Growthology

The Stimulus Sun God

Six weeks ago, Michael Cembalest, CIO of J.P. Morgan Global Wealth Management, sent out his regular "Eye on the Market" newsletter, which included a stunning chart. Comparing the current economic "rescue mission" with past recessions (as of April 22), Cembalest displayed monetary and fiscal stimuli, with the Sun deities representing the present policy response:

All you can really say about this is, wow.

Cembalest began the newsletter by recalling that "ancient sun worshippers were mostly unaware of the astronomical forces at work guaranteeing that the sun would rise every day, whether they offered a sacrifice or not." This could probably apply to most economic policymakers, who often seem to think that, but for their efforts at managing and steering the economy, all growth and activity and innovation would come to a halt and we would all pitch into poverty.

Depression Index

Our very own Tim Kane has a nice empirical piece up at Real Clear Markets today. Tim makes crystal clear just how stark things are right now in the economy.

Nice work, Tim!

Unsticky Wages? Not so fast.

Over at BusinessWeek, there's a discussion of whether a company should cut pay or lay off workers in a time of distress, with management tending to always prefer laying off workers to cutting the sacrosanct base salary.

There may be a skill effect going on here. In an era/economy dominated by low-skill jobs, a firm could more easily boost productivity by threatening to lay off or actually laying off workers. But in a knowledge economy, many of the workers feel a part of the team and eliminating part of the team can lead to diminishing returns. Just imagine if the Beatles had cut Paul McCartney (or even George Harrison.)

 

BW cites Dan Ariely, the go-to guy for behavioral economics after he wrote the magnificent book, Predictably Irrational, which is also the title of his pretty informative blog. 

Dan Ariely, a behavioral economics professor at Duke University who sees value in cutting pay vs. jobs, notes that salary is what economists call a "positional good," meaning people care more about how much they make relative to their peers than the absolute level of what they take home. That's why Wall Street bankers get angry if their bonuses don't match what rivals are pocketing a few blocks away, and why distressed U.S. autoworkers who have given up years of hard-won benefits take some solace in the knowledge that they still many more than many other industrial workers.

A skills shift? Just maybe there's a clue in this article about Professor Ariely in Haaretz. (Professor Ariely is Israeli.)  

Ariely and his colleagues ran several experiments, among everyday people in India and among American students, in which participants were given a cognitive challenge - such as a memory game or a puzzle - as well as technical tasks requiring little thought, such as fast-paced typing. The researchers promised participants bonuses of varying sizes for good performance. They discovered that when it came to the cognitive tasks, which demanded mental effort, participants who were offered the largest bonuses performed less well than those in the two other groups, which were promised smaller ones. When the task was a purely mechanical one, however, the financial incentive did prove effective. [Emphasis mine.]

This is all interesting stuff.  But Let's not be so fast to say job losses are less frequent in the new (more altruistic?) economy when the facts say the fastest rising rate of unemployment in the U.S. since the 1930s is happening right now.

Sticky Facts

Then again, the facts don't seem to back up the flexible pay argument. The best measure of compensation, according to a friend at the BLS, is the ECI (employment cost index).

Total compensation costs for civilian workers increased 0.3 percent from December 2008 to
March 2009, seasonally adjusted, the Bureau of Labor Statistics of the U.S. Department of Labor reported today.  This follows a 0.6 percent increase for the September to December 2008 period. In March 2009, wages and salaries also rose 0.3 percent, while benefits rose 0.5 percent.

The ECI is a really useful fact-based piece of reality to keep in mind as you are assaulted by news and opinion that Americans are suffering from lifestyle declines.  It is awfully hard to square that with the ECI's report of compensation growing at 2/3 a percent every quarter! Maybe the ECI is a slightly lagging indiciator, but there's no denying a deceleration down to just 1/3 a percentage point last quarter.

Who wants to bet the ECI goes negative?  I'll wager $10 to anyone (or up to 50 anyones) that ECI growth remains positive during 2009.

Entrepreneurs Stay Strong

A new Kauffman Foundation study finds that entrepreneurial activity increased in 2008. The press release and the study highlight the variable trends beneath the aggregate figures, but here's what jumped out at me: immigrants continued to found new businesses at higher rates than natives.

Most of the noise in the econo-blogosphere around immigration has concerned H1B visas and the turning away of high-skilled immigrants. But as I've noted before, we can't ignore the lower-profile immigrant entrepreneurs.

As an aside, it will be interesting to note the detailed NAICS breakdown of new firms once all the data becomes available. Our study has the general industry categories (e.g., construction, services) but not the more detailed information.

The Next Economic Wave

A recent Time magazine article pointed out that many people see the recession as a good opportunity to start a new company: "At no other time in recent history has it been easier or cheaper to start a new kind of company. Possibly a very profitable company. Let's call these start-ups LILOs, for 'a little in, a lot out.' These are Web-based businesses that cost almost nothing to get off the groundyet can turn into great moneymakers."

Indisputably, the Internent has fundamentally changed the dynamics of not only starting new companies but also starting up in a recession. If it's cheaper and easier now with this technology, perhaps Web-based firms offer one promising route out of the recession and onto a long-term growth trajectory.

The Internet, obviously, is relatively new. But the underlying story--about startups and recessions and economic growth--is an old one. The very nature of technological change and economic growth is the rise and fall of successive waves of entrepreneurs. The early New England textile manufacturers became an elite whose names (Cabot, Lowell) still today signify distinguished pedigree. Part of the reason Los Angeles became the center of the film industry was that many of the entrepreneurs were driven out of New York by the established (such as they were) companies and individuals. We can replay the same story with FM radio, software, search engines, etc. 

A generation of entrepreneurs becomes the next generation's elite, the position of whom is then challenged by newer entrepreneurs. Henri Pirenne knew this; Joseph Schumpeter and his intellectual cousins, the Austrian economists and German historicists, knew this. We are apparently rediscovering it today.

Research we have been working on the Kauffman Foundation, soon to be released, will confirm this broad theme. Recessions don't seem to matter all that much to entrepreneurs--they act as their own economic stimulus package. The most pertinent policy question, then, concerns what actions we should take or not take such that we don't squash the next emergent economic wave.

From the "Sentences We Never Thought We'd See" Department

Strong banks will be allowed to repay federal bailout funds, but only if such a move passes a test to determine whether it is in the national economic interest, the Financial Times reported on Sunday, citing a senior U.S. administration official.

Link here (emphasis added).

Short-term Backstop, Long-term Transformation

Out here in suburban Kansas, enrollment at the local community college has been increasing: Johnson County Community College (a fantastic institution, by the way) is experiencing its highest totals ever for a spring semester. The most popular fields of study? Health and entrepreneurship.

That, in and of itself, is unsurprising: higher education often sees a spike in times of recession. Yet in a larger sense, JCCC and other similar institutions around the country may augur a broader shift in the higher education landscape. At least, I hope they do. Enrollment at JCCC is now around 20,000, comparable to some of the country's best state universities--include continuing education, and the number rises. The school expects to benefit, too, from the Johnson County Education and Research Triangle.

In the early decades of the twentieth century, the "high school movement" transformed the relationship between the citizenry, the education system, and the emerging industrial economy. Undoubtedly, a similar transformation is taking place today--community colleges like JCCC, the increasing use of technology in education, completely new ways of teaching, etc etc.

The nature of these transformations is such that, while the federal government will play an unavoidably large role (just given its size and sway in education these days), we won't even be able to coherently outline the future of education until it's already upon us. The only things we can say for sure is that it will be a far more structurally diverse system than today, and it will be much more substantive than simple calls for more money.

Fix Housing, Not Homeowning

Steve Malanga thinks Americans haven't learned from the housing bust:

Even now, in the midst of our current woes, members of the Congressional Hispanic Caucus caution against reining in affordable housing lending because, “We need to keep credit easily accessible to our minority communities,” as Congressman Joe Baca has put it. And both Republicans and Democrats in Congress continue to put forward new programs to subsidize home ownership and kick start the housing market, without wondering whether further subsidies might just spark new foreclosure problems.

Until Congress shifts gears from promoting homeownership into simplifying and/or accelerating foreclosures (e.g. by converting weak mortgage holders into renters), the bottom will be elusive.

Cartoon Keynesiansim = Slamming Amity Shlaes

The Economist (magazine) blog is schizophrenic this week.  On the one hand, it does a drive-by ad hominem attack on Amity Shlaes, calling her "empirically challenged" without actually mentioning any facts she got wrong in her book, The Forgotten Man. On the other hand, the blog has a post today that points out the fallacy in the idea of Keynesian growth. The fallacy of Keynesian growth is the basic idea of The Forgotten Man, by the way, a much bigger story than spending multipliers.

Clearly, the global economy is in a deep recession, and the Democratic monopoly in power in DC is moving boldly to address it. Indeed, the moves have been so bold that Republicans are essentially united in opposition. This isn't just partisanship, as there were many centrist Democrats voting against the recent stimulus bill, and already vocal Democratic defections from other economic plans coming from the White House (witness the quiet multi-month delay in consideration of the Orwellian "Employee Free Choice Act"). These are simple facts. Unfortunately, the heated politics of the worsening recession have boiled over to the economics, and made for some nasty exchanges.

One of the core concepts being debated is whether fiscal stimulus is an effective remedy for recessions. As Harvard economist Greg Mankiw has recently and repeatedly observed, this idea was out of favor among mainstream academic economists in recent years. Unfortunately, the very word "Keynes" has become, in political conversation, an invitation to draw battle lines and simplify discourse entirely. Naturally, we all struggle to make technical economics accessible to the lay reader (i.e. the policymaker), but discussions of Keynesianism are particularly cartoonish. It is unhelpful enough when politicians want to believe that everything Keynes did, said, wrote, researched was somehow socialist. It's even worse when academics (Brad DeLong, are you listening?) play on those same cartoonish sentiments.

Defenders of the stimulus want to confuse Shlaes history book into some kind of wild-eyed hostility to all things wise and wonderful written by Keynes and every great economist since. She's no economist, they thunder! Consider BigPicture which ridiculed Shlaes last November as "economically clueless" and a "no-nothing" (know kidding) for describing a recession as two quarters of GDP decline, which is exactly what Ph.D. economists do all the time as a non-technical rule of thumb. 

Advocates of activist policy are really guilty not just of a war against apostates, but distorting their own prophet's words. They are turning Keynes into a caricature: all spending is good spending! Cartoon Keynesianism sees all politics as a struggle over the size of G, government. This cartoon is offensive and seems like a willful distortion with ulterior motives.

In truth, Keynesian stimulus need not be government spending, it can also be tax cuts. Shocker! I, for one, support the basic Keynesian idea of automatic stabilizers in place and wish we had more built into the tax system. Yet too many voices in the punditry space lump all tax cuts in the capitalism/Republican side and all spending in the socialism/Democratic side. It's insulting to both sides, and worse it marginalizes the more important conversation about growth policy. Here's the honest way economists should be talking about any short-term Keynesian spending plan: "Recovery? Maybe. Growth? No." 

That conclusion, in fact, is from the Economist blog. Quote: "Stimulus can help with recovery, but it can't do much to aid reformation—indeed, it could retard structural transitions."  Keep in mind that not all economists are even that kind to stimulus policies. Research by UCLA economists Harold L. Cole and Lee E. Ohanian in 2004 conclude FDR's policies extended the Great Depression, saying: "We found that a relapse [into another long Depression] isn't likely unless lawmakers gum up a recovery with ill-conceived stimulus policies." A 1999 paper by the economists for the Minneapolis Fed reviewing the Great Depression opens:

[T]heory predicts an extremely rapid recovery that returns output to trend around 1936. In sharp contrast, real output remained between 25 and 30 percent below trend through the late 1930s.We conclude that a new shock is needed to account for the Depression’s weak recovery. A likely culprit is New Deal policies toward monopoly and the distribution of income.

Validation

A lot of good theory works on paper, but is humbled by reality. This is what happened to Old Keynesianism, and is why modern teaching in grad schools is now done under the banner of Neo- or New Keynesianism. The identity Y = C + I + G + NX is simply too crude to tell us anything about how an economy grows. The crudest interpretation, and dumbest, was followed by Washington policymakers for decades and imagines the national income identity can be managed by fiscal policy. Whether such policy is sustainable is irrelevant. And yet, history tells us that constantly pushing G to manage Y causes an uncontrollable price inflation. Uncontrollable in the Keynesian paradigm, that is. The whole framework was superseded by expectations macro and validated by Volcker when he stopped Keynesian inflation of the 1970s with the 1980-82 monetarily induced recession.

The defenders of Cartoon Keynesianism want to believe their framework had a similar validating experience, which was the New Deal's curative power over the Great Depression. The simple history taught in most high schools today (and non-economics college courses) is that FDR's expansion of government saved the national economy. That's just not true.

There are four presidential names being bandied about: Hoover, Roosevelt, Bush, and Obama. The cartoon story says that Bush like Hoover wrecked the economy with laissez-faire extremism and that Obama like Roosevelt will tame capitalism's failure with strong government action. The reality is that government spending and budget deficits under President Bush were massive, while Hoover is infamous for raising tariffs in 1930 as well as the top income tax rate from 25 to 63 percent in 1932. So Hoover wasn't really laissez-faire in his policies, and Bush wasn't either. Every president - especially Obama - offers a mixed bag of tricks that defy labels, especially old ones.

So why did Free exchange go after Amity Shlaes?  For starters, it was echoing a long and current piece by Jonathan Chait in the New Republic, whose purpose is to paint modern Republicans as little Hoovers. Except for the little things like tax rates and free trade, which he ignores, choosing to selectively make a case about somebody else making a selective case. My theory is that this is part of a larger reckoning.

Chait wants his readers to think the Amity Shlaes is an outlier (and not the smart kind). But Chait -- perhaps because he also has no economics degree -- makes false claims about consensus in the profession, such as "the essential framework constructed by Keynes--that recessions are caused by a failure of demand, and that at the very least government should not respond to an economic slowdown by paring back its largesse--is no longer in dispute." This is just wrong. It may comes as some surprise that a 1995 survey of economic historians published in the Journal of Economic History said this:

On top of the profession's lack of agreement about the genesis of the Great Depression, there is a disagreement about the effect of the New Deal. In fact, the economists in the sample are almost evenly divided on the question of whether or not when taken "as a whole, government policies of the New Deal served to lengthen and deepen the Great Depression."

The Reckoning

This is important not just to make the point that partisans on the Left (and Right) are mean, dishonest jerks. The global recession is very real, so when even the Economist (magazine) falls into this shallow smear game, I get worried that we are collectively taking our eye off the ball. If your goal is rip-roaring growth, fixing banking, fixing mortgages, or a real cure for poverty, a debate about stimulating the short-run economy is irrelevant. At best, another trillion in G arrests a couple points of GDP decline for a couple years if you believe the macro sim models. Add up all the new plans, and you get annual trillion-dollar deficits for the next decade, according to the Brookings Instituion.

Rather than take on half of the economics profession, or Brookings, or just engage in a serious discussion of growth policy, the partisans have instead decided to target Amity Shlaes for writing a history book two years ago about the New Deal and FDR. Ironically, if you understand her title, The Forgotten Man is not about macro stabilization theory, but about the unprecedented scope of powers that were centralized in 1930s America, running roughshod over the Constitution and the middle class Americans who pay for grand plans. This, too, is fact even for fans of big G. But I guess describing facts makes you an enemy of the state and its toadies.

What is really at stake is a year of budgetary reckoning, which I now believe will become a decade of reckoning. The crisis of big entitlement promises is about to clash with the limits of taxation. Shouting down Amity Shlaes is just a warm-up.

He's at it Again

Have you ever wondered what Deliverance, the Ivy League, debt financing, and DNA have in common? Well, you're in luck: Harold Bradley has the answer.

The Matrix and the Superorganism

On the latest episode of Flight of the Conchords the other night, the prime minister of New Zealand, on a visit to the United States, believes he's living inside The Matrix and, detecting a glitch (deja vu), leaps off a building to escape. This is good TV.

Aside from comic relief, the show's invocation of the Matrix resonated as I read Tim Flannery's interesting review of what sounds like a fascinating book, The Superorganism. In what struck me as a stretch, Flannery sought to analogize the superorganism civilizations of ants to human society, particularly the continued growth of the Internet and global concerns like climate change and economic meltdown.

Humans, perhaps thankfully, are still a long way from building a global superorganism, whether intentionally or not. Even advanced societies do not function in the finely striated ways that ant colonies do, despite the awe-inspiring realization that human societies, like the ants, operate smoothly in the absence of any controlling intelligence.

Yet a reasonable analogy between ants and humans might be the systems that humans build, and I have in mind specifically the global financial system. This seems to be a close approximation of the ant superorganism in that the division of labor is quite deep, the system can often be said to be acting in one unified direction (up or down), there is innovation (ants "invented" agriculture long before humans), and it is marked by behavior in response to discrete signals.

So how does such a superorganism collapse? Here, the story becomes almost entirely human: as Alan Greenspan observed, there was "a flaw in the model that I perceived is the critical functioning structure that defines how the world works." What was the flaw? Every commentator in the economic and financial world has answered this question, but it really comes down to something as old as human civilization: hubris. Probability and risk (really, uncertainty) were distorted, misunderstood, and subsumed within an irresistible superorganism of hubris.

National Public Radio reported the other day that college students, in response to the financial crash and recession, are flocking to a major in economics. This seems understandable, but I can't help wondering: if the current generation of economists utterly failed to suspect something to be a tad askew with the global financial system, will the next generation? (Trained, incidentally, by today's economists.) Given the entirely human traits involved here, perhaps literature or classics or history would be better-advised courses of study? 

Or let's update those staid majors, even. I heard somewhere recently that some college or university now offers a master's degree in the Beatles. Maybe we need one in The Matrix as well.

Power is Power is Power

The McKinsey Quarterly has just published a special edition, "What Matters," and Carl Schramm and I co-author an essay, "The right way to regulate."

I don't know whether or not we actually lay out the "right" regulatory path, but our writing scope was broad and we used it to explore questions of finance, its relation to entrepreneurship, the role of government in the face of complexity, and the raw issue of presidential power. The last topic, radioactive for the last eight years and simmering below the surface in the prior three decades, does not seem to have been much of a public concern of late.

This is entirely appropriate: crises aren't known for bringing out one's inner constitutional scholar. Eventually, however, constitutional issues unavoidably arise and this recession should be no different. We observe in the essay that President Obama, inheriting the aggresive unitary executive philosophy of the Bush-Cheney administration and now assuming radical fiscal authority (the stimulus, the second half of TARP, the next bank rescue plan, the new budget proposal), enters office as pretty much the most powerful president in American history. 

Political inclination matters little here--we observe in the essay that the strong U.S. economic performance over the last two centuries has occurred during a time of continually rising governmental size and power. There's a lot packed into that observation: size can be a poor proxy; policy orientation matters more; pecuniary issues can be relative, etc. So irrespective of how you view the President or how you view the proper government response to the meltdown, the scope of executive power at this point in time is beyond astounding. Breathtaking, perhaps.

As a final note, I want to point out that the McKinsey "What Matters" collection includes a lot of interesting essays that I'll be further exploring in this spot over the next several days. Those in the "Innovation" section look especially tempting for critical analysis.

Does the Long Run Still Matter?

Were we to flatter ourselves, we might say that today's Financial Times Insight column by the legendary Peter Bernstein was a gauntlet thrown down at Growthology's doorstep.

It wasn't, of course, but Bernstein's short essay raises serious questions related to the entire premise of this and many other economics blogs. Has "the possibility of the long run" run away? That's Bernstein's question, and while his specific point pertains to investments, we cannot escape the larger economic growth implications of passages such as these:

"What kind of long run is this mess going to produce? . . . Can capitalism remain a 'going concern' [quoting Bill Gross] after an extended period characterised by massive government intervention into the economy--and bail-outs of firms that would otherwise have failed? . . . Will our society and economy emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?"

Heartening stuff.

Bernstein's starting point is a comparison between equity and bond yields and the famous observations made by Keynes that only the short-term storms, not the long-run fate of the ocean surface, matter for economists. But the question for us, as Bernstein frames it, is very serious: what should a long-run perspective on economic growth look like in the face of this incredible tempest? It's clear that no one can simply say, well we're concerned with the long term so we should do X, Y, Z, irrespective of how emergency policymaking will or will not impinge on the long term. 

No one can see the future, of course, as Bernstein reminds us: "the unknown today seems more than usually unknown. . . . The long run is an impenetrable mystery. It always has been." So it's somewhere close to impossible for anyone to know or precisely foresee the short and long term balance of crisis response and long run growth prospects. 

Yet we cannot pretend that the immediate future won't affect the long term. I know I'm sounding circular here, but it's an important consideration--to what extent are we foreclosing the possibilities of long-term growth, or to what extent are we expanding those possibilities? Should, that is, the short and long term questions go together? Or should we somehow imagine them to be separate, throwing our hands up in the face of complete and utter uncertainty?

Order and Mess

Our good friend Gene Wilson alerted me to an article in the Cal Tech magazine Engineering & Science, which provides a succinct look at the current financial crisis, its historical antecedents, and some modest recommendations. Many readers won't find much new information, but two things stood out.

The first is the clear historical rhyme, "just how much this crisis resembles past financial collapses." The authors point in particular to real estate panics in 1837 and the 1890s that bore striking similarities to the housing market roots of today's problems: "residential real estate may be the oldest asset market on the planet, but it still contains an important element of risk."

Second, like many other observers, the authors highlight the instigative role played by mathematical formulae. Felix Salmon has a terrific essay out in Wired that looks at the specific formula, purporting to condense all possible risks into a single correlation number, that lies at the heart of the crash. Felix and the Cal Tech professors make the same points:

"Financial firms relied upon data series that are merely a couple of decades long, or at best stretching back to World War II . . . it's as if we only relied on the earthquake record of the Los Angeles basin over the past 25 years to calculate the likelihood of the Big One." (Cal Tech)

"Li's copula function was used to price hundreds of billions of dollars' worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared . . . an ingenious way to model default correlation without even looking at historical default data." (Felix)

These and many articles have an oddly reassuring message: we're still human because we make the same mistakes over and over and we ignore history. But, in a larger sense, we're human in two annoyingly beautiful and opposing ways: we love order and continuously seek to impose it; and, the systems and institutions we build are inevitably messy, not susceptible to order.

In a paper put out last month, economist Daron Acemoglu argued that three misplaced intellectual notions had caused economists to ignore mounting economic problems. One was the belief that "through astute policy or new technologies . . . the business cycles were conquered." (This, incidentally, was a common economic belief in the 1960s when Keynes' General Theory was mathematically married to the Phillips Curve, helping precipitate inflation and slow growth.)

When we say that today's crisis has its source in human nature, no one is saying that there was once an Arcadian age during which people were humble and modest and more self-controlled than today. That's not the point. (For anyone who doubts the timelessness of the human impulse to control and its consequences, read any ancient Greek literature or any of the prophetic texts--Amos, Jeremiah, etc.)

The perpetual struggle between order and mess has often been expressed in institutions that check and balance these impulses and contest with each other. Acemoglu's second "too-quickly-accepted notion is that the capitalist economy lives in an institution-less vacuum, where markets miraculously monitor opportunistic behavior." This is why we have government; this is why, within organizations, we have management. In his essay, Felix highlights an almost complete lapse of managerial responsibility in failing to check the conquest of the quants.

I have little faith that the federal government (or anyone else) can wave legislation and--Voila!--transform the entire economy. Things are more complex than this (and government is one place we have often seen the order impluse unrestrained). The trick is to understand that messy capitalism is an engine of innovation and wealth creation and the expansion of human welfare, without losing those institutional checks that help the system organize into some semblance of order. Anyone have any ideas?

Harold Bradley . . . Again?!

This time, on mosquitoes and hedge funds.

Rethinking The Bank Bailout

Holman Jenkins, the prolific and provocative opinion writer for the Wall Street Journal, has been writing lately that the entire bank bailout mess could have been avoided had our bank regulators, the Paulson Treasury and the Bernanke Fed, decided to forbear from enforcing bank capital standards for troubled banks. By looking the other way at the mounting bank losses, but still guaranteeing bank deposits to prevent a run, policy makers could have avoided asking Congress for the $700 billion in TARP monies. We then could avoided the large (but presumably temporary) bump up in the deficit (putting aside the bump due to the stimulus package), while Members of Congress in both parties need not have angered the public with lots of bailout talk (though there still would have been some of that with the federal rescues of AIG, the housing GSEs, and the auto companies).

This is a line of argument that should be taken seriously – although more for historical purposes than anything else. Given the creation of the TARP and widespread acknowledgement now of the need for more transparency and appropriate asset valuation on bank balance sheets, it is too late to implement anything like what Jenkins recommends.

Nonetheless, it must be acknowledged that there is ample precedent in our recent history for his recommended approach. In the 1980s, our bank regulators did not force the money center banks to mark their LDC loans anywhere close to market, which very likely could have pushed many or even all of them into insolvency – and thus government ownership, as happened with Continental Illinois (which was not re-privatized until the early 1990s). By letting these banks stay in business, policymakers essentially gambled on their resurrection, which indeed happened as the economy later recovered.

The overwhelming consensus of policy makers and financial policy specialists at the time, however, was that we were lucky with this episode of regulatory forbearance, and that it should be not repeated. The problem with forbearance is that when it is combined with deposit insurance, banks that gamble for resurrection can dig themselves – and thus potentially taxpayers – into deeper graves. Indeed, some of the money centers did exactly that, using the breathing room they were given by regulators to make what turned out to be bad commercial real estate loans and loans to support leveraged buyouts. The savings and loans were much worse, gambling away roughly $150 billion in new losses that eventually had to be absorbed by taxpayers. I know $150 billion looks cheap by today’s bailout standards, but trust me as one who commented on that experience at the time, most people then thought $150 billion was a lot of money.

To keep all this from happening again, Congress passed a law in 1991 requiring regulators to take “prompt corrective action” to cure capital shortfalls in banks. This means that as a bank’s capital dwindles below the regulatory minimum, its activities are subject to an increasingly stiff regulatory regime, including suspension of dividends, salary restrictions, and a mandate to raise more capital. If all else fails, bank regulators are required to take control of the bank just short of insolvency (when capital falls to less than 2% of assets), and either operate it, sell it to other banks or investors, or liquidate, whichever is the least cost way of handling the situation.

In advocating forbearance this time around, Jenkins is essentially arguing that regulators should have effectively ignored the 1991 law (called by its acronym, FDICIA) and operated the way they did in the 1980s. But to be fair to Jenkins, presumably he would have had the regulators also clamping down on the banks’ further risk-taking – in other words, keeping them in business, but marking time until the economic recovery enabled them to make enough money to restore their capital positions (Maybe he would have had the regulators encouraging the banks to raise more capital, too, but this would have been a public acknowledgement of the banks’ weakness, something that presumably Jenkins would not want to have happened). And, although I presume Jenkins would not endorse the idea, if the Treasury back in the fall instead had backed a large publicly funded plan to help troubled homeowners – roughly the size of what President Obama has now proposed, though not necessarily with the same details – then this would have reduced the banks’ losses, and thus would have reduced the amount of forbearance that regulators would have to give.

Could have all this worked – and avoided the mess we are now in? One objection is that the U.S. couldn’t have pulled it off given all of the criticism we had leveled against Japan for practicing forbearance in the 1990s. Again and again our policy makers told Japan to face the music, and spend whatever it took and quickly to clean up its banks’ balance sheets. With the shoe on the other foot, and the whole world watching, could U.S. regulators, our Treasury Secretary and our Fed Chairman have faced the public and Wall Street and effectively have said either that the banks were really solvent on a long-term basis, or that if they weren’t it needn’t have mattered? I doubt it, but am certainly open to hearing a counter-argument.

Then there is the problem of the frozen inter-bank lending market in September, especially after Washington chose not to rescue Lehman. Had regulators openly practiced forbearance, rather than poured TARP money into the breach, would interbank lending rates have come down? Here, Jenkins has a plausible answer: the Fed could simply have guaranteed all inter-bank loans, and this would have had the same calming effect, but without the immediate expenditure of funds. To be sure, guarantees have moral hazard effects, but presumably regulators could have clamped down on bank lending to constrain it.

But this brings us to a third objection to the forbearance idea: that, to prevent a rerun of the gambling for resurrection we saw in the thrift crisis of the 1980s but with more zeros at the end, regulators would have had to tighten their oversight of bank lending. This would have resulted in the same outcome we have now – with seemingly everyone beating on the banks to loan more money, but unable to do so because of regulatory limitations, or because of fears by bank management of lending more during a sharply deteriorating economy.

Jenkins’ come-back to this is that even with this same dismal outcome we still wouldn’t have shelled out $700B and thus avoided the messy and increasingly politicized debate over the bank bailout. But I suspect we still would then have had a different debate over “where are the regulators?” I also suspect that historians and economists will be arguing about all this for years to come. Jenkins’ provocative thesis may at some point become a central topic in this debate.

That Other Kauffman Blogger, Again

In which Harold Bradley, using only a chart, terrifies us all.

Do We Know Anything?

Over the last several years, the traditional canon of public health knowledge has come under increasing skepticism. Some readers may be more familiar with these developments than me, but one of the first public discussions I can recall was a 2002 article questioning the conventional dietary recommendation to reduce fat intake and consume more carbohydrates. This, of course, was the logic behind the Atkins diet, and it doesn't appear that the debate has yet been resolved. A more recent article, reviewing the continuing uncertainties in epidemiology and public health, observed:

"Indeed, if you ask the more skeptical epidemiologists in the field what diet and lifestyle factors have been convincingly established as causes of common chronic diseases based on observational studies without clinical trials, you'll get a very short list: smoking as a cause of lung cancer and cardiovascular disease, sun exposure for skin cancer, sexual activity to spread the papilloma virus that causes cervical cancer and perhaps alcohol for a few different cancers."

Those are not insignificant findings, of course, but in the universe of disease, to say that what we can assert with certainty is limited to this handful is a bit humbling. Yet another article, addressing New York City's latest dietary crusade against salt, pointed out that we may not ever achieve complete certainty in these areas: "But there is tremendous variation among individuals. . . . It is also possible that a change in this single dietary element [salt] might disturb unknown nutritional interactions and thus generate other as yet unrecognized effects, good or bad."

So we know a lot about public health, certainly much more than we did one hundred and fifty years ago, even fifty years ago--but there is even more we don't know. There's nothing wrong with this: this is how science, or any realm of human knowledge, is supposed to be. 

But the recession and bailouts and stimulus have made me wonder the same thing about economics: despite all that we know, how much don't we know, and how much do we (dangerously) deny about how much we don't know? (I must immediately apologize for the preceding sentence, but you can see where discussions about the nature of knowledge quickly become difficult to follow.)

I'm not debating the tired question of whether or not economics is a science. Economists generate hypotheses and then seek, through empirical research, to test their validity. As long as those hypotheses are falsifiable, it has a legitimate claim to being a science. And, as Guy Sorman explained in an interesting essay last summer, economics has become a "source of hope" because it can claim to have established some enduring truths: economic growth as the surest route to improving human welfare; the market as the best way to achieve growth; the benefits of free trade; the importance of institutions and monetary stability; the indispensability of competition.

Lately, however, the Congressional debates over the stimulus bill and Treasury Secretary Timothy Geithner's uninspiring plans for the next half of TARP money seem to have raised a common question in people's minds: do we know anything? Yves Smith at Naked Capitalism was probably the harshest toward Geithner, and James Surowiecki seemed confused as to why Geithner said anything at all. Macroeconomics basically has no clothes, said Will Wilkinson: "nobody really knows" whether the bailout will work, or what alternative would work, or what "work" even means in this context. Gary Becker and Kevin Murphy raised valid questions about the stimulus based, again, on sound economic research and reasoning. Even Scott Jagow, in tentatively supporting the stimulus, basically admitted that since this appeared better than any alternatives, we might as well default to it.

I'm not saying the stimulus is a good or bad thing--but it's not exactly confidence-inspiring when you realize that, notwithstanding all of our economic knowledge, we basically have little idea about anything. Again, that's how science is, but that is far-from reassuring when the economy crumbles a little bit more every day. Human knowledge proceeds in an evolutionary fashion: theories, facts, adjusted theories, and so on. This is basically how the brain works: "perception is inference."

Ignorance or, more precisely, acknowledgement of our ignorance, can be a powerful learning tool. There are reams of academic research on the limits of knowledge, uncertainty, imperfect information, etc. Nassim Nicholas Taleb has become a superstar on the power of admitting ignorance. But all I can think about, in the face of a potentially catastrophic recession, ginormous government bailouts, and claims and counter-claims among economists, is Bill & Ted's Excellent Adventure: "the only true knowledge consists in knowing that you know nothing. That's us dude!"

Maybe I'm alone on this, but the number of respected commentators raising doubts as to what we really know and, more importantly, the extent of our ignorance we seem determined to deny, is, to put it mildly, worrisome.

The Bizarro Bailout

The ongoing sagas of the stimulus bill and financial bailout are, understandably, dominating headlines and online chatter. In no way do I intend to belittle the severity of the current recession and the overall gravity of the situation but, if history is any guide, these policy debates run in parallel to a bizarro world in which a separate economic future is developing.

In this bizarro world, the high-growth companies of tomorrow are just coming into existence, and innovations we cannot even imagine are in their infancy. A few years ago in the American Economic Review, economist Alexander Field declared the 1930s to be "the most technologically progressive of any comparable period in U.S. economic history."

In the bizarro spirit, then, I spent part of the morning canvassing what I like to think of as the frontiers of economic growth--the spaces where our future is being made right now. The stimulus and bailout matter to these frontiers, of course, but it's important to note that the as-yet-imagined future is materializing without word from Washington or Wall Street or anywhere else.

This is just awesome.

Stem cells are key.

The stimulus is apparently directed toward "shovel-ready" projects, but instead of shovels, what about nano-particles?

And this just sounds crazy, but still awesome.

Obama's Conflicted Economic Language

President Barack Obama's first press conference earlier this evening was absolutely riveting. The man cannot make up his mind whether his stimulus / rescue / spending-is-the-whole-point bill emerging from the Senate is bipartisan or a rejection of Republicans who don't have "a lot of credibility" and whose failed polciies created this mess. Which is it? He wants to be congenial and condescending at the same time, and it does not work. As a snarky point, I do find it funny that the Democrats have been saying for six years that the war against Iraq was Bush unilateralism despite a dozen or so allied nations alongside America, yet less than half a dozen Republican votes makes the Senate bill "bipartisan."

The view inside the Beltway is that the President is rallying House Democrats - who love partisanship - to go along with him in support of the Senate bill. He's using feisty language they like. But baiting the Republicans is risky public relations, and there are real doubts about whether Obama's rhetorical fence-straddling will work in gathering House votes. The reality is that the two bills going into conference are different only in the this way: one is extremely liberal and the other is extremely liberal with a superficial bipartisan gloss.

The President took pains to mention that plenty of conservative economists, even economic advisers to Senator John McCain's campaign, support his approach. That invites me to disagree.

I am highly skeptical of Keynesian efforts to manage aggregate demand through fiscal policy, particularly when that policy aims to increase G when the problem is ultimately about the financial underpinnings of the entire system, and the primary symptom is a decline in consumption, C. When the President talks about a massive trillion dollar hole in the economy, he fundamentally means a collapse in private consumption, and I believe countering a massive downturn makes sense. What troubles me is that the President could have taken a genuinely bipartisan approach -- one where centrist Republicans essentially wrote the bill -- which would have used tax rate reductions to stimulate consumption. And really, isn't that the whole point?

Obama could have done that. It would have been bipartisan -- a Keynesian stimulus focused on the consumer.  It would have moved very quickly and passed quickly. It might have focused on reducing, for instance, the payroll tax rate which is eats up roughly 15 percent of the first 90-some thousand dollars of take-home pay of most all working Americans. Meaning, cutting the payroll tax rate would be a genuinely progressive stimulus, with the benefits going to those, using the language popular among Democratic economists, most likely to spend it. 

Obama could have done that!  To put it bluntly, he did not.

Let the record show that I, for one, was willing to endorse that kind of bipartisan, tax-cutting Keynesian approach. It's hardly my principled choice, but I would have supported it. So I am more than a little put-off that he now castigates anyone who questions the wisdom of his big government spending approach as a member of the Bush administration. That's foolish, and it will backfire. Again, let the record show that I was never a Bushie. Nor was Jim Hamilton or Arnold Kling or hundreds of others who are not convinced about this particular stimulus approach.

Instead, we have a stimulus bill that is deeply divisive, and a President pretending it is something else. His press conference tonight was troubled by this paradox, which I suspect will not end well. It is not a sustainable argument, so public support is likely to fade.

Despite the core problem, the President had some very smart things to say tonight. I would like my conservative friends to give some credit where credit is due. So kudos, Mr. President. He also had some specific offenses that must be called out. Here then are the best and worst of Obama's comments tonight:

Smart Language

• "create new jobs and new businesses, and help our economy grow again, now and in the future."  This is a home run line for two reasons.  First, it is incredibly refreshing to hear a Democratic president celebrating economic growth. Admit it, Republicans! Second, Obama understands that real growth comes from new jobs and new businesses, not industrial and agricultural policy aimed at jobs of the past. It is a profoundly Schumpeterian line.

• "[N]ot a single earmark." The President is right, and this is a real achievement. Let's savor this, and remember it this fall.

• "We are still going to have to make sure that we are attracting private capital, get the credit markets flowing again, because that's the lifeblood of the economy." (another leg of the stool). Even now, President Obama is reminding Americans that the financial crisis is not over. In the end, he may realize that this is not a stool, but a pyramid. And if we only have so many bricks, we might want to use them on the foundation. That would be the financial system.

Not So Smart Language

• "It is only government that can break the vicious cycle."  This lingo doubles as unhelpful and untrue. There is not one Ph.D. economist who believes the U.S. economy won't recover in 3 years from this recession (and most think it will be much faster) even if the government does nothing. I defy you to find one. Moreover, a depression has a self-fulfilling "animal spirits" heart, so the President needs to immediately start emphasizing that recovery will happen regardless. America is resilient, and it will bounce back. Sure, maybe the big, liberal stimulus bill will accelerate the recovery. I'm willing to concede that hypothetical. But let's have some humility from his rhetoric, which will help the country if not his cause.

• "... repairing our dangerously deficient dams and levees so that we don't face another Katrina." Okay, stop with the veiled Katrina-Bush eye pokes. First, you literally can't stop hurricanes from happening again. Second, your implication that engineering can stop the flooding of homes built below sea level neglects a vastly smarter alternative: build communities above sea level. The broken windows lesson applies -- smart public spending can be better spent elsewhere.

• "Well, I visited a school down in South Carolina that was built in the 1850s. Kids are still learning in that school, as best they can .... So why wouldn't we want to build state-of-the-art schools with science labs that are teaching our kids the skills they need for the 21st century?" Here, Obama is betraying his ignorance of federalism, and I find it appalling. I agree that shoddy schools are an outrage.  The question is why the people of South Carolina tolerated it for, oh, 100+ years? Another question is why people in my state, which upgrades its school buildings, should pay for other states'? Subsidizing bad policy is offensive to me and every other American who takes the 10th amendment seriously.

• "... it's a little hard for me to take criticism from folks about this recovery package after they've presided over a doubling of the national debt. I'm not sure they have a lot of credibility when it comes to fiscal responsibility." Okay, but is it so hard to take criticism from folks who had nothing to do with the doubling of the national debt? Why is Obama dismissing those voices?