A Supply Side Approach to the Crisis
Yesterday I pointed out that credit is still robust. Growth rates are declining, however, and many people say the real crunch is around the corner. Thus, today I want to suggest a new approach to dealing with the crisis that will have benefits regardless of how the crisis unfolds.
I see the key issue as follows: Banks bridge the gap between savers and firms. We want to keep capital flowing to firms even when some of the bridges collapse. One approach tries to prop up the collapsed bridges, a second approach tries to route funds across substitute bridges. A third approach is to increase the flow pressure – in other words, I suggest a temporary but large stimulus to savings.
I suggest that for the next 12 months contributions to an IRA account will never be taxed. We can modify this in various ways to cap contributions at a certain level etc. We can even make the proposal progressive – for the next 12 months contributions to an IRA account will never be taxed and the government will match $1 for every $10 saved for anyone with income below a certain threshold. The main idea is to increase savings.
The increase in savings will help deal with our current problems by offsetting any credit crunch. (Some of the savings will also help to recapitalize banks.) In addition, the U.S. needs a higher savings rate regardless. During the 1990s as measured savings rates declined to zero commentators argued that rising asset values compensated. Well asset values are now falling so true savings are negative – thus we need to increased savings.
A big benefit of this proposal – lower taxes, higher savings and a savings bonus to those with lower incomes – is that it should appeal to both the right and the left.
Where is the Credit Crunch?
Back in February I pointed out that despite all the talk of a credit crunch commercial and industrial loans were at an all-time high and increasing. At the time, Paul Krugman and others responded that this was just temporary as firms drew on previously existing lines of credit. Well here we are in September and bank credit continues to look very robust. As Robert Higgs points out consumer loans are up, commercial and industrial loans are up, even real estate loans are up. Overall, total bank credit is up with just a slight sign of leveling off in recent weeks. So where is the credit crunch?
A credit crunch does exist in the sector of the market based on short-term, asset backed securities. In addition, interbank lending is unusually risky. But in light of what I have just said the "credit crunch" takes on a new meaning and potential new solutions are suggested. The first question I have is this. Investment banks were selling these securities and using the money to lend to whom? I do not know the answer. But let’s suppose that the money being raised in these markets was being lent to productive businesses. If so, then any solution should focus on feeding those businesses that are starved for credit.
I look at the situation as follows. Banks are bridges between savers and investors. Some of these bridges have collapsed. But altogether too much attention is being placed on fixing the collapsed bridges. Instead we should be thinking about how to route more savings across the bridges that have not collapsed. Government lending may be one way of doing this but why lend to prop up the broken bridges? Instead, why not lend directly to the investors who are in need of funds? After all, if these investors exist and have valuable projects that’s where the money is! Let the broken bridges collapse, taking the shoddy builders with them. Instead focus on the finding and rescuing the victims of any credit crunch, the investors who need funds.
Now here is a hypothesis. It may be that there just aren’t that many firms in need of funds. First, one reason that bank lending is up may be that firms with good projects have already turned to the substitute bridge of ordinary bank loans. Second, I wonder how much real lending was actually being generated by asset backed securities. Could it not be that most of the funds generated were used to buy more asset backed securities? (The growth in these securities is certainly suggestive of that possibility). If that is the case then it explains why the real economy has been remarkably resilient to the "credit crunch."
Now perhaps I am wrong about all this. Bernanke has access to a lot more data than I do and he seems very worried. I’d still like to know, however, which credit-worthy firms are credit starved. And I’d suggest that we ought to think more about alternative bridges that will connect credit-starved firms with savers.
Economists Speak
An excellent Open Letter on the Bailout signed by many economists. Hat tip to Justin Wolfers.
As economists, we want to express to Congress our great concern for the plan
proposed by Treasury Secretary Paulson to deal with the financial crisis. We are
well aware of the difficulty of the current financial situation and we agree
with the need for bold action to ensure that the financial system continues to
function. We see three fatal pitfalls in the currently proposed
plan:1) Its fairness. The plan is a
subsidy to investors at taxpayers’ expense. Investors who took risks to earn
profits must also bear the losses. Not every business failure carries systemic
risk. The government can ensure a well-functioning financial industry, able to
make new loans to creditworthy borrowers, without bailing out particular
investors and institutions whose choices proved unwise.2) Its
ambiguity. Neither the mission of the new agency nor its
oversight are clear. If taxpayers are to buy
illiquid and opaque assets from troubled sellers, the terms, occasions, and
methods of such purchases must be crystal clear ahead of time and carefully
monitored afterwards.3) Its long-term effects. If the plan is
enacted, its effects will be with us for a generation. For all their recent
troubles, Americas dynamic and innovative private capital markets have brought
the nation unparalleled prosperity. Fundamentally weakening those markets in
order to calm short-run disruptions is desperately short-sighted.For
these reasons we ask Congress not to rush, to hold appropriate hearings, and to
carefully consider the right course of action, and to wisely determine the
future of the financial industry and the U.S. economy for years to come.
Won’t Get Fooled Again
And Now for Something Completely Different
- Philosopher Saul Smilansky says his work is a cross between Kant and Monty Python. I’m not sure I’d go that far but I enjoyed hearing Smilansky and Will Wilkinson on blogginheadstv. I discussed Smilansky’s paradox of retirement argument earlier. He is now out with a book, Ten Moral Paradoxes.
- Pictures from the most alien place on earth. Worth a look (scroll down). Hat tip to Craig Newmark.
- The Sarah Connor Chronicles doesn’t get any respect but I thought the first season was great in an action-packed, edge-of-your seat, thrill-seeking sort of way. The second season has just begun. Summer Glau plays the Spock/Data learning-to-be-human cyborg that John Connor can’t admit he wants to interface with.
Glass Steagall: The Real History
Many wise people are now recognizing that the repeal of Glass-Steagall was one of the few saving graces of the current crisis. Let’s thank President Clinton (and Phil Gramm) for that wise bit of deregulation. The following potted history of the law, however, is all too typical:
Glass-Steagall was one of the many necessary measures taken by Franklin Delano Roosevelt and the Democratic Congress to deal with the Great Depression. Crudely speaking, in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble popped in 1929, exposure to Wall Street helped drag down the commercial banks….The policy response was to erect a wall between investment banking and commercial banking.
Given a history like this people wonder how repealing the law could have been a good thing. But a significant academic literature has investigated these claims and rejected them. Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates. Randall Kroszner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks. A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham. My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor). Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.
Thus, the history of banking before Glass-Steagall and now our recent experience after is consistent, generally speaking unified banking is safer and repeal was a good idea.
Google Heads to Sea, Will You?
The NYTimes Bits Blog reports:
The search and advertising company has filed for a patent
that describes a “water-based data center.” The idea is that Google
would create mobile data center platforms out at sea by stacking
containers filled with servers, storage systems and networking gear on
barges or other platforms.This would let Google push computing centers closer to people in
some regions where it’s not feasible, cost-effective or as efficient to
build a data center on land. In short, Google brings the data closer to
you, and then the data arrives at a quicker clip.Perhaps even more intriguing to some, Google has theorized about
powering these ocean data centers with energy gained just from water
splashing against the side of the barges.
Hmmm, do I spy the work of Patri Friedman, libertarian, Googler and seasteading proponent? Perhaps the seasteaders are ensuring that they have good internet access. As you may recall, Paypal entrepreneur Peter Theil is backing the seasteaders so there is more than one Silicon Valley entrepreneur with an eye on the sea.
By the way, the First Annual Seasteading Conference will be held in Burlingame, CA on October 10. The conference is sure to be interesting but shouldn’t it have been held here?
AIG is Toast
So says Felix Salmon:
AIG’s $2.5 billion of 5.85 percent notes due in 2018
plunged 19.5 cents to 33 cents on the dollar as of 9:55 a.m. in New
York, according to Trace, the bond-price reporting system of the
Financial Industry Regulatory Authority.(quote from here). 33 cents on the dollar? The message is loud and clear: AIG
is toast. This is the massive counterparty failure everybody’s been
scared of, and frankly I’m astonished that the broader stock market
isn’t plunging as a result. No one is prepared for the
repercussions here: the failure of AIG is likely to be an order of
magnitude more harmful than the failure of LTCM would have been. And
it’s not even happening on a Friday, where we could have yet another
Emergency Weekend to try to work things out.
The Wisdom of Bailouts
Thanks goodness we bailed out Bear Stearns back in March if we hadn’t we might have lost Fannie Mae and Freddie Mac, Lehman Brothers, Merrill Lynch and who knows what else. Oh wait…
Response to my Mother
My wonderful mother is upset, like pretty much everyone else, at the price of gas. "Well, the hurricane has knocked out a lot of production on the gulf coast," I say. "Yes but there’s plenty of gas in the pipes that was produced before the hurricane – the suppliers are gouging." she responds. Arrghhh….must resist, must resist, must be ….nice. "mmm," I say. You and my Econ 101 students (103 actually), however, are not so lucky.
Many people think that price is determined by historical cost. Price is never, ever, determined by historical cost. Price is determined by supply and demand. If supply or demand change then the price changes regardless of historical cost. Last year’s fashions? The price falls regardless of cost. Chopped up dead sharks? If demand is high, the price is high regardless of historical cost. If the demand for gas were to suddenly fall, the price of gas would fall too, regardless of cost. In the present situation the supply of gas has been reduced and the price has gone up. Historical cost is always irrelevant.
Is the high price due to supplier gouging? Not at all. If you want to blame anyone for the high price blame your fellow buyers not the suppliers. A high price means that some other buyer is outbidding you to obtain the limited supply. It’s buyers who push up prices in a competitive market and it’s suppliers who push prices down!
It’s true that some suppliers are making big profits but people have the cause and effect backward. It’s not the high profits which are causing the high price. It’s the high price which is causing the high profits. If you were to tax the high profits, for example, you wouldn’t reduce the price. Indeed, quite the opposite because the high profits motivate suppliers to increase the quantity of gasoline as quickly as possible.
The last point brings us full circle because as the situation stabilizes suppliers increase the quantity supplied until price is pushed down towards long-run costs (which are also historical costs). Thus, in the usual situation it appears that price is determined by historical cost. It’s only in the brief time period when a shock shifts (short-run) supply away from historical cost that we can see the truth. Price is determined by supply and demand.
Addendum: Is it just me or did Ken Arrow ever feel the need to correct his Mom on economic matters? Did Adam Smith? "Look Mom, I know you’re upset about the price of mutton but let me tell you about this new theory I’ve been working on…"
Sentence of the Day
It is through exchange that difference becomes a blessing, not a curse.
Chief Rabbi of Great Britain, Jonathan Sacks quoted in McCloskey’s The Bourgeois Virtues.
Hat tip to Steve Horowitz at The Austrian Economists who rightly says "Have the benefits of specialization and exchange ever been presented more concisely and beautifully than in that one sentence?" Maybe this should be sentence of the year.
Intelligent Design and Evolution
A few years ago I wrote (follow up here):
Suppose that you find a watch in the forest. If you know there is
no watchmaker then the theory of evolution is a brilliant and
compelling explanation for the presence of complexity without design.
But suppose that you know a watchmaker exists then surely the simplest
and most compelling explanation is that the watchmaker made the watch.
Any other explanation, particularly one so improbable
as evolution would seem to be preposterous and beside the point.Thus for someone who knows, really knows, that
god(s) exists (and there are many people who claim to know that god(s)
exists) then some form of creationism follows as a
rational deduction from the premises. It’s no point telling these
people that creationism is unscientific because given the premise that god(s) exists creationism is scientific.
If god(s) exists then evolution is almost certainly false, if not in
every particular then surely in the grand claims of a undesigned
nature.
Not surprisingly the argument created a firestorm of opposition (see the many nasty comments on the two original posts). Thus, I am quite pleased to see that renowned philosopher Thomas Nagel writing in Philosophy and Public Affairs has recently made the same argument. Nagel writes:
What [Intelligent Design] does depend on is the assumption that the hypothesis of a designer makes sense and cannot be ruled out as impossible or assigned a vanishingly small probability in advance. Once it is assigned a significant prior probability, it becomes a serious candidate for support by empirical evidence, in particular empirical evidence against the sufficiency of standard evolutionary theory to account for the observational data…
…Judge Jones cited as a decisive reason for denying ID the status of science that Michael Behe, the chief scientific witness for the defense, acknowledged that the theory would be more plausible to someone who believed in God than to someone who did not. This is just common sense, however, and the opposite is just as true: evolutionary theory as a complete explanation of the development of life is more plausible to someone who does not believe in God than to someone who does.
Nagel has much more of interest to say about teaching science given that ID is scientific if one accepts belief in god.
Hat tip to Robin Hanson’s post, Intelligent Design Honesty, at Overcoming Bias.
P(tax hike / McCain) = 0.74
Greg Mankiw has run the numbers and “according to the Intrade betting, we are likely to see a significant hike in the top income tax rate even if McCain is elected President.” As Greg notes this is actually a lower bound.
Why Libertarians Should Vote for Obama (1)
First, war. War is the antithesis of the libertarian philosophy of
consent, voluntarism and trade. With every war in American history
Leviathan has grown larger and our liberties have withered. War is the
health of the state. And now, fulfilling the dreams of Big Brother, we are
in a perpetual war.
A country cannot long combine unlimited government abroad and limited
government at home. The Republican party
has become the party of war and thus the party of unlimited government.
With war has come FEAR, magnified many times over by the governing party. Fear is pulling Americans into the arms of
the state. If only we were better at
resisting. Alas, we Americans say that
we love liberty but we are fair-weather lovers. Liberty will flourish only with peace.
Have libertarians gained on other margins in the past eight years? Not at all. Under the Republicans we have been sailing due South-West on the Nolan
Chart – fewer civil liberties and more government, including the largest new
government program in a generation, the Medicare prescription drug plan, and
the biggest nationalization since the Great Depression. Tax cuts, the summum bonum of Republican
economic policy, are a sham. The only
way to cut taxes is to cut spending and that has not happened.
The libertarian voice has not been listened to in Republican politics for a
long time. The Republicans take the libertarian wing of the party for granted
and with phony rhetoric and empty phrases have bought our support on the
cheap. Thus – since voice has failed – it is time for exit. Remember that if
a political party can count on you then you cannot count on it.
Exit is the right strategy because if there is any hope for reform it is by
casting the Republicans out of power and into the wilderness where they may
relearn virtue. Libertarians understand better
than anyone that power corrupts. The
Republican party illustrates. Lack of
power is no guarantee of virtue but Republicans are a far better – more libertarian –
party out-of-power than they are in power. When in the wilderness, Republicans turn naturally to a critique of
power and they ratchet up libertarian rhetoric about free trade, free
enterprise, abuse of government power and even the defense of civil liberties. We can hope that new leaders will arise in
this libertarian milieu.
Big Mac Attack
No country with a McDonald’s outlet, the theory contends, has ever gone to war with another….
Thomas
Friedman, who invented the theory in 1996, said people in McDonald’s
countries "don’t like to fight wars. They like to wait in line for
burgers."…The Russia-Georgia conflict has finally blown this theory out of the water.
From the Guardian. Clearly the theory was over-identified. Perhaps no two countries with Taco Bell’s every go to war with one another.
Hat tip to Chris Blattman.