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.
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.
"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?"
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.
"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)
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.
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."
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.
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:
"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?
I am far from the first to note how much John Maynard Keynes is in the air today. Several months ago, the Financial Times featured him as its Man in the News; this morning NPR ran a story on various economists' views on Keynes and the stimulus package. And, in two op-eds today by Benn Steil and Niall Ferguson, the ostensible resurrection of Keynes' ideas (as well as the economics profession in general) comes under harsh criticism.
"Keynes explicitly set out to refute the doctrine that only collectivism is capable of guaranteeing full employment. . . . Despite occasional use of collectivist language, Keynes was never a collectivist in the sense in which I have used the term--someone who wanted to replace private choice by government choice. Keynes want to insert governments into the 'gaps' of a free economy--to do things individuals wanted done, but which, in their private transactions, they could not achieve."
"So [for Keynes] it is the government's task to maintain an environment conducive to optimistic expectations--one which encourages businessmen to do their job of creating wealth and jobs. How it is to do this is essentially a second-order question: it depends on the facts of the case. Nothing was more contrary to Keynes's intentions than that governments should run permanent budget deficits. Nor was it Keynes's aim to redistribute income, nationalize the economy, or direct investment or the location of industry. His aim was simply to ensure a level of aggregate demand sufficient to enable market-clearing real wages to be established without price inflation. His theory was deliberately designed to make the microeconomic interventions favoured by the planners, regulators and corporatists irrelevant."
That was the basic thrust of David Leonhardt's cover story in this past weekend's New York Times Magazine, "The Big Fix." Given that this blog is devoted to matters pertaining to economic growth, it seems appropriate that we offer some commentary on Leonhardt's essay.
First, thank you to Bob and Tim for allowing me to join and contribute to their always-prescient blog. Bob oversells me: I hope to at least keep up with he and Tim in the pace of their insights!
Larry Ribstein and Henry Butler ask a good question, in the wake of huge investment firms collapsing and now the 50 billion Madoff ponzi scheme.:
The crisis shows that SOX did not have the advertised payoff of flushing Enronesque risk out of the market. Firms now collapsing from risks hidden in their walls and foundations were subject to SOX. What, exactly, did SOX accomplish other than imposing huge costs and giving us a false sense of security for six years?
This is a good question by itself. But the solution offered is very insightful and deserves serious attention: why not let the shareholders make adopting SOX optional?
But many of the smaller and newer firms may decide that SOX's costs outweigh its benefits. Allowing them to opt out would be like giving a tax break to entrepreneurs to help restart the economy.
If you are interested in what is really happening to U.S. manufacturing, check out this essay by Joel Kotkin:
Overall, U.S. industry has become among the most productive in the world--output has doubled over the past 25 years, and productivity has grown at a rate twice that of the rest of the economy. Far from dead, our manufacturing sector is the world's largest, with 5% of the world's population producing five times their share in industrial goods.
So what is the problem then? If it is not the effort and ingenuity of American workers or our infrastructure, Detroit's problems must lie somewhere else, largely with almost insanely bad management.
Oliver Hart and Luigi Zingales say that economists have lost their principles in the current crisis. I hear an echo of "Where is the outrage?"
From this perspective, one must ask what would have been so bad about letting Bear Stearns, AIG and Citigroup (and in the future, General Motors) go into receivership or Chapter 11 bankruptcy? One argument often made is that these institutions had huge numbers of complicated claims, and that the bankruptcy of any one of them would have led to contagion and systemic failure, causing scores of further bankruptcies.
This argument has some validity, but it suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG's obligations to J.P. Morgan and those who bought insurance from AIG.
I am more tolerant of the financial interventions made by Bernanke and the Fed because I think a financial panic qualifies as market failure. I am less sympathetic to the Paulson Plan because it seems to have made the panic worse, not better. Regardless, the government has a role it must play in maintaining a steady monetary and financial foundation. I keep in mind that those green slips of paper are worthless without the system behind them.
But there is a big, bright line that distinguishes financial interventions from other actions in business/industry or in state and local budgets. Rewards for dysfunctional actors in a system erode learning and growth in that system. That's where policy is heading now, and it is disappointing that there isn't a louder roar of protest from economic scholars.
Charles Calomiris offers some insights onto the ongoing financial crisis. I have been following the news just like you all, but am humble in recognizing that authoritative pieces are out there already (e.g. Jim Hamilton, or Bob Litan et al). But I see a kindred spirit the WSJ Calomiris interview. Two selective nuggets copied here:
The key thing we’ve learned during the downward spiral of confidence is that you have to deal with the problem in the mortgage market directly. There are probably 18 million subprime and Alt-A mortgages out of 57 million total. Probably half will end up in foreclosure. ... The problem is the completely opaque distribution of losses because no one knows how to value these mortgage losses. The way to solve the problem is from the bottom up.
Notice this is the root cure that I (and separately Hillary Clinton) suggested along the lines of HOLC 2.0. A Main street mortgage remedy was raised in the presidential contest by Senator McCain, misinterpreted, mocked, and eventually attacked by the Obama campaign. Hopefully, it will be reconsidered now that the silly season is over. Now that TARP isn't for TA (or is it?) the $700 billion could presumably be shifted to bottom-up mortgages, no?
There actually is a stock of knowledge about this. The scandal is that when Congress has been considering this, not one independent economist has been allowed to testify. Do you know why they weren’t? Paulson and Bernanke didn’t want anyone causing problems.
I don't believe anything conspiratorial about Ben Bernanke. But I do believe the politics of the financial bailout have been inept, tragically inept, bi-partisan tragicomically inept ... I could keep going. At the very least, the public should be asking why outside economists weren't part of the process, as Calomiris does. If your child were sick and Congress refused to seek the advice of independent medical doctors, what would you call that?
This Minneapolis Fed paper may be the most cited (or at least the most viewed, read, mentioned, talked about, celebrated ...) of 2008. It is easy to read, with many fine graphics. My favorite:
Kudos to the authors. Full citation is:
Myths about the Financial Crisis of 2008
V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe
Working Paper 666
Federal Reserve Bank of Minneapolis