the government builds a bridge... by taking tax money away from somebody else, and using that to pay the bridge builder... then it's just a wash.... [T]here's nothing to apply a multiplier to. (Laughs.)... [And] taxing them later isn't going to help, we know that..."? And the John Cochranes who said: "[W]hile Tobin made contributions to investing theory, the idea that spending can spur the economy was discredited decades ago. 'It’s not part of what anybody has taught graduate students since the 1960s. They are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children but it doesn’t make them less false.'" To borrow money to pay for the spending, the government will issue bonds, which means investors will be buying U.S. Treasuries instead of investing in equities or products, negating the stimulative effect, Cochrane said. It also will do nothing to unlock frozen credit..."?

Sokrates: I, at least, find myself unable to understand them. They say they believe in the quantity theory of money--that spending is equal to the economy's cash times its velocity. And they say that they believe that velocity is interest elastic--that people respond to incentives and spend the cash in their pockets more rapidly when nominal interest rates are high. They say that they believe that bond prices/interest rates are such as to balance saving and investment and make people willing to hold the stock of bonds. That's all you need to be a Hicksian. Yet they also claim that Hicks is wrong, somehow--without giving arguments. I can trip up and make foolish anybody who makes an argument, but if they don't make an argument I cannot make them look any more foolish...

Net Treasury Bond Issues to Be Held by the "True' Public, since 1980 and Projected

Bonds held by the Federal Reserve are not part of debt held by the public, no matter what OMB may say.

It's really too bad that I don't have to give a lecture on liquidity preference vs. loanable funds right now...

The U.S. Treasury-Eurodollar Interest Rate Spread (TED) Spread Is Back to Normal

Getting Financial Incentives Right Through Government Regulation of Finance Compensation

Gene Sperling on Financial Industry Executive Compensation:

Opening Statement before the U.S. House of Representatives Committee on Financial Services.

As I have said many times, shareholders ought to have fixed the problem that the financial-sector compensation system has systematically fed Wall Street hotshots the wrong incentives via short-term options-based compensation packages.

But shareholders haven't. And the problem is serious enough and has bad enough consequences for the rest of us that we need to fix it.

Rational Expectations, Efficient Markets, and Economic Welfare

I think Robert Waldmann is using the internet to carry on an argument among sometime roommates.

Robert Waldmann:

The REH vs the EMH: I think I should explain a claim I made in the post below. I assert that the efficient markets hypothesis (EMH) does not imply the rational expecations hypothesis (REH). The EMH states that asset prices are the same as they would be if everyone had rational expectations. The strong form EMH adds the assumption that everyone has complete information. The semi-strong form, like the REH has implications only for expected values conditional on public information. The EMH makes no statement about individual portfolios. It is absolutely not assumed or implied that each investor has an efficient portfolio.

In contrast, the rational expectations hypothesis says that the expected value of expectational errors conditional on public information is zero.... As used it definitely amounts to much more the assumption that observable aggregates have the values they would have if everyone had rational expectations.... This use of the phrase "rational expectations" to refer to individual behavior not aggregates is common and, as far as I know, uncontroversial....

[T]he first welfare theorem requires the assumption of rational expectations. It is absolutely not sufficient for aggregates to be the same as they would be if people had rational expectations.... I think an extremely elementary proof might be useful...

---

Me:

• There are 2 time periods t = 1 and t = 2.
• There is a coin which is flipped. It comes up heads in period 2 with probability 0.5.
• There are 2 assets:
  • A is a risk-free asset, the numeraire: One unit of risk-free asset gives one unit of consumption good in period 2.
  • B is a risky asset that gives one unit of consumption goods in period 2 if the coin comes up heads. It sells for an equilibrium price p.
• There are a continuum of agents indexed by i over [0.5-z,0.5+z] who maximize their expected value of the log of their consumption in period 2.
• Each agent is endowed with one unit of the risk-free asset.

Rational expectations implies that agents know that the probability the coin comes up heads is 0.5. If everyone has rational expecations, then the market will clear with a period-1 price p = 0.5. Each risk averse agent will find it optimal to invest 0 in the risky asset. there is 0 net supply of the risky asset. Markets clear. This outcome is Pareto efficient and maximizes total utility. The EMH therefore is satisfied if the price of the risky asset is 0.5.

Now relax the assumption of rational expectations. Assume that agent i believes that the probability that the coin will come up heads is i.

The market clearing price is 0.5. At p = 0.5 agent i's net demand for asset B is:

x(i) = [i - p]/[p - p²]

The EMH still holds in equilibrium. Supply equals demand for the risky asset at its fundamental value of p = 0.5.

The welfare outcome, however, is different. In period 2 agent i's consumption is either 1+x(i) or 1-x(i). The outcome is no longer ex-ante Pareto efficient: people bet on their beliefs, and because their beliefs are wrong utility-subtracting risk enters the world. The expected utility of agent i is:

(1/2)ln(1+x(i)) + (1/2)ln(1-x(i))

(1/2)ln(1+4[i-0.5]) + (1/2)ln(1-4[i-0.5])

If z is small so that we can approximate ln(1+y) by y - y²/2, then the approximate expected utility of agent i is:

E(U(i)) = -8[i - 0.5]².

In the model with rational expectations, the optimal policy is laissez faire.

In the model with efficient markets but without rational expectations it would be preferable to ban gambling--to impose a 100% tax on net trading profits, and redistribute the proceeds (if any).

---

Robert again:

I think it is safe to say that... [the] difference...between a model in which the optimal policy is laissez faire and a model in which the optimal policy is confiscation and equal [re]distribution of all [trading profits is of interest to economists]. I do not see how it is possible for anyone who can understand the model above to conflate rational expectations and efficient markets. Oddly, however... well known economists have done exactly that...

What If GM Were to Be Liquidated?

The threat point in the GM deal.

Andrew Ross Sorkin:

Imagining a G.M. Fire Sale - DealBook Blog - NYTimes.com: It’s hard to envision a company as large and complex as General Motors being sold off for scrap. But that’s just what the restructuring pros at AlixPartners had to do for their liquidation analysis of the company, which was filed in federal bankruptcy court in New York late Thursday.

Of course, G.M. is reorganizing in Chapter 11 and has no plans to liquidate. Bankrupt companies regularly perform this kind of exercise to give creditors a point of comparison as they consider a reorganization plan.

As a hypothetical exercise, though, the analysis is interesting: It found that in a fire sale, the largest United States automaker would likely yield less than $10 billion in net proceeds.

The costs of liquidating would be huge, according to the analysis — from $2 billion to $2.7 billion, the document says. Taking that into account, the amount left for creditors would be from $6.5 billion to $9.7 billion.

A large part of the value (from about $2.5 billion to $2.7 billion, before costs) would come from G.M.’s foreign subsidiaries, according to the analysis. These include G.M. Europe, which the company expects to sell anyway, and its units in Asia and Latin America, which G.M. has said it generally plans to keep.

And what would G.M.’s creditors get?

Bank lenders owed $5.4 billion would recover from 26.3 to 77.1 cents on the dollar. The United States Treasury, on the hook for $20.5 billion, fares even worse under this scenario, getting just 12.7 cents to 23.7 cents on the dollar for its claims. Unsecured creditors would get nothing.

Of course, there’s room for debate about many of the assumptions in the analysis, and AlixPartners readily concedes that there are plenty of unknowns. There hasn’t been a major United States automaker in liquidation in recent history, the document said, so there’s “no relevant precedent.”

For more details, take a look at the document below. The liquidation analysis starts on page 6.

http://www.scribd.com/doc/16156458/AlixPartners-Declaration-and-Liquidation-Analysis-

We Are Live at "The Week" with the Eclipse of the Chicago School

The Chicago School is eclipsed - THE WEEK:

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Richard Posner, leader of the Chicago School of Economics and Fourth Circuit Court of Appeals judge, uses his new book, “A Failure of Capitalism,” to try to rescue the Chicago School’s foundational assumption that the economy behaves as if all economic agents and actors are rational, far-sighted calculators. In some sense, Posner must try. For without this underlying assumption, the clock strikes midnight, the stately brougham of Chicago economic theory turns into a pumpkin, and the analytical horses that have pulled it so far over the past half- century turn back into little white mice.

Thus he writes: "At no stage need irrationality" on the part of markets or their participants "be posited to explain” the collapse of financial markets last year and the current deep recession.

Posner’s effort looks to me like an earlier effort to “save the appearances” in the face of discomfiting contradiction. The Jesuit astronomers of 17th-century Rome wanted above all to maintain the assumption that the sun revolved around the earth—for if it did not then the Bible’s declaration that Joshua called on God to make the sun stand still in the sky was a lie, and a Bible that lies even once cannot be the inerrant foundation of faith.

Thus the Jesuits created much more complicated models than the elegant heresy of Copernicus, in which the earth revolved around the sun. They succeeded in their attempt to save the appearances. Posner’s attempt does not: It is definitely a retrograde motion, for we see many things in the financial crisis and the recession that are not what we would see in an economy populated by smoothly rational utilitarian calculators.

• It was not rational for Bear-Stearns CEO James Cayne, with his own $1 billion fortune on the line, to allow his firm to become hostage to the excessive risks taken by his subordinates in the mortgage markets.

• It was not rational for Citigroup CEO Charles Prince to keep dancing to the music, without thinking which seat Citi would claim when the round of musical chairs came abruptly to a halt.

• It was not rational for shareholders of newly incorporated investment banks to offer traders large annual bonuses for performance assessed by a year-to-year mark-to-market yardstick—rather than rewarding them with long-run restricted stock that would hold its value only if the traders' portfolio strategies proved durable.

• It was not rational for the shareholders and executives of General Motors and Chrysler to ignore the need for a Plan B in the event Americans fell out of love with SUVs.

The litany of financial lunacy is longer than even the Eastern Orthodox litany of the saints. Yet Posner’s insistence that the crisis cannot spring from compound irrationality drives him to a claim that the real cause is a failure of government—specifically a too-lax, too-nurturing, insufficiently strict Mommy State that raised the children all wrong.

"The mistakes were systemic,” he writes, “the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools." What we needed, Posner implies, was a Daddy State in the early 2000s that would have kept interest rates high, kept the recovery from the 2001 recession much weaker, and kept unemployment much higher. The Daddy State should have restricted financial innovation because a "depression is too remote an event to influence business behavior. The profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy."

Posner's claim that the Princes of Wall Street were rationally ignoring small probabilities is simply not true. The venture capitalists of Silicon Valley in the 1990s raised money for their funds overwhelmingly through equity rather than debt tranches. They did so because they wanted themselves and their clients to retain some considerable fraction of their fortunes in an event that they regarded as small probability—but actually happened—that the overwhelming bulk of the value from the internet revolution flowed to customers rather than to businesses.

Jamie Dimon and his team at JPMorgan Chase tried to move their firm out of the subprime mortgage market and into position to profit from the correction by the end of 2006. So did Lloyd Blankfein and his team at Goldman Sachs. (They suffered anyway because neither imagined the possibility that a hedged long position in mortgages was not really hedged at all if the counterparty on the short leg was AIG.)

Yet while Posner insists on saving the appearance of individual rationality, he is willing to jettison the Chicago School's conclusion that markets are everywhere and always perfect. As Robert Solow observed: "If I had written that, it would not be news. From Richard Posner, it is." Abandoning the conclusion of market perfection opens the door to the idea that government needs to properly check, balance, and regulate markets in order to help them function as well as possible. But clinging to the assumption of individual rationality forces Posner’s view of what regulation is appropriate into a very awkward straightjacket.

If the dons of the Chicago School were locked in an ivory tower, it would not matter that Posner tries to save the appearances, and so attributes the crisis not to failure on the part of “capitalists” but rather of regulators. Posner, however, is one of America’s leading public intellectuals. His views spread. His influence is very wide. For example, Jonathan Rauch in The New York Times Book Review joins in and extends Posner’s error. For Rauch, “to see the crisis through populist spectacles, as President Obama does when he attributes it to 'irresponsibility,' is to misunderstand the whole problem by blaming capitalists." Rauch echoes and congratulates Posner, asserting that Posner’s “merciless scrutiny” leaves "not one populist cliché” remaining intact.

But Posner’s Chicago clichés not only remain intact but burst into full flower. Attributing responsibility to the errant Princes of Wall Street, and the directors and shareholders who were supposed to be overseeing them, would be "populism." And "populism" is bad. There should be no sanctions—not even a reduction in influence—for financiers. As for reregulation of the financial market, we should be satisfied with “pretty small beer,” because the failure was not a failure of individual capitalists but of capitalism itself.

As remedy, we should prohibit the Federal Reserve from seeking full employment through low interest rates. One actor whom Posner does clearly blame is Alan Greenspan, whose reduction of interest rates to 1 percent in 2002–2003 was, in Posner's eyes, a root of the evil. Full employment already loses out to price stability when the latter is threatened by inflation. In Posner's view, full employment must also give way if achieving it requires low interest rates.

Let us conduct a thought experiment. Suppose that Judge Posner had been willing to embrace Copernican theory. In that case, what would his policy recommendations have been? Start with the observation that financial markets have six useful purposes:

• to aggregate the money of people who ought to be savers into pools large enough to finance large-scale enterprises.

• to channel the money of people who ought to be savers to institutions and people who ought to be borrowers.

• to spread risks so that no one individual finds herself ruined by the failure of any one investment or the bankruptcy of any one company or the slow growth of any one region.

• to keep managements efficient by upsetting and replacing teams and organizations that have outlived their usefulness.

• to encourage savings by creating liquidity—the marvelous fact that one can own a piece of an extremely illiquid and durable piece of social capital (an oil refinery, say) and yet get your money out quickly and cheaply should you suddenly have an unexpected need for it.

• to take the money of rich people who like to gamble and, by providing some excitement for them as they watch their gains and losses, use it to buy capital equipment that raises the wages of the rest of us (at the price of paying a 20 percent cut to the Princes of Wall Street). This is a superior use for the rich—and for the rest of us—than, say, taking their wealth to the craps tables of Vegas.

Wall Street innovations and practices are useful only insofar as they promote these six useful purposes. Call them aggregation, accumulation, diversification, efficientization, liquiditization, and casinoization.

By these standards, the current compensation scheme on Wall Street—large annual bonuses based on annual marked-to-market results—is absurd. It helps achieve none of these six goals, and it greatly increases the chance of a crash by providing everyone with an incentive to help their friends by marking up value, marking down risk, and ignoring the impact of their actions on the long-term survival of the enterprise. Silicon Valley compensation schemes seem much better: no large payouts until assets have reached maturity and portfolio strategies have proved their value in all phases of the business cycle.

From this perspective, the rapid growth of derivative markets has also proved to be absurd. Derivatives were supposed to assist in risk spreading and diversification. Amateurs and outsiders could take on a position easily, and the professionals who sold it to them could then dynamically hedge it away, and so tap the risk-bearing capacity of the public to a greater degree. It did not work, and it made the books of Wall Street firms opaque even to the most sophisticated of executives. Kenneth Arrow would tell us that stocks, bonds, commodities, puts, and calls alone already carry us as close to a spanning set of securities as we are going to get. The potential diversification benefits of more complicated securities appear to be outweighed by the information they destroy.

The thirty-to-one effective leverage ratios achieved in the 2000s by major banks were absurd. When public money is involved—and when high-leverage portfolio strategies become common, public money is always involved—any system that relies on the intelligence of equity holders to restrain traders’ risks within bounds at a thirty-to-one leverage ratio is absurd. Every financial institution should be a bank holding company regulated by the Federal Reserve. And every bank holding company should keep a healthy proportion of its liabilities—10 percent? 20 p?—on deposit at the local Federal Reserve.

In the future, we need to change the culture of Wall Street by changing how top-earning financial professionals are paid, changing the assets they trade to make the markets less opaque, and changing the risks they run by taking capital requirements very seriously once again. If we accomplish all three, there’s a chance that the next Minsky Moment that comes along will be a minor disturbance rather than a globe-shaking catastrophe for 100 million people.

The key irrationality was a private-sector failure on the part of the shareholders and top managements of the banks to make sure that their traders had an appropriate stake in the long-run survival of the bank and not just in constructing a portfolio that would be marked-to-market at a high valuation on Dec. 31. And the government needs, for all our sakes, to compensate for this private-sector irrationality. That’s the conclusion that Posner’s book should have reached. But it never gets there: Because to get there, he would have had to begin his book by acknowledging that it matters that the earth revolves around the sun.

Project Syndicate: The Hidden Purposes of High Finance

BusinessWorld Online: Commentary -- By J. Bradford Delong: "The hidden purposes of high finance": BERKELEY — No one questions the usefulness of "low" finance.

The ability to use checks, banknotes, and credit cards rather than having to cart around chests of silver, scales, and reagents to assay purity, and needing armed guards to protect the silver (and more guards to watch the first set of guards) has obvious efficiencies.

So does the ability of households to borrow and lend in order not to be forced to match income and expenditure every day, week, month, or year.

But what use is "high" finance?

Economists’ conventional description depicts high finance as providing us with three types of utility. First, it allows for many savers to pool their wealth to finance large enterprises that can achieve the efficiencies of scale possible from capital-intensive modern industry.

Second, high finance provides an arena to curb the worst abuses by managers of large corporations. Managers’ fear that if the stock price drops too low they will be out on their ears provides a useful restraint.

Finally, high finance allows for portfolio diversification, so that individual investors can seek high expected returns without being forced to assume large, idiosyncratic risks of bankruptcy and poverty.

But these are the benefits of high finance as they apply to the ideal world of economists — that is, a world of rational utilitarian actors who are skilled calculators of expected utility under uncertainty, who are masters of dynamic programming. We do not live in such a world.

Economists have spent their lives attempting to evolve theories that would account for how salient features of reality might emerge if we did live in their ideal world, but since we don’t, their theoretical enterprise is of doubtful utility. It is like describing how one could bake a delicious wedding cake using only honey, bicarbonate of soda, and raw eggplant.

If we take the world as it really is, we see that high finance performs two further tasks that advance our collective welfare. It induces us to save, accumulate, and invest by promising us safe, liquid investments even in extraordinary times.

It is a fact that we are much happier saving and accumulating, and that we are much more likely to do so when we think that the resources we have saved and accumulated are at hand. It is also true that when we invest our wealth — in Pfizer’s intellectual property, factories in Shenzhen, or worldwide distribution networks — it is not, in fact, at hand. Our invested wealth can only be made to appear liquid, and only if there is no general shift in our collective desire for liquidity.

And it is also a fact that we are happier saving and accumulating if we receive positive and negative feedback on our decisions on a time scale that allows us to believe that we can do better next time by altering our strategy — hence marketwatch.com and CNN/Money.

Of course, investors who believe that their wealth is securely liquid, and that they are adding value for themselves by buying and selling are suffering from a delusion. Our financial wealth is not liquid in an emergency. And when we buy and sell, we are enriching not ourselves, but the specialists and market makers.

But we benefit from these delusions. Psychologically, we are naturally impatient, so it is good for us to believe that our wealth is safe and secure, and that we can add to it through skillful acts of investment, because that delusion makes us behave less impatiently. And, collectively, that delusion boosts our savings, and thus our capital stock, which in turn boosts all of our wages and salaries as well.

Seventy-three years ago, John Maynard Keynes thought about the reform and regulation of financial markets from the perspective of the first three purposes and found himself "moved toward... mak[ing] the purchase of an investment permanent and indissoluble, like marriage...." But he immediately drew back: the fact "that each individual investor flatters himself that his commitment is ’liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk...."

Moreover, for Keynes, "[t]he game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll...."

It is for these reasons that we have seemed frozen for the past generation or two whenever we have contemplated reforming our system of financial regulation. And it is why, even in the face of a severe financial crisis, we remain frozen today.

Origins of the Present (Financial) Crisis

Mark Thoma sends us to Paul Krugman, who argues that American financial regulation went off on the wrong track with Reagan-Garn-St. Germain:

Economist's View: Paul Krugman: Reagan Did It: Reagan... essentially ended New Deal restrictions on mortgage lending... that, in particular, limited the ability of families to buy homes without putting a significant amount of money down. These restrictions were put in place in the 1930s by political leaders who had just experienced a terrible financial crisis, and were trying to prevent another. But by 1980 the memory of the Depression had faded. Government, declared Reagan, is the problem, not the solution; the magic of the marketplace must be set free. And so the precautionary rules were scrapped.... We weren’t always a nation of big debts and low savings: in the 1970s Americans saved almost 10 percent of their income...

It was only after the Reagan deregulation that thrift gradually disappeared..., culminating in the near-zero savings rate ... on the eve of the great crisis.... All this, we were assured, was a good thing: sure, Americans were piling up debt... but their finances looked fine once you took into account the rising values of their houses and their stock portfolios. Oops. Now, the proximate causes of today’s economic crisis lie in events that took place long after Reagan... — in the global savings glut... and in the giant housing bubble that savings glut helped inflate. But it was the explosion of debt over the previous quarter-century that made the U.S. economy so vulnerable. Overstretched borrowers were bound to start defaulting in large numbers once the housing bubble burst and unemployment began to rise.

These defaults in turn wreaked havoc with a financial system that — also mainly thanks to Reagan-era deregulation — took on too much risk with too little capital. There’s plenty of blame to go around... But the prime villains behind the mess we’re in were Reagan and his circle of advisers — men who forgot the lessons of America’s last great financial crisis, and condemned the rest of us to repeat it...

Vicious Circles in the Mortgage Market

The recession is not finished with us yet:

Foreclosure Woes Mount for Those With Good Credit: A record 12 percent of homeowners with a mortgage are behind on their payments or in foreclosure as the housing crisis spreads to borrowers with good credit. And the wave of foreclosures isn't expected to crest until the end of next year, the Mortgage Bankers Association said Thursday. The foreclosure rate on prime fixed-rate loans doubled in the last year, and now represents the largest share of new foreclosures. Nearly 6 percent of fixed-rate mortgages to borrowers with good credit were in the foreclosure process. At the same time, almost half of all adjustable-rate loans made to borrowers with shaky credit were past due or in foreclosure.

The worst of the trouble continues to be centered in California, Nevada, Arizona and Florida, which accounted for 46 percent of new foreclosures in the country. There were no signs of improvement. The pain, however, is spreading throughout the country as job losses take their toll. The number of newly laid off people requesting jobless benefits fell last week, the government said Thursday, but the number of people receiving unemployment benefits was the highest on record. These borrowers are harder for lenders to help with loan modifications. President Barack Obama's recent loan modification and refinancing plan might stem some foreclosures, but not enough to significantly alter the crisis.

"It may be too much to say that numbers will fall because of the plan. It's more correct to say that the numbers won't be as high," said Jay Brinkmann, chief economist for the Mortgage Bankers Association.

Refocusing the Discussion of the Mortgage Boom...

Edmund Andrews emails:

The [premise of my] book is that my mortgage was obviously insane, and my goal was to explore how and why it was possible in the first place. [The book] is not a "cautionary tale," or a morality play about Everyman. It's an attempt to show the deception/self-deception and corruption of people at each level in the food chain. The Magazine excerpt is only about my self-delusion as a borrower, but the book tells about all the other players up to and including Greenspan. Those are the best parts...

He asks that the subject of the discussion be the book as a whole rather than just the New York Times Magazine article. I agree: that Edmund Andrews acted somewhat like a moonstruck idiot is not especially interesting--save perhaps in the hands of F. Scott Fitzgerald. That American Home Mortgage and company were willing to finance his acting like an idiot and so drag themelves down as well is somewhat more interesting.

Busted: Life Inside the Great Mortgage Meltdown, by Edmund L. Andrews.

New York Times Crashed-and-Burned-and-Smoking Watch (Ombudsman Clark Hoyt Edition)

Can the New York Times please hire an ombudsman to deal with its ombudsman, Clark Hoyt?

Clark Hoyt: On Thursday, [New York Times reporter Edmund Andrews] came under attack from a blogger for The Atlantic for not mentioning in his book that his wife had twice filed for bankruptcy — the second time while they were married, though Andrews said it involved an old loan from a family member. He said he had wanted to spare his wife any more embarrassment. The blogger said the omission undercut Andrews’s story, but I think it was clear that he and his wife could not manage their finances, bankruptcies or no. Still, he should have revealed the second one, if only to head off the criticism...

This grates for four reasons:

1. "a weblogger" has a name: Megan McArdle of the Atlantic Monthly. She deserves credit for her work.

2. "a weblogger" has a reputation--a considerably better reputation at this point than Clark Hoyt or the New York Times, I believe. When something appears attached to Megan McArdle, I know that she is smart, has worked hard, and is trying her best to get the story right. Readers deserve to know who Clark Hoyt is pitting himself and his organization against so that they can make their own assessments of credibility. I know that Megan McArdle tries (if not always succeeds). I don't know about the reporters and editors of the New York Times--indeed, I know that at times they work hard to get the story wrong, witness Elizabeth Bumiller, "1 in 7 Detainees Rejoined Jihad".

3. At the time when Hoyt wrote he knew or ought to have known that Patrica Berreiro's second bankruptcy discharged $29,000 in family loans, $7997.25 in lawyers' bills, $3604 in telecommunications bills, $9065 in medical bills, $5377 in credit-card debt, $188 in veterinary bills, and $83 in fines from the Los Angeles Public Library. To write that it "involved an old loan from a family member" is remarkably incomplete.

4. Megan McArdle's point is that dysfunctions in mortgage lending have next to nothing to do with Edmund Andrews's personal financial crisis. The crisis comes from the radical disjunction between the style of life Andrews and his wife expect and Andrews's income--$10,000 a month, $3,500 in taxes, $4,000 (in the book; $5,000 in the bankruptcy filing) in alimony and child support, leaving $2,500 a month to live on for all expenses. If Andrews hadn't bought his house in Silver Spring he would, McArdle believes, be in a worse financial position right now--for one thing, his landlord would have evicted him. I think she is probably right, and that Patricia Berreiro's second bankruptcy is telling evidence for McArdle's position. Hoyt's claim that "I think it was clear that [Andrews] and his wife could not manage their finances, bankruptcies or no" appears to me to be a deliberate attempt to miss the entire point.

So Ed Andrews's adventures in real estate have lost him $46K in NYT stock that he sold to make his down payment--stock that would now be worth $14K...

He has now lived rent-free for the ten months since be stopped paying his mortgage--call that +$32K...

He paid essentially a market rent for the house via his mortgage payment but he got a tax shield worth $500 a month for 42 months--+$21K...

And he pumped $58K out in his home equity loan...

So by my count his adventure in real estate has enabled him and his wife to spend $97K more over the past five years and still arrive at the same asset position as if they had rented...

There are three ways that the debt system screws people:

1. It leads them to take out too-large loans at too-high interest rates so that they spend or lose a fortune and get nothing for it--but Andrews's interest rates have been more than reasonable.

2. It gets them overhoused--they buy a big house they cannot really use, and they knock around in it, and they pay for that big house through the nose. But Andrews's house was not a McMansion and was not in a pricey central location like Clevland Park.

3. It allows them to escape from habits of thrift--they wind up broke, while if the system hadn't been nudging them in the wrong direction they would have been OK.

Andrews is clearly not a victim of the system in senses (1) or (2). Now Megan McArdle is arguing that he is not a victim of the system in sense (3) either--that no matter what the financial system Andrews would now be facing bankruptcy. Moreover, on this reading the debt system has actually advantaged Andrews substantially. In a counterfactual world in which Andrews had rented and not bought, he would now have an extra $14K in New York Times stock (all that would be left of the $46K in stock he sold in 2004 to assemble the down payment, but in the meanwhile he paid about $2.5K a month in mortgage payments for a house it would have cost him about $2.5K a month to rent, the deductability of mortgage interest has given him about $21K in tax shields, he has lived rent-free for ten months since he stopped making mortgage payments and so gained an additional $25K, and he pumped $58K in home equity loans out of the house. As I see it, the willingness of the financial system to lend to him has allowed him to spend an extra $90K since 2004.

The question is: if the financial system had not encouraged him to borrow so much, would he have made wiser decisions and arrived at this point with more assets? Megan McArdle argues that Patricia Barreiro's two bankruptcies spaced eight years apart make that highly unlikely, and she has a very strong case.

That's why it is of interest--not Hoyt's "he should have revealed the second [bankruptcy], if only to head off the criticism," but because it shapes how we assess the damage done by the too-easy availability of credit.

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McMegan:

Megan McArdle: Patty Barreiro's second bankruptcy [in 2007] does not merely clear a lawsuit. The value of the settlement was $29,000. The total vale of the unsecured claims discharged was $55,313, inclding almost $8,000 for legal services, almost $10,000 in medical bills, $1200 in phone bills, $1100 owed to Comcast, and $5400 in credit card debt.... Andrews is saying that the lawsuit was the driving factor behind the bankruptcy, and that the other unsecured debts are therefore somehow irrelevant. But neither the book nor the bankruptcy filing indicate the means to clear the other unsecured claims without Chapter 7; by her own worksheets, she had very little income and their joint income was exceeded by their allowable expenses. Plus, of course, they're awaiting foreclosure now...

And here.

Green Shoots

Felix Salmon:

TED datapoint of the day: 48bp : Remember the TED spread? It closed at 139bp on March 17, which was a decided improvement over the levels over 400bp we saw last fall, but was still pretty wide. Yesterday, however, it closed at 58bp, and today it’s finally broken the 50bp barrier, last at 48bp. Back when the likes of Paul Krugman started blogging the TED spread, in March 2008, it was oscillating wildly between about 100bp and 200bp. Now it’s back to much more normal levels — and I wonder whether that means the interbank market is beginning to pick up again. Any volume figures on that?

Ed Andrews, Patty Barreiro, and Serial Bankruptcy: Megan McArdle: Smart Young Blogger or All-Knowing Being?

Felix Salmon says: McMegan FTW!!!!

Megan McArdle reports from the Montgomery County Courthouse:

The Road to Bankruptcy: At the end of his book's harrowing account of mortgage mistakes and credit card crises,  Edmund Andrews writes:  "While our misadventure had certainly been more extreme than those of many other Americans, our situation was not all that unusual."  And indeed the book reads like the story of an American Everyman, easily sucked in to the alluring world of easy credit as he struggled to blend a new family.  The terrifying implication is that it could happen to you--to anyone who leads with their heart and not their head. But... the story has been tidied up a little. Patty Barreiro, Andrews' wife, has declared bankruptcy twice.  The second time was while they were married, a detail that didn't make it into either the book or the excerpt....

Andrews' desire to shield his wife is understandable--hell, laudable.  No decent person wants to parade their spouse's financial trouble in front of the world.  But this is material information that changes the tenor of his story. Serial bankruptcy... doesn't just happen to anyone, particularly anyone with a six figure salary. In September 1998, California bankruptcy court records indicate that Patty and her first husband declared bankruptcy... family income of $174,000 in 1996, $87,000 in 1997, and $126,000 in the first nine months of 1998... the couple owed about $30,000 on 8 credit cards, over $200,000 in back taxes, and almost $15,000 in private school tuition, as well as substantial car and mortgage payments. In 2007, nearly as soon as she was eligible, Patty Barreiro filed again in Montgomery Country. When called for comment yesterday, Andrews was unavailable.... The bankruptcy code requires filers to wait 8 years after a previous Chapter 7 discharge.  Barely four months after she became eligible, Patty Barreiro filed again.  And the filing shows some suggestion of strategic debt management. Ms. Barreiro filed separately from Andrews, and had to amend the filing to include Andrews' income after a complaint from a creditor.... She filed when her income was at rock bottom, consisting only of unemployment; the timing may have just excluded having to declare $5,000 in freelance editing income Andrews mentions in the book. And she shed what appear to be jointly incurred debts, such as a Comcast account....

Serial bankruptcies can, of course, happen to anyone with enough bad luck.  But they usually don't.  And when they do, they usually hit people with marginal incomes that leave no margin for error in the budget.  Most people, even in LA, are able to build a sustainable budget out of an income in the low six figures. Moreover, pesky bad luck isn't really the picture painted by either filing.  Rather, Ms. Barreiro seems to have spent most of the last two decades living right up to the edge of her income, and beyond, and then massively defaulting. If you structure your finances so that absolutely everything has to go right, it's hard to blame the mortgage company when you don't quite make it.

Andrews has been admirably open about many of the poor decisions and the wishful thinking that led him deep into debt.  Nonetheless, he has laid much of the blame onto irresponsible bankers and mortgage brokers. The missing bankruptcies substantially undermine this basic narrative arc of Andrews' story.  Particularly in his book, the bankers are the villains, America's current troubles are the inevitable denouement of their maniacal greed, and the Andrews household stands in for an American public led, by their own greed and longing and hopeful trust, into the money pit....

[I]t's still true that she and Andrews were able to dig themselves in a lot deeper because of fantastically easy credit from a variety of fantastically stupid bankers, most of whom now seem to have gone fantastically bankrupt. But while the willing lenders amplified the problem, given Ms. Barreiro's history, it seems unlikely they were at the root of it. It's hard to see them as victims either of those bankers, or a mass mania. Andrews married a woman with a lengthy history of debt and spending problems.  Serial bankrupts were getting into trouble long before there was a credit bubble, indeed long before there were credit cards or 30-year self-amortizing mortgages...

I disagree with Megan. If a road leads to the edge of a precipice and someone falls off, it is not terribly constructive to say: "Well! They were unsteady on their feet!" Instead, you build a guardrail. We are jumped-up East African Plains Apes whose key cognitive talents are figuring out which food is ripe, determining whether it is safe to leap to the next branch, keeping track of who is sleeping with whom so we don't proposition the wrong person and get beaten up, and guarding our children from violent death--we don't have the smarts to avoid serial bankruptcy. Which is why we should nudge ourselves into social systems in which serial bankruptcy is a very difficult thing to accomplish.

The financial companies of America bet that Patty Berreiro's financial judgment was so bad that they could extract enough in sky-high interest from her on her debts before she went bankrupt to make it a winning proposition to them although not to her. People whose business model rests on subtracting value from their customers need to be regulated out of existence.

And, of course, there are the shareholders who did not guard their own interests as well because they too were jumped-up East African Plains Apes. You can hear a certain glee in Ed Andrews' observation that two of his three mortgage lenders are now bankrupt.

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Laura Rowley:

Yahoo! Personal Finance: Calculators,Money Advice,Guides,& More: In a 'New York Times' story headlined “My Personal Credit Crisis”, economics reporter Edmund Andrews, 48, lays bare his finances and admits to a headlong dive into the subprime debacle. In the piece, excerpted from a forthcoming book, he describes buying a home he couldn’t afford with his second wife, Patty, falling ever deeper in debt, and cashing out his equity to finance a lifestyle that cost $3,000 a month more than they were earning. It ends with Andrews defaulting on the mortgage and, eight months later, still waiting for the bank to begin foreclosure proceedings.

Andrews’ story is riddled with classic personal-finance errors thought to be the province of the uneducated, underemployed, and ill-fated. Andrews was none of these; he earned $120,000 a year and didn’t suffer a disability or job loss. He explains his folly this way: "The money was there, and I was in love…I just thought I could beat the odds." But -- at least in hindsight -- the colossal improbability of beating the odds leaps off the written page. This is magical thinking at its finest, from a guy whose job is to write about the facts all day long. Multiplied by tens of millions of homeowners, it brought the U.S. economy to its knees.

Here are just a few lessons from his story:

1. Price your passions. Andrews divorced his first wife after 21 years of marriage and was responsible for $4,000 a month in alimony and child-support payments. This left him with $2,777 a month in take-home pay to support his new wife and her children.... [P]eople who stayed married accumulated 93 percent more wealth than single or divorced people.... In the book 'Spend ‘Til the End', authors Lawrence Kotlikoff and Scott Burns urge readers to “price their passions”...

2. Budget for the worst-case scenario. After the $2,500 mortgage payment, Andrews had $277 a month left for necessities, and hoped that Patty’s salary would make up the difference: “I was banking on Patty to earn enough money to keep us afloat.” Five months after moving into their home, Andrews was shocked to find just $196 left in his checking account. He writes, “How could I have glossed over the fact that we were spending about $3,000 more than we were earning, month after month?”...

3. Avoid the two-income trap. Counting on a second salary to make ends meet in the first place was an enormous gamble. Andrews writes, “Patty had spent much of the previous two decades as a stay-at-home mother in Los Angeles. Her last full-time job as an editor at a political research company was back in the early 1980s”...

4. Know what you can afford. A mortgage, property taxes, and insurance should total no more than 29 percent of gross income -- and those expenses, plus other long-term debts, should be no more than 36 percent of gross income...

5. Call your bank and ask them to cut you off in the event you attempt a debit or ATM transaction and the account has insufficient funds. As Andrews’ finances spiraled out of control, he repeatedly overshot his checking account. “Every time I overdrew my checking account by even a few dollars, the bank would tap my Mastercard for $100, helpfully deposit the cash in my account, and charge me $10 for the privilege,” Andrew writes. He recounts a $5 overdraft for school supplies. Assuming he deposited money two weeks later to repay the overdraft, his annual APR on the $10 overdraft “loan” would be 5,200 percent. (Here’s the calculator.)

6. Have a serious conversation about money with your intended before you tie the knot...

This Is Getting Damned Annoying: Will I Ever Be Allowed to Disagree with Paul Krugman Again About Anything? (Niall Ferguson Edition)

There have been two annoying things about the past decade. The first is that I feel like I have been living in a Ken Macleod novel--and one of the more dystopic ones too, at least up until January 21, 2009 (I am glad he has stopped: Ken: please don't get cranky again). The second is that the best way to understand the world is through these two rules:

1. Paul Krugman's analysis is correct.
2. If you think that Paul Krugman's analysis is incorrect, see rule number 1.

Most recently, I thought that Paul Krugman must be being too harsh on Niall Ferguson. Ferguson could not really have forgotten so much economics as to believe that when interest rates are zero deficit spending is inherently contractionary, could he? But Paul said he did:

Liquidity preference, loanable funds, and Niall Ferguson (wonkish) - Paul Krugman Blog - NYTimes.com: Joe Nocera... fails to mention... the most depressing aspect... further confirmation that we’re living in a Dark Age of macroeconomics, in which hard-won knowledge has simply been forgotten. What’s the evidence? Niall Ferguson “explaining” that fiscal expansion will actually be contractionary, because it will drive up interest rates. At least that’s what I think he said....

[I]t might be useful to re-explain why [in] our current predicament... fiscal deficits won’t drive up interest rates unless they also expand the economy.... I imagine Niall Ferguson was thinking... of... the “loanable funds” model.... Keynes pointed out was that this picture is incomplete if... the economy is not at full employment.... [S]upply and demand for [loanable] funds... tells you what the interest rate would be conditional on the level of GDP... defines a relationship between the interest rate and GDP....

So what determines the level of GDP, and hence also ties down the interest rate?... [A]dd “liquidity preference”, the supply and demand for money. In the modern world... the central bank adjusts the money supply so as to [try to] achieve a target interest rate.... [But r]ight now the interest rate that the Fed chooses is essentially zero [and cannot go any lower], but that’s not enough to achieve full employment... the interest rate the Fed would like to have is negative... the Fed’s own economists estimate the desired Fed funds rate at -5 percent....

So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending... until the excess supply of savings has been sopped up... [and the interest rate consistent with full employment rises above zero].

Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession. But the fact remains that our current problem is, in effect, a problem of excess worldwide savings, looking for someplace to go.

And Krugman reiterated his judgment:

China and the liquidity trap - Paul Krugman Blog - NYTimes.com: By the way, I’ve had a chance to see the transcript of the PEN/ NY Review event, and I don’t think I was misrepresenting Niall Ferguson’s position...

Sure enough, now that I have taken a look at the transcript, I have to once again agree that Paul Krugman's analysis is correct. This is annoying. This is damned annoying. In fact, this is beyond annoying:

Niall Ferguson: Now we are in the therapy phase, and what therapy ar we using? Well, it is very interesting because we are using two quite contradictory courses of therapy. One is the prescription of Dr. Friedman, Milton Friedman, that is, that is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the 1930s. I am fine with that. That is the right thing to do. But thre is qnother course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr. Keynes, John Maynard Keynes, and that therapy involves the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year and the issuance therefore of vast quantities of freshly-minted bonds.

There is a clear contradiction between these two policies, and we are trying to have it both ways. You cannot be a Keynesian and a monetarist simultaneously, at least I cannot see how you can, because if the aim of the monetarist policy is to keep interest rates down to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.... [T]here is going to be... a very painful tug-of-war between our monetary policy and our fiscal policy...

A real monetarist--like Milton Friedman's teacher Jacob Viner, say--would argue (in fact, did argue during the Great Depression) that when the interest rate is near zero monetary expansion and deficit spending do not offset but reinforce each other, for essentially the reasons set out by Krugman. As Paul said in rebuttal to Ferguson: "There is... no contradiction between the Federal Reserve's actions and... fiscal stimulus. It is very much necessary to do both..."

Normally the banking system buys bonds from corporations which then spend the money investing in plant and equipment. Right now that process has broken down, and until the banking system gets fixed the second-best is to have the government step into the role. As Krugman writes:

By buying a lot of private securities, the Federal Reserve is... playing the role the private banking system is no longer playing properly... debt-financed spending on infrastructure by the Obama administraiton is filling the hole left by the collapse in business investment....

Conclusion? Once again:

There is not an excess demand for savings that is going to drive up interest rates...

Niall Ferguson does indeed know a lot less than economists knew in the 1920s. Back then when R.G. Hawtrey was laying out the Treasury View he claimed that fiscal policy was ineffective--and was wrong. Niall Ferguson's belief that fiscal policy is destructive shows that he has not even got that far.

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UPDATE: As a "friend" points out, Ferguson spent considerable time trying to bait Krugman into losing his cool:

• As d² points out, the references to "Dr. Keynes" appear for some reason to work like a red flag to a bull on status-conscious Englishmen--for Keynes never got a Ph.D.--but it doesn't work on Dr. Krugman.
• "I rather fear that, at the risk of provoking the man sitting on the other side of me, that it says 1936 on the bottle of Dr. Keynes’ medicine..."
• "[I]if you listened carefully to what Paul Krumgan said, he actually agreed with me [laughter]..."
• "So, I hate to teach arithmetic to a Nobel laureate, it doesn’t quite add up..."
• Madrick: "Let’s let Paul speak..." Krugman: "Oh, Dear..." Ferguson: "Oh Dear indeed..." Krugman: "Let’s talk national income accounting offstage..."
*

The Return of Hyman Minsky

Paul Krugman writes:

The night they reread Minsky: Brad DeLong offers a neat little model of speculative fluctuations in asset prices, based on the idea that investors gradually switch strategies based on what seems to work for other people: if people buying stocks seem to be doing well, more people move into stocks, driving up prices and making stocks look even more attractive. It’s very close to Shiller’s notion of bubbles as natural Ponzi schemes. And Brad’s version is very much what I was saying in this piece written in 1999 — one I had a lot of fun writing.

What’s missing, as Brad himself points out, is the asymmetry of booms and crashes. What he doesn’t say is that what we really need is a model that can produce a Minsky moment — the point at which margin calls force deleveraging.

I’ll be giving the Robbins Lectures at the LSE next month. The title of this post is also the title of my third lecture. I hope I actually have a model by then

Paul is talking about my April 21, 2009 Economics 202b lecture on bubbles:

Let us begin with a very long quote from Chrles Kindleberger, who in turn begins with Hyman Minsky....

[Kindleberger] is, I think, right. And here I have a problem. For it is pretty clear to me that the conventional model of bubbles is not terribly illuminating as a model of this process. The conventional model of bubbles starts with the assumption of a constant required rate of return r. It continues with a one-period equilibrium condition for the price of an asset paying a dividend dt. If there is even one rational, utility-maximizing agent in the economy, than for that agent...

Download now or preview on posterous

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Posted via email from http://braddelong.posterous.com/delong-econ-202b-april-21-2009-lecture-notes at Brad DeLong's Scrapbook

Moral Courage from Edmund Andrews

Overextended and on the economic beat:

My Personal Credit Crisis: I joined millions of otherwise-sane Americans in what we now know was a catastrophic binge on overpriced real estate and reckless mortgages. Nobody duped or hypnotized me.... Patty was brainy, regal, sexy, fiery and eclectic. She was one of my closest friends when we were both students at an American high school in Argentina. Back then, we would talk together about politics and books at a coffee shop every day after school. We were not romantic in those days and went our separate ways after high school. But each of us would go through bruising two-decade-long marriages, and we felt that sweet spark of remembrance and renewal upon meeting again in middle age.

After a one-year bicoastal courtship, Patty was about to move from her home in Los Angeles to Washington. We would need a home.... Silver Spring, Md.... $460,000....

The only problem was money. Having separated from my wife of 21 years, who had physical custody of our sons, I was handing over $4,000 a month in alimony and child-support payments. That left me with take-home pay of $2,777.... At any other time in history, the idea of someone like me borrowing more than $400,000 would have seemed insane. But this was unlike any other time in history. My real estate agent gave me the number of Bob Andrews, a loan officer at American Home Mortgage Corporation....

“I am here to enable dreams,” he explained to me long afterward. Bob’s view was that if I’d been unemployed for seven years and didn’t have a dime to my name but I wanted a house, he wouldn’t question my prudence. “Who am I to tell you that you shouldn’t do what you want to do? I am here to sell money and to help you do what you want to do. At the end of the day, it’s your signature on the mortgage — not mine.”... My lenders weren’t assuming that I was an angel. They were betting that a default would be more painful to me than to them. If I wanted to take a risk, for whatever reason, they were not going to second-guess me. What mattered more than anything, Bob explained, was a person’s credit record.... “Don’t worry,” Bob reassured me, saying what almost everybody else in real estate was saying at that moment. “The value of your house will be higher in five years. You’ll be able to refinance.”...

Patty’s re-entry into the job market was bumpy.... We were spending way more than we were earning.... We had very different ideas about money.... We were lurching from paycheck to paycheck, one big home repair away from disaster. Meanwhile, neither of us was paying attention to how easy our bank had made it to build up debt. The key was the overdraft protection — more accurately described as “bounced-check loans.” Every time I overdrew my checking account by even a few dollars, the bank would tap my MasterCard for $100, helpfully deposit the cash in my account and charge me $10 for the privilege.... Chase Bank had cold-called me to offer a “platinum” card with no interest charges for the first six months. I took them up on it and shifted $3,000 in debt from my old card onto the new Chase card. But instead of paying down the balance before the interest charges began, I let it balloon to $6,000. Chase had sent us blank checks that we could use to either pay bills or give ourselves cash advances. I dismissed them as a cheap trick to lure dimwits into borrowing more money. In March, I grabbed one of the checks and used it to pay down $1,000 on my more expensive credit card....

Patty had suddenly got the break that seemed to solve our problems. In November 2005, she was hired as a full-time editor at a nonprofit organization with a salary of $60,000 a year.... I felt foolish, ashamed and angry as I confessed to Bob.... “What we’re going to do is a two-step plan,” he announced.... The way Bob figured it, my monthly payment would be down to about $3,200 by the fall... at least $500 a month less than the combined total of what I was paying on everything right then. And mortgage interest, unlike interest on credit-card debt, is entirely tax-deductible.

The whole plan worked exactly as Bob had predicted.... We were still loaded with debt, but we weren’t paying 27 percent interest rates on our credit cards. Patty was earning a solid salary, and I was earning extra money working overtime at The Times.... [O]n Oct. 10, 2006, when Patty lost her job. “Don’t worry,” she said bravely. “This will not be like the first time I was looking for a job. I’ve learned so much since then, and I am going to find another job quickly.” In the meantime, she said, she could collect unemployment for six months. She would also cash out her retirement account, which had about $7,000 in it. By any measure, the loss of Patty’s job was a financial catastrophe. We hadn’t yet gone more than 30 days delinquent on the mortgage, thanks, in part, to $15,000 I had borrowed shamefacedly from my mother after Patty stopped working....

November, four years after buying the house, we finally crossed our personal Rubicon and fell 30 days behind on our mortgage. “The last thing Chase wants is to foreclose on your home,” JPMorgan Chase wrote us. It assured us that it wanted to “help” and was willing to evaluate us for a number of “alternatives.” If we didn’t “resolve” our payment delinquency, it politely warned, “you will lose your home.” I took a certain pride that I outlasted two of my three mortgage lenders. American Home, my original lender, collapsed overnight when the financial markets first froze up in August 2007. Fremont, my second lender, was forced out of the mortgage business by federal regulators. That left me with JPMorgan Chase, one of the few big banks smart enough to sell off most of the subprime loans it financed. It still serviced my loan, but it wasn’t on the hook if I defaulted....

When I first called Chase in October, a representative named Sarah said I didn’t qualify for a loan modification because I wasn’t yet 90 days past due.... I called Chase back in January, when I was 90 days past due. Another representative told me that I would automatically be evaluated for a loan modification. “You should just wait until you hear from one of our negotiators,” he told me politely.... I tried again in late March. “I’m sorry, but our analysts have been backed up,” yet another Chase rep told me, even more politely than the previous one. She said each analyst had about 500 distressed borrowers to deal with, and it had been taking about five weeks for customers to get a direct response. The delays seemed to be getting longer.

I was actually beginning to feel sorry for Chase. It seemed to be so flooded with defaulting borrowers that it didn’t have time to foreclose on my house. Eight months after my last payment to the bank, I am still waiting for the ax to fall...

DeLong: Econ 202b: May 14: Policies that Might Work II: Banking

Are They or Aren't They?

Put me on record as saying that the Federal Reserve is making a bad mistake if Treasury ten-year bond yields rise far above 3% while the unemployment rate is still rising.

Jon Hilsenrath:

Fed’s Not Targeting Long Bond Rates: Bond investors have spent a lot of time in recent weeks wondering whether the Federal Reserve would increase its purchases of long term Treasurys now that yields on 10 year notes have pushed up beyond 3%. Fed Chairman Ben Bernanke offered some insight into his thinking on the issue at a hearing of the Joint Economic Committee.

The move above 3% isn’t fundamentally important, he suggested. “We are not targeting a particular interest rate” with the long term Treasury note purchase program, he said. That’s not to say the Fed won’t decide later to buy more Treasury bonds than already announced. Mr. Bernanke said he believed the program was helping to bring down private sector interest rates, many of which are benchmarked off of Treasury bonds. But it does suggest bond investors shouldn’t be so hung up on the 3% rate.

Yves Smith: Preventing the Next Financial Crisis by Reforming Wall Street Pay

Yves Smith leads those of us who want Silicon-Valley compensation schemes for Wall Street:

naked capitalism: Obama Administration Considering Tackling Financial Services Pay: Before anyone gets hysterical, the focus of the efforts by Team Obama on financial services industry pay appears to be to force the industry to stop rewarding undue risk taking. As much as I have been critical of many Administration plans, this, at least in concept, is a good one. Why? Because I sincerely doubt Team Obama will do more than set guidelines and principles. and that may not even prove necessary if they show enough resolve. If the industry wasn't so predictably out to keep all its perquisites despite its horrific performance, this sort of effort would not be necessary. We've had some fulminating by Goldman CEO Lloyd Blankfein, plus an earlier line of thought in a Financial Times comment mainly on the failings of risk management:

More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.

This would take the firms a fair bit of the way back to the old partnership model. Funny how they were more careful about risk when it was their own capital on the line. But the exposure in those days was even greater, since the partners are personally liable. LTCM managed to blow itself up even though its principals have almost all of their money invested it. Yes, this would be a huge step in the right direction, but I wonder if any model that involves limited liability, other people's money, and a government backstop (which we now know is guaranteed for big players) is still a troublesome mix. But fine sentiments are no substitute for action, and there seems to have been perilously little, save UBS's malus plan, in which much of the bonus is put in escrow and may be reduced if some of the recipient's actions are found to have been damaging to the bank.

The problem with any action on the bonus structure front is that it needs to be reasonably broad based. One firm acting alone, save perhaps Goldman, is likely to expose itself to defections if its program is too far out of line with industry norms. Thus if the industry has any sense, Team Obama's pressure will presumably elicit responses from the industry. Note that some of the ideas being bandied about apply to traditional lenders, such as banning rewards based on meeting volume targets, which creates incentives to ignore loan quality. From the Wall Street Journal:

The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry, including at companies that did not receive federal bailout money, according to people familiar with the matter. The initiative, which is in its early stages, is part of an ambitious and likely controversial effort to broadly address the way financial companies pay employees and executives, including an attempt to more closely align pay with long-term performance.... Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality. The administration is also discussing issuing "best practices" to guide firms in structuring pay. At the same time, House Financial Services Committee Chairman Barney Frank (D., Mass.) is working on legislation that could strengthen the government's ability both to monitor compensation and to curb incentives that threaten a company's viability or pose a systemic risk to the economy.... But any legislation passed would make it harder for policy makers to dial back limits once the financial crisis subsides...

Yves here. Please. That last sentence is editorializing. How many rules and laws went unenforced in the last cycle? And if bad incentives lead banks to take risks that pose a danger to the system, which they have, trying to influence their practices is not a bad concept. Have we forgotten that banks run off the cliff like lemmings at least every ten years? The bigger point is that banks are subject to taxpayer backstops. That puts them in a very different category than most businesses. Since the banks have abused their access to the public till, more intrusive policies are called for. Back to the article:

Regulators have long had the power to sanction a bank for excessive pay structures, but have rarely used it.... Government officials said their effort, which is just beginning, isn't aimed at setting pay or establishing detailed rules. "This is not going to be about capping compensation or micro-management," said an administration official. "It will be about understanding what is the best way to align compensation with sound risk management and long-term value creation." Despite the banking industry's weakened state, it would likely try to push back against curbs on how financial firms can compensate people. Bank executives have complained to federal officials that strict rules could prompt some of their best employees to move to parts of the financial industry that aren't regulated, such as hedge funds, private-equity firms and foreign banks. They've also argued that paying substantial bonuses is integral to how the industry works....

During a recent congressional hearing, Chairman Ben Bernanke said the Fed was working on rules that will "ask or tell banks to structure their compensation, not just at the very top level but down much further, in a way that is consistent with safety and soundness -- which means that payments, bonuses and so on should be tied to performance and should not induce excessive risk." In an indication of how broad the effort may become, Federal Deposit Insurance Corp. Chairman Sheila Bair said regulators need to examine compensation practices in the mortgage industry, suggesting new limits could stretch beyond banks...

Notes and Handouts for Berkeley Physics Colloquium, May 11, 2009

Audio: http://www.j-bradford-delong.net/2009_mov/20090511_physics.m4a

• The fall in the adult employment-population ratio
• The increase in risk and the collapse in risk tolerance
• The fall in monetary velocity
• What determines monetary velocity?
• Policy to fix it 1: dump money into the economy
  • Unjust enrichment
  • Inflationary overhang
  • Might not work when i<<1
• Policy to fix it 2: raise Treasury bond interest rates
  • By making Treasury bonds less attractive to hold--flood the zone
    • But then you have to spend the money you have earned by selling the Treasury bonds
  • By making corporate bonds more attractive to hold
    • Guarantees
    • Asset repurchases
    • Bank recapitalizations
• How did we get here?
  • Herd behavior
  • Short horizons
  • Limits to arbitrage
• What do we do for the long term?

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What is happening to employment?...

Increasing risk and collapsing risk tolerance...

Are the banks about to fail?...

Increasing risk and collapsing risk tolerance affect all asset prices...

Why asymmetry? The fall in monetary velocity...

Asymmetry arising from deflation...

Flight to safety produces a collapse in monetary velocity...

Normally we deal with collapsing velocity via monetary policy...

But may not work if interest rates are very low...

Guess where we are now?

Time to try alternative policies to try to raise the short-term interest rate on Treasury bonds...

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How did we get here?

What do we do to improve the system?

A Short Talk on the Financial Crisis

http://www.j-bradford-delong.net/2009_mov/20090505_crisis_talk.m4a

...with a noncommercial announcement at its end.

Obama's First 100 Days

And the four timescales on which he must act:

• The three-year time-scale: the economic crisis.
• The fifteen-year time scale: the health cost crisis.
• The seventy-five-year time scale: the global power crisis.
• The 375-year time scale: the global climate crisis.

http://www.j-bradford-delong.net/2009_mov/20090507_100_days.m4a

DeLong: Econ 202b Lecture May 7, 2009: Trying (and Failing) to Understand the "Modern Chicago" View of the Financial Crisis

Download now or preview on posterous

• Audio

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Posted via email from http://braddelong.posterous.com/delong-econ-202b-lecture-may-7-2009-trying-an at Brad DeLong's Scrapbook

DeLong: Econ 202b: Sample Exam