Economist's View

Climate Change Legislation and Protectionism

Martin Feldstein opposes border adjustments related to cap-and-trade:

Will Cap-and-Trade Incite Protectionism?, by Martin Feldstein, Commentary, Project Syndicate: There is a serious danger that the international adoption of cap-and-trade legislation to limit carbon-dioxide emissions will trigger a new round of protectionist measures. ... 150 countries are scheduled to meet in Copenhagen in December to discuss ways to reduce CO2 emissions.

Governments have ... focused on a cap-and-trade system as a way of increasing the cost of CO2-intensive products... The cap-and-trade system ... imposes a carbon tax without having to admit that it is really a tax.

A cap-and-trade system can cause serious risks to international trade. Even if every country has a cap-and-trade system and all aim at the same relative reduction in national CO2 emissions, the resulting permit prices will differ because of national differences in initial CO2 levels and in domestic production characteristics. Because the price of the CO2 permits in a country is reflected in the prices of its products, the cap-and-trade system affects its international competitiveness.

When the permit prices become large enough to have a significant effect on CO2 emissions, there will be political pressure to introduce tariffs on imports that offset the advantage of countries with low permit prices. Such offsetting tariffs would have to differ among products ... and among countries (being higher for countries with low permit prices). Such a system of complex differential tariffs is just the kind of protectionism that governments have been working to eliminate since the start of the GATT process more than 50 years ago.

Worse still, cap-and-trade systems in practice do not rely solely on auctions to distribute the emissions permits. ... Such complexities make it impossible to compare the impact of CO2 policies among countries, which in turn would invite those who want to protect domestic jobs to argue for higher tariff levels.

There is no easy answer to this problem. But before rushing to impose tariffs, it is important to remember that cap-and-trade policies would not be the only government source of differences in competitiveness. Better roads, ports, and even schools all contribute to a country’s competitiveness. No one attempts to use tariffs to balance those government-created differences in competitiveness, and there should be no such attempts if a cap-and-trade system is introduced.

If an international agreement to impose a cap-and-trade scheme is adopted in Copenhagen, the countries there should agree as well that there will be no attempt to introduce offsetting tariffs that would ultimately threaten our global system of free trade.

Paul Krugman on what to do if other countries refuse to participate:

Climate, trade, Obama, by Paul Krugman: I think the president has this wrong:

President Obama on Sunday praised the energy bill passed by the House late last week as an “extraordinary first step,” but he spoke out against a provision that would impose trade penalties on countries that do not accept limits on global warming pollution. ...

The truth is that there’s perfectly sound economics behind border adjustments related to cap-and-trade. The way to think about it is in terms of a well-established theory — the theory of non-economic objectives in trade policy — that owes its origins to Jagdish Bhagwati, who certainly can’t be accused of being a protectionist. The essential idea is that if you have a non-economic objective, such as self-sufficiency in food production, you should choose policy instruments to align incentives with that objective; in normal circumstances this leads to consumer or producer intervention, rarely to tariffs.

But in this case the non-economic objective is to reduce greenhouse gas emissions, never mind their source. If you only impose restrictions on greenhouse gas emissions from domestic sources, you give consumers no incentive to avoid purchasing products that cause emissions in other countries; as a result, you have an inefficient outcome even from a world point of view. So border adjustments here are entirely legitimate in terms of basic economics.

And they’re also probably OK under trade law. The WTO has looked at the issue, and suggests that carbon tariffs may be viewed the same way as border adjustments associated with value-added taxes. ... Because it’s essentially a tax on consumers, it’s legal, and also economically efficient, to collect it on imported goods as well as domestic production; it’s a matter of leveling the playing field, not protectionism.

And the same would be true of carbon tariffs.

What’s happening here, I think, is that people are relying on what Paul Samuelson called an economic “shibboleth” — they’re relying on some slogan rather than thinking through the underlying economics. In this case the shibboleth is “free trade good, protection bad”, when what the economics really says is that incentives should reflect the marginal cost of greenhouse gases in all goods, wherever produced — which in this case happens to imply border adjustments.

links for 2009-07-04

• Conceptual revolutions in twentieth-century art - voxeu.org
• The Internationalization of U.S. Doctorate Education - NBER Digest
• A funny thing happened on the way to the federal funds market - macroblog
• Asian Officials Push Back Against Savings Glut Theory - WSJ.com
• New Deal 2.0 - links
• FT Alphaville - links
• Abnormal Returns - links
• naked capitalism - links
• Credit Writedowns - links

Malthus "Would have been Very Much at Home in the Blogosphere"

In Thomas Malthus' time, there was a dispute over the corn laws (which were tariffs on imported grains imposed in the early 1800s). Landlords favored the corn laws, and though the landlords were the most powerful class at that time, they were coming under increasing attack from the rising merchant and industrial capital classes. Why the conflict?

The tariffs raised the price of corn, something the landlords favored, but since corn was a key component of the subsistence workers relied upon to survive, the price of labor - the wage rate - would reflect the price of corn. If the price of corn was high, wages would be high, and when the price of labor rises merchants and capitalists would have a more difficult time selling their goods profitably. The fear was compounded by the end of the Napoleonic wars and the threat of large imports of cheap grain from France.

So what was the effect of the corn laws on the price of corn, on wages, on the welfare of the poor, and so on? Finding an answer to this question, as well as the answer to what impact poor laws have, and what causes gluts (recessions) drove both Malthus and Ricardo to develop theoretical models that could guide them to the answer and hence to the correct policy prescription. Thus, their analytical contributions to economics were driven primarily by the important social questions of the time.

Here's more on Malthus:

Malthus blogging on the Corn Laws, by Daniel Little: I think that Thomas Malthus would have been very much at home in the blogosphere. He weighed in on the issues of the day, bringing careful logical analysis of economic theory to bear on the policy issues that were up for debate. And he was very interested in making the connection between economic principles and real empirical evidence. This is particularly true in his contributions to the debate on the Corn Laws in 1814 and 1815. Malthus authored pamphlets on these issues in 1814 ("Observations on the effects of the corn laws"; link) and 1815 ("Grounds of an opinion on the policy of restricting the importation of foreign corn"; link), and they repay scrutiny today; they are powerful instances of a very smart economist probing the theory and the facts surrounding a complex policy issue. (Here is a nice survey of Malthus's theories; link.)

The Corn Laws might be thought of as a form of "stimulus package" for the British economy in the early nineteenth century. By setting a high tariff on the import of wheat and other grains, Parliament aimed to protect the agricultural sector and to encourage the expansion of grain production to make Britain more independent from external grain providers. One might also compare the debate to the NAFTA debate or to policy deliberations in the 1960s concerning "import substitution" strategies. Opponents argued that removal of the tariffs would bring down the price of grain, a central component of the wage basket; this would help the poor and would also permit a significant reduction of the wage as well. So the issue divides the interests of land owners, industrialists, and the poor.

Malthus's position in the two essays is somewhat different. In the first article he promises to lay out the issue dispassionately, dispelling false opinions about what the effects of the proposed policy might be and diving into the advantages and disadvantages of the policy. He writes that "some important considerations have been neglected on both sides of the question, and the effects of the corn laws, and of a rise or fall in the price of corn, on the agriculture and general wealth of the state, have not yet been fully laid before the public." A bit further on, he writes:

My main object is to assist in affording the materials for a just and enlightened decision; and whatever that decision may be, to prevent disappointment, in the event of the effects of the measure not being such as were previously contemplated. Nothing would tend so powerfully to bring the general principles of political economy into disrepute, and to prevent their spreading, as their being supported upon any occasion by reasoning, which constant and unequivocal experience should afterwards prove to be fallacious.

So--"let's do rigorous and systematic analysis based on the principles of political economy and our best understanding of the facts." Good advice for a policy debate.

Quite a bit of the analysis is devoted to refuting an idea that Malthus attributes to Adam Smith ... [...continue reading...]

Does Lack of Insurance Distort the Market for Romance?

[Suggested by email]

Obama Economic Forecast

Spencer at Angry Bear:

The right is having a lot of fun commenting about the economic forecast by the Obama team being too optimistic. ... I guess they are right, Obama along with everyone else has massively underestimated the damage Team Bush did to our economy.

Rationing Health Care

Uwe Reinhardt:

‘Rationing’ Health Care: What Does It Mean?, by Uwe E. Reinhardt, Economix: As the dreaded R-word — rationing — once again worms its way into our debate on health care reform, it may be helpful to relearn what is taught about rationing in freshman economics.

In their well-known textbook Microeconomics, the Harvard professor Michael L. Katz and the Princeton professor Harvey S. Rosen, for example, put it thusly:

Prices ration scarce resources. If bread were free, a huge quantity of it would be demanded. Because the resources used to produce bread are scarce, the actual amount of bread has to be rationed among its potential users. Not everyone can have all the bread that they could possibly want. The bread must be rationed somehow; the price system accomplishes this in the following way: Everyone who is willing to pay the equilibrium price gets the good, and everyone who does not, does not. [Italics added.]

In short, free markets are not an alternative to rationing. They are just one particular form of rationing. ...

Many critics of the current health reform efforts would have us believe that only governments ration things.

When a government insurance program refuses to pay for procedures that the managers of those insurance pools do not consider worth the taxpayer’s money, these critics immediately trot out the R-word. It is the core of their argument against cost-effectiveness analysis and a public health plan for the non-elderly.

On the other hand, these same people believe that when, for similar reasons, a private health insurer refuses to pay for a particular procedure or has a price-tiered formulary for drugs – e.g., asking the insured to pay a 35 percent coinsurance rate on highly expensive biologic specialty drugs that effectively put that drug out of the patient’s reach — the insurer is not rationing health care. Instead, the insurer is merely allowing “consumers” (formerly “patients”) to use their discretion on how to use their own money. The insurers are said to be managing prudently and efficiently, forcing patients to trade off the benefits of health care against their other budget priorities. ...

One must wonder where people worried about “rationing” health care have been in the last 20 years. Could they possibly be unaware that the United States health system has rationed health care in spades for many years, on the economist’s definition of rationing, and that President Obama and Congress are now desperately seeking to reduce or eliminate that form of rationing?

Let me remind rationing-phobes what they would find in the huge body of research literature and media reports on our health system, should they ever trouble themselves to read it ...[list here]...

As I read it, the main thrust of the health care reforms espoused by President Obama and his allies in Congress is first of all to reduce rationing on the basis of price and ability to pay in our health system.

An important allied goal is to seek greater value for the dollar in health care, through comparative effectiveness analysis and payment reform. ...

To suggest that the main goal of the health-reform efforts is to cram rationing down the throat of hapless, non-elite Americans reflects either woeful ignorance or of utter cynicism. Take your pick.

I tired to make the same basic argument here: "Health Care Rationing Rhetoric".

Bruce Bartlett:

Health Care: Costs And Reform, by Bruce Bartlett, Commentary, Forbes: When asked about the federal government's long-term budget problem, Barack Obama always responds that it is essentially a health issue. Unless we fix the health care system, he says, we cannot get control of the budget. This is the key reason why Obama has stressed the need for health reform this year.

There is certainly truth in this proposition. ... According to CBO, spending for Medicare has risen 2.3% per year faster per beneficiary than growth of nominal GDP per capita since 1975. Obviously, this is a trend that cannot be allowed to continue or Medicare will eventually eat up 100% of currently projected tax receipts.

The problem of health care spending growing faster than incomes is also a problem that plagues the private sector, which explains why total spending on health care in the economy has doubled over the last 30 years to a current level of about 16% of GDP. CBO estimates that this percentage will double again over the next 25 years to 31% of GDP.

Americans widely believe that while the our health system is expensive it is nevertheless the best in the world. However, a new report from the Organization for Economic Cooperation and Development suggests otherwise. ...

Paul Krugman: That ’30s Show

The economy needs more help:

That ’30s Show, by Paul Krugman, Commentary, NY Times: O.K., Thursday’s jobs report settles it. We’re going to need a bigger stimulus. But does the president know that?...

Since the recession began, the U.S. economy has lost 6 ½ million jobs — and as that grim employment report confirmed, it’s continuing to lose jobs at a rapid pace. Once you take into account the 100,000-plus new jobs that we need each month just to keep up with a growing population, we’re about 8 ½ million jobs in the hole.

And the ... job figures weren’t the only bad news in Thursday’s report, which also showed wages stalling and possibly on the verge of outright decline. That’s a recipe for a descent into Japanese-style deflation, which is very difficult to reverse. Lost decade, anyone?

Wait — there’s more bad news: the fiscal crisis of the states. Unlike the federal government, states are required to run balanced budgets. And faced with a sharp drop in revenue, most states are preparing savage budget cuts, many of them at the expense of the most vulnerable. Aside from directly creating a great deal of misery, these cuts will depress the economy even further.

So what do we have to counter this scary prospect? We have the Obama stimulus plan, which aims to create 3 ½ million jobs by late next year. That’s ... not remotely enough. And there doesn’t seem to be much else going on. Do you remember the administration’s plan to sharply reduce the rate of foreclosures, or its plan to get the banks lending again by taking toxic assets off their balance sheets? Neither do I.

All of this is depressingly familiar to anyone who has studied economic policy in the 1930s. ... President Obama and his officials need to ramp up their efforts, starting with a plan to make the stimulus bigger. Just to be clear, I’m well aware of how difficult it will be to get such a plan enacted.

There won’t be any cooperation from Republican leaders... Indeed, these leaders responded to the latest job numbers by proclaiming the failure of the Obama economic plan. That’s ludicrous, of course. The administration warned from the beginning that it would be several quarters before the plan had any major positive effects. ...

It’s also not clear whether the administration will get much help from Senate “centrists,” who partially eviscerated the original stimulus plan...

And as an economist, I’d add that many members of my profession are playing a distinctly unhelpful role.

It has been a rude shock to see so many economists with good reputations recycling old fallacies — like the claim that any rise in government spending automatically displaces an equal amount of private spending, even when there is mass unemployment — and ... grossly exaggerated claims about the evils of short-run budget deficits. ...

Also, as in the 1930s, the opponents of action are peddling scare stories about inflation even as deflation looms.

So getting another round of stimulus will be difficult. But it’s essential.

Obama administration economists understand the stakes. Indeed, just a few weeks ago, Christina Romer, the chairwoman of the Council of Economic Advisers, published an article on the “lessons of 1937” — the year that F.D.R. gave in to the deficit and inflation hawks, with disastrous consequences...

What I don’t know is whether the administration has faced up to the inadequacy of what it has done so far.

So here’s my message to the president: You need to get both your economic team and your political people working on additional stimulus, now. Because if you don’t, you’ll soon be facing your own personal 1937.

links for 2009-07-03

• This Is Their Reform Strategy For Big Banks? - The Baseline Scenario
• Treasury's View of PPIP, an Update - The Stash
• Put transit where the people are - Ed Glaeser
• The Wranglers - Information Processing
• Second Life data offers window into how trends spread - EurekAlert
• A Smart Critique of the Public Plan (Sort Of) - Ezra Klein
• Bring the Unemployment Numbers Down Now - Economic Perspectives
• An Emerging Split: Treasury vs. the National Economic Council - Economix
• Explaining the trade collapse - voxeu.org
• ‘Easy Money’ Didn’t Sink the Economy - Economic Perspectives
• American jobs data are worse than we think - Mohamed El-Erian
• The Labor Market is Still Down - Jeff Frankel
• Harmful financial innovation - Willem Buiter

links for 2009-07-03

• Felix Salmon - links
• The Stash - links
• Matthew Yglesias - links
• Chris Martenson - links
• The Big Picture - links
• FT Alphaville - links
• naked capitalism - links
• Abnormal Returns - links
• Free Exchange - links
• Paul Kedrosky - links
• Marginal Revolution - links
• New Deal 2.0 - links

Tom Keene's "On the Economy"

From earlier today:

Thoma Says Fiscal Policy Needs 6 to 9 Months to Take Effect

July 2 (Bloomberg) -- Mark Thoma, professor of economics at the University of Oregon, talks with Bloomberg's Tom Keene about U.S. employment, consumer confidence and the fiscal stimulus. Listen/Download

[Recent podcasts include: DeLong, Roubini, Eichengreen, Ritholtz, and Blinder.]

"Old Speeches, New Policies"

Greg Mankiw responds to this post, "Deficits are Worrisome, but Not as Worrisome as an Economy that is ... Rapidly Shedding Jobs" (or maybe it was this):

Old Speeches, New Policies, by Greg Mankiw: For academics, it always a delight when some old, obscure thing we've written suddenly gets noticed. So I was pleased when econoblogger Mark Thoma decided to draw attention yesterday to a speech I gave six years ago (pdf version) to the National Association of Business Economists. I had not looked at that speech in years, but looking back at it today, I think that it holds up pretty well. So, please, feel free to follow the link and read the whole thing.

The part of the speech that Mark highlights on his blog is the defense of running budget deficits during a recession. I am a bit puzzled about why Mark picked up that piece, however. Mark seems to be suggesting that my speech can somehow be construed as a defense of Obama fiscal policy. Yet I don't think that aspect of current economic policy is controversial. As I wrote in the NY Times in March of this year, "Few economists would blame either the Bush administration or the Obama administration for running budget deficits during an economic downturn." ...

The controversial part of current fiscal policy are, first, the relative reliance on spending hikes versus tax cuts as short-run stimulus and, second, the long-term picture. ...

This speech was given in September 2003, just under two years after the end of the 2001 recession, but job growth remained sluggish. From the speech:

Growth had resumed after the end of the recession in November 2001, but the pace of growth was far from satisfactory. And of course the labor market remained, and still remains, lagging behind.

So what did they propose? As a follow-up to the "Administration’s tax cut in 2001 and the stimulus package of 2002," they proposed another stimulus package, and never mind the deficit:

Because further policy action was clearly needed, the President pushed hard for the passage of his Jobs and Growth initiative. The purpose of this initiative was not only to help push the economy back toward its potential but also to raise this potential by improving supply-side incentives for work and investment.

I'm sure the Obama administration will be pleased to know that, should this recovery be similarly jobless, or W-shpaed - if the recovery is listless or non-existent for any reason - that, rather than harping on the deficit and the potential problems it might cause, they can count on Greg Mankiw's support for another round of fiscal stimulus to try to turn things around. (And if a lot of the spending is on infrastructure, as it was this time, he should also be pleased with the long-run supply-side effects of these policies.)

The Consequences of External Reform: Lessons from the French Revolution

Was Hayek right that the "institutions of a society had to evolve organically and could not be designed"?:

The consequences of external reform: Lessons from the French Revolution, by Daron Acemoglu, Davide Cantoni, Simon Johnson, and James A Robinson, Vox EU: Different incentives, created by variation in key institutions such as property rights and the functioning of markets, explain why some countries are much more prosperous than others. Therefore, institutions often need to be reformed to improve the economic conditions in poor countries. There is a lot of controversy, however, about how this can be done, and, in particular, whether agents external to a country can successfully impose or foster institutional reform.

“Big Bang” external reforms

Knowing the answer to this question is important for understanding whether, for example, the mass expansion of resources for the IMF announced recently by the G20 is likely to be effective. Many, like Rodrik (2007), argue that external reform has been a failure and reject reform agendas such as the “Washington consensus” as being inappropriate to the problems of countries with poor institutions. This argument is reminiscent of Hayek (1960), who claimed that the institutions of a society had to evolve organically and could not be designed. Those who advocate these views point to the relative success of gradual Chinese economic reforms as opposed to reforms in the former Soviet Union, which took place in a “Big Bang” fashion with a lot of external influence. Interestingly, the conservative English philosopher Edmund Burke seems to have been a precursor to these views. In 1790, he condemned the radicalism and the interventionist spirit of the French Revolution and argued:

“It is with infinite caution that any man should venture upon pulling down an edifice, which has answered in any tolerable degree for ages the common purposes of society, or on building it up again without having models and patterns of approved utility before his eyes.”(p.152).

In Acemoglu, Cantoni, Johnson and Robinson (2009), we argue that the impact of the French Revolution on the institutions of Europe can be seen as a “natural experiment” that sheds light on these debates. After 1792, French armies invaded and reformed the institutions of many European countries. The package of reforms the French imposed on areas they conquered included the civil code, the abolition of guilds and the remnants of feudalism, the introduction of equality before the law, and the undermining of aristocratic privilege. These reforms clearly relate to the above-mentioned debates. They were imposed “Big Bang” style from the outside. And, institutions such as the civil code were self-consciously designed and were not necessarily “appropriate” for the lands on which they were imposed. If externally-imposed and “Big Bang” reform is generally costly or if designed institutions like the civil code create major distortions, the reforms should have had negative effects on nineteenth-century Europe.

"Hire the Unemployed"

The stimulus package had two components, new spending and tax cuts. Everybody knew that the spending component would take time to put into place, six months or more for a lot of the infrastructure projects, and that meant that we needed something to increase demand and provide a bridge until the new spending comes online.

Enter the tax cuts that the GOP insisted upon, tax cuts that were a larger part of the stimulus package than I thought justified. These cuts were to come online immediately and stimulate demand until the spending could begin taking up some of the slack later in the year. I would have preferred targeted, non-infrastructure spending that could have been put in place almost as fast as the tax cuts (particularly those that simply require making existing programs more generous), but that type of spending was considered wasteful because it didn't add to our long-run capacity for growth and hence had little chance of being part of the stimulus package.

The problem was partly bad luck. A crisis hit and we had the bad luck of having an administration that opposed active intervention and though there was a bit of a stimulus attempt through a one time tax rebate, a strategy theory predicts won't do much to help, the real action in terms of stimulating the economy was left to the new administration. So nothing was done, nothing could have been done until the new administration took over, and given the insistence that any new spending be on infrastructure projects with clear benefits, tax cuts were the main hope for an immediate effect.

So if the policy has failed at this point, it is not the spending component since, fully consistent with predictions when it was enacted, it was going to be months before it could be of any help. What failed is the GOP's insistence that tax cuts be used to provide an immediate boost to the economy. Increasing food stamps, unemployment compensation, payments to help states with declining revenues and increasing demands for social services, payments to help unemployed workers maintain health care, digging (needed) holes, there were many, many other ways to provide more immediate relief and stimulate the economy at the same time, but no, it had to be tax cuts or nothing.

Finally, I want to note that what we maximize matters. For example, we can maximize GDP growth over the next ten or twenty years, or we can maximize employment over the next few months. Which we choose to maximize has a big effect on the policies we put in place. If we use the stimulus money to maximize GDP and growth - which is essentially what we did - that will have a much slower effect on employment than if we maximize employment directly. The efficiency argument always leads you to maximize output, and efficiency prevailed in the structure of the current package, but I think an argument can also be made that maximizing employment provides social benefits that are just as large, or larger.

Just noticed this, which makes a surprisingly similar point:

A Message to President Obama: Stop Priming the Pump, Hire the Unemployed, by Pavlina R. Tcherneva: Many have called President Obama’s stimulus plan a return to Keynesian policy. Some of us who like reading Keynes professionally or for leisure have already been scratching our heads. I have wondered in particular whether the plan isn’t set up to work in a manner completely backwards from what Keynes himself had in mind when he advocated economic stabilization by government.

There are two things to remember about Keynes’s fiscal policy proposals: 1) government spending was always linked to the goal of full employment... and 2) to achieve macro-stability and full employment, the government had to employ the unemployed directly into public works.

By contrast, most modern economists believe that 1) there is some natural level of unemployment that includes the structurally unemployed, which governments cannot generally tackle, and that 2) public employment is an inefficient use of public resources.

So, when the government is called to action, the economic profession has replaced Keynes’s “fiscal policy via public works” with a “leaky bucket pump-priming mechanism.”

How is the latter policy supposed to work? Instead of employing the unemployed directly, the idea is to generate large enough government expenditures to produce a level of economic growth that would, in turn, gradually reduce unemployment. For example, the government could spend money on various private sector contracts, stimulate different private industries, offer investment subsidies and tax cuts, and increase unemployment insurance payments, in hope that it will boost GDP sufficiently to reduce unemployment to desired levels. This is essentially the underlying logic behind President Obama’s stimulus package. But it is also a bit of a gamble.

Not all of these injections will be effective because the fiscal stimulus enters the economy through “a leaky bucket”. Some of the money will be lost in transit (because of administrative costs, for example) and much of it will have no direct job creation effects (e.g. the tax cut component of the recovery act). Nevertheless, despite this leaky bucket, the theory goes, sooner or later, large enough government expenditures will produce the kind of growth that would reduce unemployment. ...

All of this is ... why Keynes never had any “leaky bucket” or “pump priming” idea in mind. For him “the real problem fundamental yet essentially simple…[is] to provide employment for everyone” (Keynes 1980, 267) and the most bang for the buck from fiscal policy would be achieved via direct job creation. This he called “on the spot” employment via public works.

As I have argued elsewhere, it is useful to think of Keynesian fiscal policy, not as aggregate demand management, but as labor demand management. ...

Commentators often call this a policy of “make work” but Keynes didn’t advocate digging holes, burying jars with money and digging them out, or any other similarly worthless projects. The key was to marry the two goals: to employ the unemployed directly and to make sure that they do useful things. Once they are put to work on a particular project, Keynes argued, “there can be only one object in the economy, namely to substitute some other, better, and wiser piece of expenditure for it” (Keynes 1982, 146). We might as well ask a very basic question: is there really a shortage of useful things to do?

If we insist on calling ourselves Keynesians again, and more importantly, if President Obama’s plan for economic stabilization should generate rapid reduction in unemployment, it would help to set fiscal policy straight. Instead of relying on “leaky fiscal buckets” we could return to “labor demand management” a la Keynes that provides immediate employment opportunities to the unemployed via bold and creative public works projects, which generate useful output and services for all.

"The Purely Rational Economic Man is Indeed Close to Being a Social Moron"

Daniel Little discusses Karl Polyani's views on whether self-interest, rationality, and market institutions are universal features of human behavior:

Polanyi on the market, by Daniel Little: Karl Polanyi's The Great Transformation is a classic statement of a polar position in the issue of the universality of instrumental rationality and market institutions in explaining concrete historical circumstances in the recent and distant past. Polanyi maintains that the concept of economic rationality is a very specific historical construct that applies chiefly to the forms of market society that emerged in Western Europe in the early modern period. Market behavior came to replace other forms of motivation within European society in this period, and individuals came to act more and more on the basis of a calculation of self-interest. However, Polanyi holds that this form of behavior, like the economic institutions of the market within which it emerged, is highly specific to a particular time and place. To make use of this model of action as though it were a universal feature and determinant of human behavior is as unjustified as it would be to extend medieval chivalry to all times and places.

No society could, naturally, live for any length of time unless it possessed an economy of some sort; but previously to our time no economy has ever existed that, even in principle, was controlled by markets. . . . Gain and profit made on exchange never before played an important part in human economy. (Polanyi 1957:43)

While history and ethnography know of various kinds of economies, most of them comprising the institutions of markets, they know of no economy prior to our own, even approximately controlled and regulated by markets. . . . The role played by markets in the internal economy of the various countries . . . was insignificant up to recent times. (Polanyi 1957:44)

Against the idea that it is "natural" for men and women to be motivated primarily by self-interest, Polanyi writes:

For, if one conclusion stands out more clearly than another from the recent study of early societies it is the changelessness of man as a social being. His natural endowments reappear with a remarkable constancy in societies of all times and places; and the necessary preconditions of the survival of human society appear to be immutably the same. (Polanyi 1957:46)

The outstanding discovery of recent historical and anthropological research is that man's economy, as a rule, is submerged in his social relationships. He does not act so as to safeguard his individual interest in the possession of material goods; he acts so as to safeguard his social standing, his social claims, his social assets. He values material goods only in so far as they serve this end. Neither the process of production nor that of distribution is linked to specific economic interests attached to the possession of goods; but every single step in that process is geared to a number of social interests which eventually ensure that the required step be taken. . . . The economic system will be run on non-economic motives. (Polanyi 1957:46)

Thus Polanyi maintains that it is socially motivated behavior -- ªbehavior motivated toward the interests of one's family, clan, or village” -- rather than self-interested behavior that is "natural" for human beings; rational self-interest is rather a feature of a highly specific society: market society. Instead, Polanyi's account urges that the analysis pay primary attention to patterns of reciprocity and redistribution, shared values, traditions, and the determining role of community and politics. And he argues that virtually every society – traditional as well as modern – depends upon these sorts of social motivations.

In place of economic rationality and the market mechanism providing the basis for organization of the premarket economy, Polanyi argues that communitarian patterns of organization are to be found in a range of traditional societies:

Stiglitz: The UN Takes Charge (Update: and The Economic Lessons of the Iraq War)

Joseph Stiglitz says the UN has a key role to play in "reforming the global financial and economic system":

The UN Takes Charge, by Joseph Stiglitz, Commentary, Project Syndicate: ...On June 23, a United Nations conference ... reached a consensus both about the causes of the downturn and why it was affecting developing countries so badly. It outlined some of the measures that should be considered and established a working group to explore the way forward...

The agreement was ... in many ways ... a clearer articulation of the crisis and what needs to be done than that offered by the G-20, the UN showed that decision-making needn’t be restricted to a self-selected club, lacking political legitimacy, and largely dominated by those who had considerable responsibility for the crisis in the first place. Indeed, the agreement showed the value of a more inclusive approach – for example, by asking key questions that might be too politically sensitive for some of the larger countries to raise, or by pointing out concerns that resonate with the poorest, even if they are less important for the richest.

One might have thought that the United States would have taken a leadership role, since the crisis was made there. Indeed, the US Treasury (including ... members of President Barack Obama’s economic team) pushed capital- and financial-market liberalization, which resulted in the rapid contagion of America’s problems around the world. ...[M]any participants were simply relieved that America did not put up obstacles..., as would have been the case if George W. Bush were still president. ...

The most sensitive issue touched upon by the UN conference – too sensitive to be discussed at the G-20 – was reform of the global reserve system. ... On the last day of the conference, as America was expressing its reservations about even discussing ... this issue..., China was once again reiterating that the time had come to begin working on a global reserve currency. Since a country’s currency can be a reserve currency only if others are willing to accept it as such, time may be running out for the dollar.

Emblematic of the difference between the UN and the G-20 conferences was the discussion of bank secrecy: whereas the G-20 focused on tax evasion, the UN Conference addressed corruption, too, which some experts contend gives rise to outflows from some of the poorest countries that are greater than the foreign assistance they receive.

The US and other advanced industrial countries pushed globalization. But this crisis has shown that they have not managed globalization as well as they should have. If globalization is to work for everyone, decisions about how to manage it must be made in a democratic and inclusive manner... The UN, notwithstanding all of its flaws, is the one inclusive international institution. This UN conference ... demonstrated the key role that the UN must play in any global discussion about reforming the global financial and economic system.

Update: Just noticed something else from Stiglitz, along with Linda J. Bilmes, on the economic lessons of the Iraq war:

The U.S. in Iraq: An economics lesson, by Linda J. Bilmes and Joseph Stiglitz, Commentary, LA Times: Tuesday, the U.S. "stood down" in Iraq, finalizing the pullout of 140,000 troops from Iraqi cities and towns -- the first step on the long path home. ...

But not so fast. The conflict that began in 2003 is far from over..., and the next chapter -- confronting a Taliban that reasserted itself in Afghanistan while the U.S. was sidetracked in Iraq -- will be expensive and bloody. ...

Meanwhile, in Iraq,... U.S. officials have said we are likely to station 50,000 troops at military bases in the country for the foreseeable future. This is because the ... country ranks high on lists of the most dangerous places on Earth, with a continual stream of suicide bombings and murders...

Moreover, the U.S. has barely begun to face the enormous financial bill for the war.

links for 2009-07-02

• A V-shaped recession? - Econbrowser
• When Our Brains Short-Circuit - NYTimes.com
• The Death of a Montana Forest - NYTimes.com
• Treasury to Name 9 'Toxic' Managers - WSJ.com
• Nitpicking Brad Delong on Fannie/Freddie - Richard Green
• Health Care Deform - TNR
• New class of black holes discovered - EurekAlert
• Adverse Selection 101: Asset Detoxification Failed - Kenneth Kuttner

links for 2009-07-02

• Felix Salmon - links
• Ezra Klein - links
• The Stash - links
• Matthew Yglesias - links
• Brad DeLong - links
• Credit Writedowns - links
• Marginal Revolution - links
• FT Alphaville - links
• Abnormal Returns - links

"A Bubble Mystery"

Barkley Rosser has a post that elaborates on comments he made here to Should We Pop Bubbles?, but first some background. This is from last July:

Gradual Decline before the Crash?: Barkley Rosser says the period after the peak of a speculative bubble can often be broken into two periods, the first characterized by a gradual decline, i.e. a period of "financial distress," and a second where there is a massive panic and crash. He also says he has a model that can explain how this happens...:

Falling from the Period of Financial Distress into the Panic and Crash, by Barkley Rosser: In 1972, Hyman Minsky described the "period of financial distress," in a paper in a journal that no longer exists..., "Financial Instability: The Economics of Disaster." Charles P. Kindleberger picked up on this and followed Minsky's analysis in his famous book, Manias, Panics, and Crashes: A History of Financial Crises, the 4th edn of which appeared in 2000... The period of financial distress is a gradual decline after the peak of a speculative bubble that precedes the final and massive panic and crash, driven by the insiders having exited but the sucker outsiders hanging on hoping for a revival, but finally giving up in the final collapse. According to Appendix B of Kindleberger's 2000 edition, 37 of the 47 great historical speculative bubbles exhibited such a period before the final crash, even though all the theoretical models predict a crash immediately following the peak with no such period.

In 1991 I published the first mathematical model of such a phenomenon in my book From Catastrophe to Chaos: A General Theory of Economic Discontinuities_(Kluwer, Chap. 5)..., although nobody seems to have noticed... In 1997, I published a paper describing this model (and related matters)... This paper has never been cited. More recently I have coauthored a paper that ...[is] now under a long revise and resubmit, still waiting for an answer ... with Mauro Gallegati and Antonio Palestrini, "The Period of Financial Distress in Speculative Markets: Interacting Heterogeneous Agents and Financial Constraints" (available at my website), that lays all this out in much more up-to-date mathematical modeling.

So, why am I boring all of you with this self-citation? Well, Dean Baker is constantly claiming credit for his forecasts of doom and gloom. It looks like we might be finally reaching the big crash in the US mortgage market after a period of distress that started last August (if not earlier). I and my coauthors are the only people to have provided actually formal models of this phenomenon, beyond the verbal and historical discussions provided by the brilliant Minsky and Kindleberger (both of whom I knew...). I have been forecasting this in unpublished lectures all over the globe for years, but never have put it up into the blogosphere. So, I am claiming credit, to the extent it is due, although the basic ideas were clearly laid out earlier by Minsky and Kindleberger. ...

Here's the follow-up:

Update on the Period of Financial Distress and a Bubble Mystery, by Barkley Rosser: Nearly a year ago (7/12/08) I posted here on "Falling from the Period of Financial Distress into Panic and Crash" In that I noted my own work on this concept, which Charles Kindleberger claimed in his Manias, Panics, and Crashes has been the most common pattern of speculative bubbles and crashes (37 out of 47 bubbles listed in Appendix B of his 2000 4th edition). What is involved is for there to be a gradual decline in prices initially after the peak of a bubble, with the crash coming sometime later. The paper I cited then on this by Mauro Gallegati, Antonio Palestrini, and me ... has now been accepted for publication and is forthcoming in Macroeconomic Dynamics.

The three patterns that Kindleberger, drawing on the work of Hyman Minsky, argued we have generally seen are ones with such a period of distress as described above, ones that go up to a peak and then crash hard (which are what most theoretical models of crashes predict), and ones that go up to a peak and then decline gradually without a crash, but usually a bit faster than they went up. In the last few years I would argue we have seen all three patterns. The peak-followed-by-crash pattern looks like the oil market last year, which hit $147 per barrel last July only to fall hard to $32 per barrel by November. The more or less symmetric up-then-down-without a crash pattern looks like the US housing market, which, according to the Case-Shiller index, began rising in 1998, peaked in mid-2006, and has been going down since about the way it went up, with quite a ways to go.

Last year I had it in my mind that the global financial derivatives market smelled like a period of financial distress pattern, and now I think that it was indeed. The peak was in August 2007, when the problems in those markets first began to appear. The crash was the dramatic "Minsky moment" in mid-September 2008.

Which brings me to a fourth pattern that is somewhat mysterious, a variation on the pattern that does not have a crash. Whereas most such bubbles go down more rapidly than they went up, and some go down at about the same rate, there is one that has gone down at a much slower rate, indeed may still be in its decline. I am referring to housing in Japan. A graph of the pattern up to 2005 can be seen here. Around 2006 there was a brief cessation of the decline, but it has since resumed. In any case, that figure shows that the index rose in three years from 150 to its peak around 200, but took ten years thereafter to get back to 150, and it took 15 years from the peak in 1991 to get back down to the level it was in 1986, a clear asymmetry in the direction of going up much faster than it has gone down.

Now, according to private communication from Kindlebeger to me, this is the only major bubble in world history to exhibit such a pattern, and why it has done so remains a mystery. I saw a paper (still unpublished) some years ago that argued that it was Japanese banks manipulating the real estate market to keep the value of their most important collateral from declining too rapidly in the face of broader financial pressure that have been behind this pattern, but I have not seen that confirmed. That would suggest that the pattern has had deep implications for the broader Japanese economy. In any case, this curious decline in Japan remains a mystery (and some say that US housing prices could go down for a much longer time than many think, pointing to this strange case), but it may ultimately have to do with the Japanese wishing to preserve their broader economic system in the face of pressures to more deeply transform it.

Video: Krugman and Taylor

I thought the list of questions asked by the moderator, Fareed Zakaria, and particularly the way some of the questions were framed said a lot about how the debate over economic policy is playing in public (e.g. calling Robert Samuelson a "sober guy" in the premise to a question on health care reform):

"Deficits are Worrisome, but Not as Worrisome as an Economy that is Not Growing and is Rapidly Shedding Jobs"

What do you think of this administration's arguments for deficit spending to spur the economy?:

Remarks of the Chair of the Council of Economic Advisers: ...I very much appreciate the opportunity to speak with you today. I will take this time to discuss recent developments in the economy, and some of the challenges the nation faces going forward. I ... also ... want to discuss some larger issues about how fiscal policy should be evaluated...

I view the economy as experiencing something similar to a tug of war. ... On the contraction end of the rope are the shocks that the U.S. economy has experienced... Pulling hard on the other end of the rope are the expansionary forces of monetary and fiscal policy—the Federal Reserve’s series of interest rate cuts and the Administration’s ... stimulus package...

Monetary and fiscal policy – the two main levers of macroeconomic stabilization policy – are both actively engaged..., both leaning hard against the headwinds...I will not say much today about monetary policy. This is not to diminish in any way the crucial role of the Federal Reserve in helping to counter the adverse forces in this recession. But fiscal policy is my beat as CEA chair, so that will be the focus of my comments. ...

[A]nalysis done within the Administration has shown ... that ... the ... job market is not what we would like it to be right now, but it would have been worse without the Administration’s actions.

One can view the short-run effects [of our policies]... from a classic Keynesian perspective. ... This ... helps maintain the aggregate demand for goods and services. There is nothing novel about this. It is very conventional short-run stabilization policy: You can find it in all of the leading textbooks. ...

The qualitative effects ... on the short-run output gap ... are not controversial. There is less agreement on quantifying these effects—how many jobs are created, how much growth is increased, and so on. To answer these questions, one would normally turn to a macroeconomic model such as those maintained by private forecasting firms, the Federal Reserve, and other institutions. I view such models as being very useful at relatively short time horizons such as one or two years. ...

Of course, the expansionary effects ... will be offset to some degree by the effects of the budget deficits that arise... Deficits can raise interest rates and crowd out of investment, although I should note that the magnitude of this effect is much debated in the economics literature. The main problem now facing the U.S. economy is not high interest rates...

The Administration would prefer not to have deficits, but deficit reduction is only one of many goals. ... Deficits are worrisome, but not as worrisome as an economy that is not growing and is rapidly shedding jobs. ...

The most important fiscal challenge facing the United States is not the current short-term deficits,... but instead the looming long-term deficits associated with the rise in entitlement spending ...

We do not yet have all the answers to the problems posed by entitlement costs, but we are hard at work. ... These longer-term issues, however, should not blind us to the immediate needs of the economy. The President came into office inheriting an economy ...[in] a recession. He has responded vigorously to the challenges and, as a result, the current outlook for the U.S. economy is bright...

That was Greg Mankiw, on September 15, 2003 in a speech to the NABE. [Note: verb tense changed from past to present in a few places, 'chairman' was changed to 'chair,' and he is, of course, mainly promoting tax cuts, not government spending.]

"The Revival of the Big Markets vs. State Planning Debate"

The possibility of an outbreak of protectionism has been raised frequently as a potential byproduct of the recession, but that may not be the biggest concern with regard to developing countries. When Stiglitz and Easterly agree, that's noteworthy:

Joe Stiglitz preaches markets to poor countries!, by William Easterly: Stiglitz in the current issue of Vanity Fair is afraid how poor countries will respond to the global crisis and the record of American hypocrisy on economic policy (like what America prescribed for itself in 2008-2009 vs. what it prescribed for Asia during 1997 crisis). All of this will tarnish market economics so much, fears Stiglitz, that poor countries will turn away from markets altogether in favor of some heavy-handed state planning and socialism. Stiglitz, who is not usually considered market economics’ best friend, is right to be scared. ...

One of the reasons to be worried is the precedent from the 1930s Depression – not the usual worry about a huge wave of global protectionism. No, the worry is about the intellectual precedent that the Depression so discredited markets that government planning and intervention became the default model of development economics for the next 30 years – the 1950s through the 1970s.

I’m thrilled to have a heavyweight like Joe Stiglitz to make this case better and more credibly than I could.... The issue now is not subtleties about the right type of financial regulation, global vs. local standards, or calibrating fiscal stimulus. The issue in development now is the revival of the big markets vs. state planning debate. Let’s hope it comes out differently this time than it did for early development economics after the Depression.

Here's a small part of Stiglitz' essay:

Wall Street’s Toxic Message, by Joseph Stiglitz: ...[N]o crisis, especially one of this severity, recedes without leaving a legacy. And among this one’s legacies will be a worldwide battle over ... what kind of economic system is likely to deliver the greatest benefit to the most people. Nowhere is that battle raging more hotly than in the Third World... In much of the world,... the battle between capitalism and socialism—or at least something that many Americans would label as socialism—still rages. While there may be no winners in the current economic crisis, there are losers, and among the big losers is support for American-style capitalism. This has consequences we’ll be living with for a long time to come. ...

I worry that, as [other countries] see more clearly the flaws in America’s economic and social system, many in the developing world will draw the wrong conclusions. A few countries—and maybe America itself—will learn the right lessons. They will realize that what is required for success is a regime where the roles of market and government are in balance, and where a strong state administers effective regulations. They will realize that the power of special interests must be curbed.

But, for many other countries, the consequences will be messier, and profoundly tragic. The former Communist countries generally turned, after the dismal failure of their postwar system, to market capitalism, replacing Karl Marx with Milton Friedman as their god. The new religion has not served them well. Many countries may conclude not simply that unfettered capitalism, American-style, has failed but that the very concept of a market economy ... is ... unworkable under any circumstances. Old-style Communism won’t be back, but a variety of forms of excessive market intervention will return. And these will fail. The poor suffered under market fundamentalism—we had trickle-up economics, not trickle-down economics. But ... these new regimes ... will not deliver growth. Without growth there cannot be sustainable poverty reduction. There has been no successful economy that has not relied heavily on markets. ... The ... governments brought to power on the basis of rage against American-style capitalism ... will lead to more poverty. ...

Faith in democracy is another victim. In the developing world, people look at Washington and see a system of government that allowed Wall Street to write self-serving rules which put at risk the entire global economy—and then, when the day of reckoning came, turned to Wall Street to manage the recovery. They see continued re-distributions of wealth to the top of the pyramid, transparently at the expense of ordinary citizens. They see, in short, a fundamental problem of political accountability in the American system of democracy. After they have seen all this, it is but a short step to conclude that something is fatally wrong, and inevitably so, with democracy itself. ...

Francis Fukuyama ... was wrong to think that the forces of liberal democracy and the market economy would inevitably triumph, and that there could be no turning back. But he was not wrong to believe that democracy and market forces are essential to a just and prosperous world. The economic crisis, created largely by America’s behavior, has done more damage to these fundamental values than any totalitarian regime ever could have. ...

"The Treasury View"

Free Exchange:

The Treasury view, Free Exchange: ...Noam Scheiber has a nice post up examining the view of PPIP—the plan to sell subsidised toxic assets at auction—from inside the Treasury. Here's a quote from a Treasury official:

...If you had asked--I don’t want to speak for the secretary--what’s problem number one? I think he'd say capital. Problem two? Capital. Problem three? Capital. Everything was in the service of that view. The legacy loans program was meant to help clean balance sheets. It was not an independent good in itself. It was seen as friendly to equity raising. Now people say the legacy loans thing is not gaining as much traction, so is that a failure? But because we had a good outcome in terms of raising equity, [the banks] were able to raise equity without shedding assets ... you should be okay with that.

Mr Scheiber also reprints a quote from a Goldman Sachs employee, originally in the Wall Street Journal, noting that PPIP is "the greatest program that never occurred... [because it] created confidence in the markets so banks can raise equity capital".

I don't know that I buy the Treasury spin—that they saw that banks needed more capital than the government could provide, and so they crafted an incredibly generous asset purchase plan understanding that it would boost Wall Street spirits, allowing banks to raise private capital and thereby making actual deployment of the plan unnecessary. Remember just how dire things appeared at the time of the plan's construction, and recall how many defenders of the plan—myself included—argued that there were no other options with tolerable risk levels available. Meanwhile, it's not clear that PPIP (as opposed to other interventions or the natural resolution of the crisis) had anything to do with the market's rebound, which began well after the initial description of the administration's proposal and well before the release of key programme details.

Which isn't to say that no one in the administration foresaw this possibility or planned for it. I would argue, however, that the current state of affairs was not really the expected outcome, and that the banking plan benefitted enormously from events outside of Treasury's control.

I don't disagree with that. But if it's true that the plan inspired confidence, intended or not, and that caused private investors to put capital into these institutions based upon the assumption that the banks would be made healthier by ridding themselves of toxicity through the PPIP, and now the government says "just kidding," isn't that a double-cross? Would the private investors have still put capital into the banks had they known the double-cross was coming? And if they wouldn't have, doesn't the continued presence of these assets on the books mean there's more risk present than we ought to be comfortable with?

links for 2009-07-01

• Yellen Takes a Big Swing at Inflation Hawks - Real Time Economics
• Bank Woes Deepening in Europe - NYTimes.com
• Oregon Logging Rule Is Overturned - NYTimes.com
• ‘Operator? Can You Put Me Through to Ant Nest 251?’ - Olivia Judson
• Fiscal Restraint from Those 50 Little Herbert Hoovers - pgl
• Fossil primate suggests common Asian ancestor, challenges 'Ida' - EurekAlert
• Mistake by Obama’s Advisers in Predicting Job Losses - NYTimes.com
• Trickle-Down Economics Fails to Deliver as Promised - Real Time Economics
• Financial sector pro-cyclicality: Lessons from the crisis, Part I - voxeu.org
• Financial sector pro-cyclicality: Lessons from the crisis, Part II - voxeu.org
• Explaining the FOMC - Real Time Economics
• The savings glut. Controversy guaranteed - Brad Setser

links for 2009-07-01

• naked capitalism - links
• Felix Salmon - links
• The Stash - links
• Ezra Klein - links
• Credit Writedowns - links
• Matthew Yglesias - links
• Free Exchange - links
• New Deal 2.0 - links
• Abnormal Returns - links
• Marginal Revolution - links
• Brad DeLong - links
• Chris Martenson - links

Bankslaughter?

Paul Collier says we should hold financial institutions responsible for reckless behavior if we want to temper their inclination to take excessive risk:

A law to tame wild bankers, by Paul Collier, Commentary, CIF: Deregulation of the banks was built on two intellectual pillars. One was that regulation was not necessary because banks would self-regulate in order to protect their reputation. Please stop laughing. The other was that regulation would not work because regulators would always be one step behind the bankers. And unfortunately we cannot laugh this one off. Indeed, the technical problems facing regulation are now compounded by political impediments. Green shoots, lobbying by the banks, and turf wars among the regulators have eroded the momentum for action. So if banks cannot effectively be regulated by the authorities, what can be done?

The Turner review came up with two solutions. One is radically to raise the capital requirements of banks so that shareholders have something to lose if management goes wrong. The other is to change incentive payments for managers so bonuses depend on the past three years of performance. The increase in capital requirements makes sense. But the three-year rule is weak. The inherent problem facing shareholders is that incentive payments cannot go negative. However much damage a manager inflicts, wiping out both shareholders and depositors, the consequences cannot be remotely commensurate. As a result, even bonuses with a three-year lag bias the system towards risk-taking. If you thought big bonuses were history you have missed BAB, the new banking mnemonic: yes, Bonuses Are Back.

So how can we avoid another Northern Rock? While shareholders cannot impose genuine penalties, governments can. Fear of jail would discourage excessive risk. Before bankers huff about blunting incentives, yes, I realise that without carrots, bankers will just sit and gaze at the office ceiling. Bankers, set your minds at rest: the introduction of penalties would permit BABEL: that is, the carrots for genuinely smart behaviour could be Even Larger.

The key problem with using the law against bankers has been the difficulty of getting a conviction: surely, the managers of Northern Rock did not intend to profit at our expense. We do not need to set the burden of proof that high. Intention misses the point. Faced with a corpse and a killer, police do not need to prove ill intent: manslaughter sets the hurdle lower than murder. It is enough to show the killer was irresponsible. That is the standard we need; we need a crime of managing a bank irresponsibly: in other words, bankslaughter.

On Turner's proposal a manager can still benefit from recklessness – as long as the bank does not blow up within three years. After that, if the bank crashes he can be off playing golf. With bankslaughter, when the bank blows up – even if it is a decade later – a criminal investigation traces back to determine whether crucial decisions were reckless. If a reasonable banker faced with the information available at the time would not have taken those risks, the person responsible is dragged off the golf course and jailed.

Once bankslaughter was on the books, bonuses would be less dangerous. Managers would have to weigh the balance between risk and return and take defensible decisions. I doubt hyper-caution would be a problem: the overly cautious would not get bonuses. Surely we can rely on our bankers to exhibit the necessary degree of greed.

Bankslaughter would target the wild fringe rather than the average banker. The wild fringe matters: sometimes it generates a crisis that becomes systemic. We now know that as early as 2004, the Bank of England anticipated that Northern Rock would implode. Its business model was so risky that other banks had not adopted it. But in the short term, reckless behaviour looks smart, and so wiser management teams were coming under pressure to emulate it. By the time of its demise, the Rock was doing a fifth of British mortgages.

By curtailing the wild fringe, bankslaughter would complement Turner's approach, which is to make the average bank behave better. Both are needed. Turner's concern about performance is manifestly necessary. But the crisis has revealed that some banks are more rotten than others. In Britain, the two Scottish banks and Northern Rock were pioneers of imprudence. In Ireland two banks run by an alliance of construction firms and politicians swept the country to ruin. Even if shareholder capital is at risk, some banks are likely to suffer because of poor corporate governance.

Had bankslaughter been on the books, the management of Northern Rock would now perhaps be in the dock. But, vengeful as we feel, the point of criminal sanction would not be to punish reckless behaviour but to discourage it. If this law had existed, would our financial knights have been so errant?

Do Tipping Points Exist?

Are tipping points "mythological"?:

The Tipping Point: Fascinating but Mythological?, by William Easterly: The “tipping point” is a popular concept covering a whole range of phenomena (and a best-selling book by Malcolm Gladwell) where individual behavior depends on the behavior of the herd.

Its original application was to racial segregation. Nobel Laureate Thomas Schelling developed a beautifully simple model for this. Suppose that whites have different degrees of racism – some would “tolerate” higher shares of nonwhites than others. Schelling showed that the less racist whites would still wind up exiting during tipping because of a chain reaction. At first only the most extreme racist whites exit. But their departure causes the white share to go down, making the second most extreme racist whites uncomfortable, so they also exit. The white share goes down some more, and so now even less racist whites will be uncomfortable being a white minority, and they will wind up exiting too. So the remarkable prediction of the tipping point model is that just a little bit of integration that directly bothered only the most racist whites wound up causing ALL of the whites to exit. So even if the typical white was perfectly happy with integrated neighborhoods, these neighborhoods would be so unstable that the final outcome would be extreme racial segregation. ...

It’s easy to imagine development applications for the tipping point idea. Suppose that people decide to get highly educated based on what is the share of highly educated people in the population. After all, it’s only worthwhile being educated if you can talk to and work with a lot of other highly educated people. If the share of educated people falls below a tipping point, a lot of people will stop getting highly educated, which decreases even further the incentive to get highly educated, and we get the same kind of chain reaction... Assuming that low education causes poverty, this is a “poverty trap” story of low education and underdevelopment.

The tipping point stories are fascinating, but do we observe them in the real world? I got intrigued with this question a while ago, and eventually published a paper testing the predictions of the tipping point story (ungated version here) for its original application: racial segregation of US neighborhoods (reminder to self: my job is not only to blog, also to be a full time academic researcher that must “publish or perish”). The basic prediction is that mixed neighborhoods are unstable but segregated neighborhoods are stable. Data on American neighborhoods from 1970 to 2000 rejected these predictions – it was the segregated neighborhoods that were unstable. There was as much “white flight” out of all-white neighborhoods as there was out of mixed neighborhoods, and there was a white influx into segregated nonwhite neighborhoods. Neighborhoods are still very segregated in the year 2000, but not because of tipping. ...

Of course, this is only one test of the tipping point for racial segregation over one time period. Maybe the tipping point is real in other contexts. But think twice and check for evidence before you accept popular stories like the Tipping Point.

Did Greenspan Make a Mistake in 2001-2004 by Keeping Too Rates Low?

David Beckworth says Brad DeLong can quit wondering, Greenspan's "low interest rate policy in the early-to-mid 2000s was truly a mistake" [Update: see Brad Delong for more]:

Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake, by David Beckworth: 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... 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 as can be seen in the figure...

Should We Pop Bubbles?

This may help Brad DeLong settle his inner conflict over whether Greenspan made an error by not moving interest rates to limit the housing boom. Guillermo Calvo and Rudy Loo-Kung argue that the benefits of bubbles almost always outweigh their costs (and thus there's no need for regulation to prevent them).

I think the authors are correct to point out that distributional issues are omitted from the analysis. Also, the assumption that social welfare depends only upon consumption is important as it rules out any utility costs associated with losing a home, a job, changing schools, etc. over and above the loss of consumption. In addition, using the aggregate consumption level of a composite commodity to index social welfare doesn't capture the costs associated with producing the subotimal mix of goods (e.g. too much housing, not enough of other goods), all that matters is the total quantity that is produced and consumed. Finally, I was surprised that the downturn and upturn phases of the cycle were assumed to be of equal length as I thought a slower return to normal growth (as compared to the downturn) - something that would increase the costs of the collapse - was the normal scenario:

Should we rush to further regulate financial institutions?, by Guillermo Calvo and Rudy Loo-Kung, Vox EU:

‘Tis better to have loved and lost,
Than never to have loved at all.
Tennyson, 1850.

In times of systemic financial distress, hunting for culprits becomes a popular sport. The Madoffs of this world are easy targets because crisis makes crookery harder to conceal. While there is no question that crooks should be sent to jail, increasing financial regulation is a different issue and requires careful analysis. Rushing to impose tighter regulations may hamper recovery and growth. Empirical evidence strongly supports the view that growth and financial development go hand in hand (Demirgüç-Kunt and Levine 2008). Although it is much harder to establish that financial development causes growth, few would doubt that, at least temporarily, financial deregulation could promote higher growth. A genuine concern, however, is that the financial sector is prone to crises, which are typically associated with serious effects on output and employment.

We cannot reach definite conclusions about the desirability of risky financial arrangements in a short column. Our objective is much more modest. We examine the welfare implications of financial deregulations that result in higher growth but end in tears and perform the exercise in the context of a benchmark case in which consumption is the ultimate source of welfare, ignoring possibly relevant behavioural finance and political economy considerations. We base our analysis on estimates of the costs of financial crises in emerging market economies (since the 1980s), a cauldron of financial crises in the last thirty years. Our results support deregulation even under those dire circumstances.¹

Rapid Resolution Plans

No disagreement with this. The failure to have dissolution plans for systemically important institutions on the shelf and ready to go turned out to be costly, so credible dissolution plans are certainly needed. However, the argument seems to assume that too big and too interconnected firms cannot be avoided, something I'm not ready to concede:

A sound funeral plan can prolong a bank’s life, by Anil Kashyap, Commentary, Financial Times: Buried within the 88-page Obama administration proposal to overhaul financial regulation is an overlooked option called a “rapid resolution plan”. It mandates that systemically important financial companies be required regularly to file a “funeral plan”: a set of instructions for how the institution could be quickly dismantled should the need to do so arise. ... It could be implemented now, without the need for legislative action. Regulators should do so immediately.

The first benefit is that regulators would gain a stronger negotiating position with a dying institution. Throughout this crisis the authorities have had to intervene without knowing exactly what hidden traps might emerge if a bank were to be closed down. The bankers know this and can exploit the fear of the unknown to press for bail-outs.

It is remarkable that such rules do not already exist. ... The crisis has shown us that the sudden unwinding of a large, complex financial institution is terrifying for the financial system. ...

A second immediate benefit would be to force bank managers to think much more carefully about the complex financial structures they have created. If bankers had to explain every single step needed (and the associated consequences) to shut down their subsidiaries in all the various jurisdictions in which they operate, they would have a big incentive to simplify their organisations. ...

Over the medium term, there would be additional benefits. The headline component of the plan would be the requirement for banks to estimate the number of days it would take to shut down. Banks that require longer to close would have to hold more capital. This would place management under serious pressure to improve their plans...

Senior members of the management team and the board would have to understand the funeral plan. Crucially, they would be forced to sign off on its accuracy. This might also lead to closer scrutiny of new products or lines of business if they jeopardised an orderly unwinding. ...

This proposal is far from a cure-all. One big problem is that resolution rules themselves, especially when multiple legal systems are involved, are quite complicated. But the plan has an extremely high benefit-to-cost ratio and could be put in place right away. ...

links for 2009-06-30

• A Quick Look Back at Waxman-Markey and the Road Ahead - Robert Stavins
• Do you know how much your home is worth? - voxeu.org
• Hybrid "Superpredator" Invading California Ponds - National Geographic
• More Signs of the Demise of Behavioral Economics? - Cheap Talk
• Why The Stimulus Isn't Working - Economic Perspectives
• Employer Health Benefits: Hawaii's Experience - FRBSF Economic Letter
• Greenspan Speaks - Models & Agents
• How to Set Greenhouse Gas Emissions Targets for All Countries - Jeff Frankel
• Why does Japan have so many elevator operator? - Daniel Gross
• Young Japanese Raise Their Voices Over Economy - NYTimes.com
• Why We Need a Second Stimulus - TNR
• New Plan Ties Lower College Loan Payments to Income - NYTimes.com
• Bucking the Banks - Chris hayes
• In Which Greg Mankiw Confesses to Remarkable Ignorance - Brad DeLong
• Debating the Public Option - The American Prospect

links for 2009-06-30

• naked capitalism - links
• Felix Salmon - links
• Matthew Yglesias - links
• Ezra Klein - links
• Credit Writedowns - links
• Free Exchange - links
• The Big Picture - links
• Chris Martenson - links
• Brad DeLong - links
• Abnormal Returns - links
• New Deal 2.0 - links
• Marginal Revolution - links

An "Ethical Dilemma" in End of Life Care

This looks at the costs of extending the end of life by a short period of time and tries to draw a boundary between those cases when treatment should be applied, and those when it is not worth it to do so (the conclusion is that "studies powered to detect a survival advantage of two months or less should test only interventions that can be marketed at a cost of less than $20,000 for a course of treatment").

How do we draw this line (and if you don't think we should, how do we avoid drawing it)? Usually, I would give the standard answer that we should employ these life-extending procedures up until the point where the marginal cost of the treatment equals the marginal benefit, and let someone else worry about how to actually measure the costs and benefits. But in this case the measurement of the benefits - life itself - seems particularly hard to quantify, and trying to account for quality of life complicates it further, and it is not clear to me that a market test is even appropriate when there may not be a tomorrow and standard opportunity cost tradeoffs are missing from the evaluation (update: thinking more, I suppose this is just "cap-T" in our models, which isn't too hard to handle in the deterministic case, i.e. where T is known in advance with certainty, but the evaluation still seems problematic due to the other reasons that are cited). So I don't think there is a good answer to this question, at least not one that standard economic models can deliver:

How much is life worth? The $440 billion question, EurekAlert: The decision to use expensive cancer therapies that typically produce only a relatively short extension of survival is a serious ethical dilemma in the U.S. that needs to be addressed by the oncology community, according to a commentary published online June 29 in the Journal of the National Cancer Institute.

Tito Fojo, M.D., Ph.D., of the Medical Oncology Branch, Center of Cancer Research at the National Cancer Institute, in Bethesda, Md., and Christine Grady, Ph.D., of the Department of Bioethics, the Clinical Center at the National Institutes of Health, ... illustrate cost-benefit relationships for several cancer drugs, including cetuximab for treatment of non-small cell lung cancer, touted as "practice changing" and new standards of care by professional societies, including the American Society of Clinical Oncology. ...

According to Fojo and Grady,... 18 weeks of cetuximab treatment for non-small cell lung cancer, which was found to extend life by 1.2 months, costs an average of $80,000, which translates into an expenditure of $800,000 to prolong the life of one patient by 1 year. At this rate, it would cost $440 billion annually ... to extend the lives of 550,000 Americans who die of cancer annually by 1 year.

To address the issue, the commentators recommend that studies powered to detect a survival advantage of two months or less should test only interventions that can be marketed at a cost of less than $20,000 for a course of treatment.

Every life is of infinite value, the authors say, but spiraling costs of cancer care makes this dilemma inescapable.

"The current situation cannot continue. We cannot ignore the cumulative costs of the tests and treatments we recommend and prescribe. As the agents of change, professional societies, including their academic and practicing oncologist members, must lead the way," the authors write. "The time to start is now."

DeLong: Sympathy for Greenspan

Brad DeLong can't decide whether or not Greenspan made a mistake when he kept interest rates low after the collapse of the dot.com bubble:

Sympathy for Greenspan, by J. Bradford DeLong, Commentary, Project Syndicate: In the circles in which I travel, there is near-universal consensus that America’s monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis. ... US policymakers erred when:

-the decision was made to eschew principles-based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government’s guarantee of the commercial banking system was enough to keep us out of trouble;

-the Fed and the Treasury decided, once we were in trouble, to nationalise AIG and pay its bills rather than to support its counterparties, which allowed financiers to pretend that their strategies were fundamentally sound;

-the Fed and the Treasury decided to let Lehman Brothers go into uncontrolled bankruptcy in order to try to teach financiers that having an ill-capitalised counterparty was not without risk, and that people should not expect the government to come to their rescue automatically.

There is, however, a lively debate about whether there was a fourth big mistake: Alan Greenspan’s decision in 2001-2004 to push and keep nominal interest rates on US Treasury securities very low in order to try to keep the economy near full employment. In other words, should Greenspan have kept interest rates higher and triggered a recession in order to avert the growth of a housing bubble? ...

Full employment is better than high unemployment if it can be accomplished without inflation, Greenspan thought. If a bubble develops, and if the bubble ... collapses, threatening to cause a depression, the Fed would have the policy tools to short-circuit that chain. In hindsight, Greenspan was wrong. But the question is: was the bet that Greenspan made a favourable one? ...

I am genuinely unsure as to which side I come down on in this debate. ... What I do know is that the way the issue is usually posed is wrong. People claim that Greenspan’s Fed “aggressively pushed interest rates below a natural level.” But what is the natural level? In the 1920’s, Swedish economist Knut Wicksell defined it as the interest rate at which, economy-wide, desired investment equals desired savings, implying no upward pressure on consumer prices, resource prices, or wages as aggregate demand outruns supply, and no downward pressure on these prices as supply exceeds demand.

On Wicksell’s definition — the best, and, in fact, the only definition I know of — the market interest rate was, if anything, above the natural interest rate in the early 2000’s: the threat was deflation, not accelerating inflation. The natural interest rate was low because, as the Fed’s current chairman Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). ...

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, which would have deepened and prolonged the recession that started in 2001.

But today is one of those days when I don’t think that Greenspan’s failure to raise interest rates above the natural rate to generate high unemployment and avert the growth of a mortgage-finance bubble was a mistake. There were plenty of other mistakes that generated the catastrophe that faces us today.

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.

Paul Krugman: Betraying the Planet

Are the arguments against the need to act to prevent climate change based upon a morally defensible position grounded in science, or, given the predicted consequences of inaction, a morally indefensible position based upon ideology and political interests?:

Betraying the Planet, by Paul Krugman, Commentary, NY Times: So the House passed the Waxman-Markey climate-change bill. In political terms, it was a remarkable achievement.

But 212 representatives voted no. A handful of these no votes came from representatives who considered the bill too weak, but most rejected the bill because they rejected the whole notion that we have to do something about greenhouse gases.

And as I watched the deniers make their arguments, I couldn’t help thinking that I was watching a form of treason — treason against the planet.

To fully appreciate the irresponsibility and immorality of climate-change denial, you need to know about the grim turn taken by the latest climate research.

The ... planet is changing faster than even pessimists expected: ice caps are shrinking, arid zones spreading, at a terrifying rate. And according to a number of recent studies, catastrophe — a rise in temperature so large as to be almost unthinkable — can no longer be considered a mere possibility. It is, instead, the most likely outcome if we continue along our present course.

Thus researchers at M.I.T., who were previously predicting a temperature rise of a little more than 4 degrees by the end of this century, are now predicting a rise of more than 9 degrees. ...

Temperature increases on the scale predicted by ... researchers ... would create huge disruptions in our lives and our economy. As a recent authoritative U.S. government report points out, by the end of this century..., Illinois may have the climate of East Texas, and ... deadly heat waves ... may become annual or biannual events.

In other words, we’re facing a clear and present danger to our way of life, perhaps even to civilization itself. How can anyone justify failing to act?

Well, sometimes even the most authoritative analyses get things wrong. And if dissenting opinion-makers and politicians ... had carefully studied the issue, consulted with experts and concluded that the overwhelming scientific consensus was misguided — they could at least claim to be acting responsibly.

But if you watched the debate..., you didn’t see people who’ve thought hard about a crucial issue, and are trying to do the right thing. What you saw, instead, were people who ... don’t like the political and policy implications of climate change, so they’ve decided not to believe in it — and they’ll grab any argument, no matter how disreputable, that feeds their denial.

Indeed, if there was a defining moment in Friday’s debate, it was the declaration by Representative Paul Broun of Georgia that climate change is nothing but a “hoax” ... “perpetrated out of the scientific community.” ... Mr. Broun’s declaration was met with a round of applause from his Republican colleagues.

Given this contempt for hard science, I’m almost reluctant to mention the deniers’ dishonesty on matters economic. But in addition to rejecting climate science, the opponents of the climate bill made a point of misrepresenting ... studies of the bill’s economic impact, which all suggest that the cost will be relatively low.

Still, is it fair to call climate denial a form of treason? Isn’t it politics as usual?

Yes, it is — and that’s why it’s unforgivable.

Do you remember ... when Bush administration officials claimed that terrorism posed an “existential threat” to America,... [so] normal rules no longer applied? That was hyperbole — but the existential threat from climate change is all too real.

Yet the deniers are choosing, willfully, to ignore that threat, placing future generations of Americans in grave danger, simply because it’s in their political interest to pretend that there’s nothing to worry about. If that’s not betrayal, I don’t know what is.

Fed Watch: A Tangled Policy Web

Tim Duy:

A Tangled Policy Web, by Tim Duy: Incoming data continues to confirm an emerging period of relative economic tranquility following the financial storm of 2008. Importantly, the bleeding in consumer spending has been staunched, despite ongoing job losses that look likely to remain a feature of the American economic landscape for months to come. But incoming data also point to America's sustained and perplexing dependence on foreign capital inflows - a dependence that suggests an underlying economic vulnerability that has yet to be addressed. Whether it needs to be addressed next month, next year, or next decade is still a question that continues to haunt the followers of global macro trends.

The most recent Personal Income and Outlays report, for May 2009, highlights many of the trends currently impacting the evolution of economic activity. The headline jump in incomes, like that of the previous month, was driven by federal stimulus. Declining private wage and salary disbursements are a more telling indicator of the health of household finances, and are consistent with ongoing labor market weakness. The best bet is the that private wage gains remain subdued, even as conditions stabilize. Although the apparent peak of initial claims is in the rearview mirror, persistent high levels of claims points to a jobless recovery.

Of course, in the absence of federal stimulus, the underlying weak income growth indicates sustained pressures on consumer spending power. Indeed, the numbers tell a clear story of stabilization, but little to suggest that a V shaped recovery for consumer spending is at hand:

In addition, the report adds further credence to the claims that American's long affair with spending has ended in a bitter divorce, with the saving rate climbing to its highest level in 15 years. To be sure, some of the increase is likely not sustainable in the short run, as it partly reflects a time lag between federal stimulus and the spending it was meant to encourage. That said, the underlying saving increase is tempering the impact of stimulus spending, as households sock some of it away for the next rainy day and/or pay down crippling debt loads, effectively turning private debt into public debt. And note that large shifts in consumer behavior are not required to have significant macroeconomic implications. Small changes across households - a little less, percentage wise, spending here and there adds up. From Bloomberg:

links for 2009-06-29

• When to Impose Fiscal Restraint and With What - pgl
• Caveat Mortgagor - James Surowiecki
• Mice run faster on high-grade oil - EurekAlert
• Obama Warns Against Trade Penalties in Energy Bill - NYT
• Obama is choosing to be weak - Clive Crook
• U.S. Plan to Stem Foreclosures Is Mired in Paper Avalanche - NYT
• Google Makes a Case That It Isn’t So Big - NYT
• Against Gerontocracy - Economic Principals
• Deficit Disorder - pgl
• How Americans spend their 24 hours - News N Economics
• Chinese Now Say "No Change" in Currency Policy - Yves Smith

links for 2009-06-29

• naked capitalism - links
• Abnormal Returns - links
• Credit Writedowns - links
• Chris Martenson - links
• Paul Kedrosky - links
• Marginal Revolution - links
• Brad DeLong - links

Old Economy/New Economy

How did people survive without Google? A colleague, Bill Harbaugh, emails:

I stink, and I needed a Laundromat in Lyon. Google translate says that's called a laverie in French. Google maps says there's one 4 blocks away. Is it open on Sunday? Laundromats don't have websites. But Google street views shows the front door - Ouvert 7 Jours.

Then the washing machine swallowed my last Euros. 

What's behind Recent Changes in Long-Term Interst Rates?

Martin Feldstein says we need to cut social programs so that we don't "weaken demand in the near term and hurt economic incentives in the long run":

The Fed must reassure markets on inflation, by Martin Feldstein, Commentary, Financial Times: The interest rate on 10-year US Treasury bonds almost doubled in six months, rising from 2.26 per cent last December to 3.98 per cent in mid-June, before decreasing slightly in recent days. This sharp rise happened despite the Federal Reserve’s ... policy aimed at lowering long-term rates by buying $300bn of Treasuries and promising to buy more than $1,000bn of mortgage securities. ...

There is no single reason for the sharp rise in rates... The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. ... The prospective decline of the dollar is also a potential source of inflation. ...

But such an explanation is deceptively easy. ... Those scared by Lehman Brothers’ collapse wanted the safety and liquidity of ordinary Treasury bonds, causing their yields to fall sharply...

Treasury yields rose this month to their level a year earlier because improving market conditions meant investors were no longer willing to pay for the extreme liquidity of Treasuries. Inflation was thus not the only, and perhaps not even the main, reason for the rise in rates.

Why did the Fed’s massive buying of long-term Treasury bonds not hold down the bond rate? The answer is that bond markets are less impressed by the $300bn of Fed purchases than by the official projection of $10,000bn of government borrowing over the next decade... The resulting crowding out of private investment will require higher future interest rates, and that is reflected in current long-term rates.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors’ concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. ...

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

Here's (my interpretation of) Paul Krugman's argument about the source of recent movements in long-term interest rates:

There are two reasons long-term rates might rise, first more worries about the debt and inflation in the future would drive rates up, and second the prospect of better economic conditions in the future would have the same effect, rates would go up.

Suppose we receive bad news about the current state of the economy. That should cause expectations of lower output growth in the future, and hence lower tax revenues and higher spending on social programs than would exist with a stronger economy. So the bad news should cause an expectation of a larger deficit and more inflation worries, and that would drive long-term interest rates up (these worries would also make foreign central banks less likely to fund US borrowing which would reinforce the increase in long-term interest rates).

But if it is future economic conditions that are driving the changes in long-term interest rates, bad news about the economy should drive rates down.

Last week, we received bad news about the economy. If the debt/inflation/foreign lending story is correct, long-term rates should have gone up. If the state of the economy story is driving rates, rates should have fallen. What did long-term rates actually do? They fell.

A Public Plan

[I'm hoping this education example will give some insight into the public health care plan, or at least give you another way to think about it.]

Suppose that education is only available from private sector schools, and that education within this system is very expensive. Because of the expense, millions of people do not have access to education. Further suppose that due to the characteristics of the education market, there is reason to believe that the private institutions are bloated with excess costs (and, in addition to all the other excess costs, 30% of their expenditures came from competition for students rather than delivering education). To make matters worse, the already too high costs are expected to escalate rapidly in the future and further limit access to education. (And there's more. If costs aren't controlled, the government's Educare program for the very young will begin to eat up a huge share of the federal budget.)

Now suppose the government decides to solve both the access and cost problems by setting up a public plan for education. Here's how it works.

The government will build schools, staff them, purchase supplies, and so on, but there's a catch. The schools will have to run without any government subsidies, none at all, not a dime (so this is different than what we actually do since some or all of the education bill is subsidized, some for college, all for lower grades).

If these schools provide exactly the same education as the private sector schools but cost less to attend, then that would either force the private sector schools to find a way to compete by bringing costs down, and they ought to be able to match the government run institution, or they would go out of business. It's true that the public institutions might have an advantage in buying books in bulk, that sort of thing, and they could probably get books and other supplies for less than individual private schools could get them, but what's wrong with scale economies? And to the extent that it is the power that comes from their size as public institutions rather than actual efficiencies, it's important to remember that the publishers aren't without their own countervailing market power, so this makes the playing field more level.

As to access, one option is to do as we do with schools now and implicitly subsidize everyone who attends, rich and poor alike, by giving government subsidies to the schools (tuition falls by the amount of the subsidy, to zero for public elementary and high schools, part way to zero for colleges). But that would violate the no government help rule we imposed above. The other way to do this is to take the money that would have been used to subsidize the schools and instead give it out to individuals who couldn't attend school otherwise (perhaps graduated by income). That avoids giving subsidies to those who don't need them, and the subsidies can then be concentrated on those who do. The additional help available to those who need it would, in turn, allow more people access to education, a key goal of the policy.

So, the idea is to build government schools that must run without any help from taxpayers, and the public schools will compete side by side with the private schools. Rather than limiting choice, this adds one more choice, and it's a choice nobody has to make if the public schools turn out to be more expensive than than the competing private schools. Then, to increase access to education, give individuals the tuition subsidies they need to make it possible for them to attend the public school. Finally, for any conservatives opposed to the public plan, notice that if individuals can use the subsidy on either a public or a private sector school, this is basically a voucher system. However, in this case the goal of the voucher system is to reduce costs in the overly expensive private sector rather than to discipline the public institutions, something the private sector shouldn't fear if, in fact, it is the least cost provider of education.

links for 2009-06-28

• Volcker Gets Less Than He Wants in Curbing Excesses - Bloomberg
• G.M., Detroit and the Fall of the Black Middle Class - NYTimes.com
• Book Review - 'The Industrial Revolutionaries - NYTimes.com
• Central banking as partisan politics - Willem Buiter
• The Lost Continent (Africa) - Robert Skidelsky
• The CRA... Still Not Causing the Meltdown - Obsidian Wings
• Most Subprime Lenders Weren’t Covered by CRA - The Big Picture

links for 2009-06-28

• naked capitalism - links
• Brad DeLong - links
• Marginal Revolution - links
• Chris Blattman - links

Are Advances in Technology the Source of Rising Medical Costs?

I'm not sure what to think of this. If it's true that medical technology increases life expectancy without increasing per capita medical expenditures, that's good news, but that result differs from other work in the area (and it leaves me wondering what is behind the actual and projected increase in health care costs if the source is something other than this):

The quality of medical care, behavioral risk factors, and longevity growth, by Frank R. Lichtenberg, Vox EU: The cost of medical care continues to rise rapidly in the US and other industrialized countries. According to a report from consulting firm PricewaterhouseCoopers, US employers who offer health insurance coverage could see a 9% cost increase between 2009 and 2010, and their workers may face an even larger increase.

Some observers argue that rapidly increasing health care expenditure is due, to an important extent, to medical innovation – the development and use of new drugs, diagnostics, and procedures. For example, the Kaiser Family Foundation (2007), citing Rettig (1994), claims that “advances in medical technology have contributed to rising overall US health care spending.”

Other observers argue that most medical innovations do not improve people’s health. Lexchin (2004), for example, claims that “at best one third of new drugs offer some additional clinical benefit and perhaps as few as 3% are major therapeutic advances.”

If both of these claims were true, medical innovation would result in the worst of both worlds – a large increase in cost and little or no increase in benefit (in the form of improved health outcomes). However, a study that I have recently performed casts considerable doubt on both of these claims. My findings indicate that medical innovation has yielded significant increases in life expectancy without increasing medical expenditure.

"Pure Political Theater, and I Don't Like It"

Jim Hamilton:

On grilling the Fed Chair, Econbrowser: I got a bit angry at accounts of the latest appearance of Federal Reserve Chair Ben Bernanke before the U.S. Congress. ...

It is one thing to have different views from those of the Fed Chair on particular decisions that have been made-- I certainly have plenty of areas of disagreement of my own. But it is another matter to question Bernanke's intellect or personal integrity. As someone who's known him for 25 years, I would place him above 99.9% of those recently in power in Washington on the integrity dimension, not to mention IQ. His actions over the past two years have been guided by one and only one motive, that being to minimize the harm caused to ordinary people by the financial turmoil. Whether you agree or disagree with all the steps he's taken, let's start with an understanding that that's been his overriding goal.

These interrogations reveal more about those doing the grilling than they reveal about Bernanke. I see this as pure political theater, and I don't like it.

If Congress wants to explore more usefully the wisdom and motives behind some of the decisions that have been made, it might want to investigate why some legislators are now pushing for Fannie and Freddie to guarantee a riskier category of mortgage condo loans.

"The Persian Bazaars"

The Persian Bazaars of 1910 (as viewed through western eyes):

Islamic History Sourcebook: Eustache de Lory: The Persian Bazaars, 1910: Like the bazaars in Constantinople and Cairo, those of Teheran consist of an immense labyrinth of streets covered with brick vaults, forming an uninterrupted row of little domes, in the middle of each of which a round hole is pierced to let in the light. Through this hole the sun darts its rays like the flash-lights of a man-of-war amid the half-lights of the vaults, which in summer keep the air so cool.

When you enter the great central artery, which starts from the south of the Sabz-Meidan, you are in the Bazaar of the Shoemakers. On both sides of the vault are stalls, from ten to fifteen feet square, with a floor about three feet above the ground. These are occupied by the makers of all sorts of shoes. Here are pahboush, yellow, or green for the mullahs; there are the tiny red slippers with turned-up toes and metal heels which the women wear. Farther on are the ugly boots of blacking leather or patent leather with elastic sides, which are intended for those who wish to enjoy the advantages of civilization. Then come the shops where you buy the giveh, the national shoes of Persia, made of very strong white linen, with soles of plaited thongs dyed green; and the yellow top-boots, with the red rolled-over tops and very turned-up toes and thick soles, like Tartar boots, which are worn by the Persians in the mountains.

links for 2009-06-27

• The American Consumer: Reforming, Or Just Resting? - Carroll and Slacalek
• The cost of medical innovation - voxeu.org
• As Incomes Rebound, Saving Hits Highest Rate in 15 Years - NYT
• Why we have both Fannie and Freddie - Richard Green
• Can Asia free itself from the IMF? - Barry Eichengreen
• Merrill Lynch Camp: Ben Bernanke Is Telling the Truth - Atlantic Business
• Bernanke Grilling May Weaken Case for Fed as Risk Regulator - Bloomberg
• Wartime China - Daniel Little
• Interview with Kevin Murphy - Federal Reserve Bank of Minneapolis
• Why we shouldn’t subsidise clean-energy technologies - voxeu.org
• Bush's court appointments emphasized ideology over diversity - EurekAlert
• Thinking of you (Theory of Mind) - MIT News

links for 2009-06-27

• naked capitalism - links
• New Deal 2.0 - links
• Felix Salmon - links
• Matthew Yglesias - links
• Brad DeLong - links
• Econbrowser - links
• Marginal Revolution - links
• Abnormal Returns - links
• Chris Martenson - links
• Paul Kedrosky - links
• FT Alphaville - links

"The Second Derivative is Bad"

John Hempton is "feeling just that little bit less certain" that the rate of deterioration in the economy has slowed:

The second derivative is bad, Bronte Capital: I have been firmly in the “second derivative is good” camp for some time. Green shoots were few and far between – but the economy no longer appeared to be in free-fall. ...

The data I considered most persuasive was the delinquency data at Fannie and Freddie. It gets worse every month, but until the last data point it was getting worse at a decreasing rate (especially if you adjusted for the foreclosure moratoriums they implemented).  

Today I am more worried. My favorite data point (rate of increase of Freddie Mac delinquency) has deteriorated – especially in their insured portfolio. Its not sharp deterioration – and it is possible – even likely – that Freddie Mac will have end credit losses considerably lower than the bears anticipate. But as a second derivative bull I am feeling just that little bit less certain.

"China Crosses the Rubicon"

According to this analysis, China's economic interests are having a big impact on its strategic plans. It also makes it sound as thought Russia and China could be be headed for conflict over border regions. I'm not sure if this will generate much discussion or not, but I'm curious what you think about this:

China Crosses the Rubicon, by Wen Liao, Commentary, Project Syndicate: For two decades, Chinese diplomacy has been guided by the concept of the country's "peaceful rise." Today, however, China needs a new strategic doctrine, because the most remarkable aspect of Sri Lanka's recent victory over the Tamil Tigers is ... the fact that China provided ... both the military supplies and diplomatic cover ... needed to prosecute the war. ...

So, not only has China become central to every aspect of the global financial and economic system, it has now demonstrated its strategic effectiveness in a region traditionally outside its orbit. ... What will this change mean in practice in the world's hot spots like North Korea, Pakistan, and Central Asia?

Paul Krugman: Not Enough Audacity

Will Obama give away too much in an attempt to get health care reform legislation through congress?:

Not Enough Audacity, by Paul Krugman, Commentary, NY Times: When it comes to domestic policy, there are two Barack Obamas.

On one side there’s Barack the Policy Wonk, whose command of the issues ... is a joy to behold. But on the other side there’s Barack the Post-Partisan, who searches for common ground where none exists, and whose negotiations with himself lead to policies that are far too weak.

Both Baracks were on display in the president’s press conference earlier this week. First, Mr. Obama offered a crystal-clear explanation of the case for health care reform, and ... a public option competing with private insurers. “If private insurers say that the marketplace provides the best quality health care, if they tell us that they’re offering a good deal,” he asked, “then why is it that the government, which they say can’t run anything, suddenly is going to drive them out of business? That’s not logical.”

But when asked whether the public option was non-negotiable he waffled, declaring that there are no “lines in the sand.” ...

The big question here is whether health care is about to go the way of the stimulus bill. At the beginning of this year,... Mr. Obama made an eloquent case for a strong economic stimulus — then delivered a proposal falling well short of what independent analysts ... considered necessary..., presumably,... to attract bipartisan support. But ... Mr. Obama was able to pick up only three Senate Republicans...

At the time, some of us warned...: if unemployment surpassed the administration’s optimistic projections, Republicans wouldn’t accept the need for more stimulus. Instead, they’d declare the whole economic policy a failure. And that’s exactly how it’s playing out. ...

The point is that ... policy has to be good enough to do the job. You might think that half a loaf is always better than none — but it isn’t if the failure of half-measures ends up discrediting your whole policy approach.

Which brings us back to health care. ...[R]eform isn’t worth having if you can only get it on terms so compromised that it’s doomed to fail. What will determine the success or failure..? Above all,... successful cost control. We really, really don’t want to get into a position a few years from now where premiums are rising rapidly, many Americans are priced out of the insurance market despite government subsidies, and the cost of health care subsidies is a growing strain on the budget.

And that’s why the public plan is an important part of reform: it would help keep costs down through a combination of low overhead and bargaining power. That’s ... a conclusion based on solid experience. Currently, Medicare has much lower administrative costs than private insurance companies, while federal health care programs ... pay much less for prescription drugs than non-federal buyers. There’s every reason to believe that a public option could achieve similar savings.

Indeed, the prospects for such savings are precisely what have the opponents of a public plan so terrified. Mr. Obama was right: if they really believed their own rhetoric about government waste and inefficiency, they wouldn’t be so worried that the public option would put private insurers out of business. Behind the boilerplate about big government, rationing and all that lies the real concern: fear that the public plan would succeed.

So Mr. Obama and Democrats in Congress have to hang tough — no more gratuitous giveaways in the attempt to sound reasonable. And reform advocates have to keep up the pressure to stay on track. Yes, the perfect is the enemy of the good; but so is the not-good-enough-to-work. Health reform has to be done right.