Category: Economics

There is obviously much more to the full understanding of the current
financial crisis, but the root is this conflict between the genuine social value
of increased variety and spread of risk-bearing securities and the limits
imposed by the growing difficulty of understanding the underlying risks imposed
by growing complexity.

Here is more.  Arrow, of course, has long been interested in issues of complexity and computability, even though his work is within the usual neoclassical confines.  One way of putting the point is that starting a new market creates a negative externality on other people by eroding their knowledge and understanding of context and thus limiting the general ease of economy-wide transparency.  I’m not sure this is true (we usually think of the extra market as adding knowledge), but it is an interesting way to categorize current problems.

The Environmental Security Hypothesis says that in tough times men will prefer women who are good at production, generally older, taller, heavier, less curvaceous women with less body fat.  In good times, they will prefer women who are good at reproduction, generally younger, shorter, lighter, more curvaceous women.  Pettijohn and and Jungeberg look at the characteristics of playboy playmates from 1960 to 2000 and find:

Consistent with Environmental Security Hypothesis predictions, when social and economic conditions were difficult, older, heavier, taller Playboy Playmates of the Year with larger waists, smaller eyes, larger waist-to-hip ratios, smaller bust-to-waist ratios, and smaller body mass index values were selected. These results suggest that environmental security may influence perceptions and preferences for women with certain body and facial features.

Econometricians who wish to investigate further may download the data here (yes really).  The 2008 Playmate of the year, Jayde Nicole. does not seem to fit the hypothesis however.

The new trade theory starts with the observation that while this
[the old trade theory] explains a lot of world trade, it also misses a lot. France and Germany
sell lots of stuff to each other, even though they have similar
climates and resources; so do the United States and Canada. What’s that
about?

The answer is that there are many goods that aren’t like wheat or
bananas, but are instead like wide-bodied jet aircraft. There are only
a few places in which wide-bodied jets are produced, because of the
enormous economies of scale – you only want a couple of factories
worldwide. Those factories have to be somewhere, and those countries
that get the factories export jets, while everyone else imports them.

But who gets the aircraft factories, or the factory producing a
specialized kind of machine tool, or the plant producing a particular
model of car that selected consumers all over the world want? The
answer of new trade theory – and it was a tremendously liberating
answer – is that it doesn’t matter. There are many economies-of-scale
goods; everyone gets some of them; and the details, which may be
largely a story of historical accident, aren’t important.

Here is the whole post, which covers his work on economic geography as well and relates it to his work on trade.  As you might expect, it is a very good exposition of…Paul Krugman.

If you are wondering, one early writer who saw a link between trade, location, urban economics, and increasing returns was the 17th century British pamphleteer Nicholas Barbon; his full name was Nicholas Unless-Jesus-Christ-Had-Died-For-Thee-Thou-Hadst-Been-Damned Barbon.  Barbon was also a precursor of aggregate demand theories of macroeconomics and an influence on Adam Smith.

But the Harvard economist [Dani Rodrik] finds the blog – short for Web log – useful because it serves as a reference catalog for his ideas. “I now constantly Google my own blog for ideas that I knew I had at some point,” he says. “Previously, the ideas would have come and gone. The first good thing is that I have them a little more developed, and, secondly, I can actually recover them.”

Here is the whole story, on the rise of the econ blogosphere, which has much from yours truly.  It is in this issue from the Richmond Fed, which has much of interest on economics and the economics profession.  Here is an article on experimental vs. behavioral economics.

Today you get more Felix Salmon, who nails it:

America’s banks — and the world’s, for that matter — have had de facto
unlimited access to very cheap Fed liquidity for many months now. That
hasn’t induced them to lend. Will this latest recapitalization do the
trick? I’m far from convinced. And what’s more, the demand for loans is drying up fast: do you
really feel like buying a bigger house right now, or taking out a car
loan? Well, businesses are in the same boat. In a recession, their ROI
falls, so they borrow less.

I am, however, a little worried about Felix’s proposal to make banks lend the money.  It’s not that I have a better idea, but I suspect any scheme of compulsion will bring either higher risk or ways to game the scheme or both.  And if bank shareholders and CEOs do not wish those loans to be made, our current system of corporate governance quickly becomes unworkable.

If you’re running an insolvent bank, and you get a slug of equity from
Treasury, your shareholders will thank you if you use that equity to
take some very large risks. If they pay off and you make lots of money,
then their shares are really worth something; if they fail and you lose
even more money, well, there was never really any money for them to
begin with anyway.

That’s Felix Salmon: read the whole thing.  Read this too.  Here is Megan McArdle on the pooling equilibrium.  Here is a good article on how Paulson "sold" his plan to the bankers.  And here are yet some more sentences to ponder:

So it in the end, we have what is basically an economic loan, but structured
in a way to game bank capital adequacy requirements. What strange times we live
in when Treasury and the Fed have to engineer a deal to circumvent their own
regulations.

The main new proposals would:

– for the next two years, give businesses a $3,000 income-tax credit for each new full-time employee they hire above the number in their current workforce;

– allow savers with tax-favored Individual Retirement Accounts and 401(k)’s to withdraw 15 percent of those retirement savings, up to a maximum of $10,000, without paying a tax penalty as the law currently requires for withdrawals before age 59 and a half;

– bar financial institutions that take advantage of the Treasury’s rescue plan from foreclosing on the mortgages of any homeowners who are making “good-faith efforts” to make payments;

– direct the Treasury and the Federal Reserve to create a temporary facility for loans to state and local governments, similar to the Fed’s new arrangement to loan corporations money by buying their commercial paper, which are the I.O.U.s that help businesses with daily operating expenses like payrolls.

Here is the article.  I doubt if the substitution effect generated by #1 is large.  I fear the precedent set by #2 and I don’t understand the enforceability of #3.  Savings withdrawals are in effect a form of fiscal policy and I don’t yet see how fiscal policy is supposed to cure us of our current mess, which is rooted in coordination problems.  Let’s hope #4 does not become necessary.  Of course it is before an election and each candidate has to propose doing something in addition to the status quo.  But a lot will happen between now and 1/20; fortunately these proposals won’t be taken very seriously.

Here are McCain’s proposals, I may discuss them soon.

Via Mark Thoma, Susan Woodward has an idea:

The true values of mortgage assets are generally thought to be a mystery. But
little-mentioned among discussions … of the crisis is that the Treasury has
access to the best resources in the business for estimating the hold-to-maturity
values of mortgages and mortgage-backed securities. This team is at Fannie Mae,
which the government now effectively directs.

You might laugh, or cry, but the reality is that most proposed paths out of the crisis involve a circularity problem.  And, courtesy of Chris Masse, here is another paragraph to ponder:

Krugman’s award could bring Bush face-to-face with his
antagonist. The president typically invites Nobel Prize winners
to the White House in November or December.    

Here’s the problem: As a matter of simple arithmetic, total spending in
the economy is necessarily equal to total income (every sale is also a
purchase, and vice versa). So if people decide to spend less on
investment goods, doesn’t that mean that they must be deciding to spend
more on consumption goods–implying that an investment slump should
always be accompanied by a corresponding consumption boom? And if so
why should there be a rise in unemployment?

Here is the link once again.  But I think the point is more effective in reverse.  Why should the boom be a boom in the first place?  The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages.  In other words, the Austrian theory doesn’t generate the very high degree of comovement found in the data.  Or, in other words, there aren’t that many countercyclical assets.

One MR commentator suggests this, this, and this as responses.  They make various points against Krugman (who I might add is not as clear as usual in this piece) but they don’t solve this central problem of generating the amount of comovement found in the data.  The best shot is to relax the Austrian-favored methodological assumption of full employment; I leave it as an exercise for the reader whether that could work and what other problems for the theory it might create. 

I should add that Gordon Tullock has made much the same point, as has Bob Lucas or for that matter Piero Sraffa in 1932.

Not yet, the economy is staying above water.  Toward the future, here is a very good list of credit market indicators to follow.  A lot of the credit markets reopen tomorrow.  Felix Salmon is optimistic.  But in Iceland shoppers are emptying the shelves because it is hard to import food.  Kashkari says the Treasury will invest only in healthy banks; of course recapitalization makes the most sense for unhealthy banks.  One way to try to figure out what is happening is to work backwards from the lies but that can end up being very misleading.

He is cited for trade theory and, appropriately, location theory and economic geography.  He could have been cited for his work on currency crises as well.  Here are the most basic links on Paul, it is hard to know where to start.  I have to say I did not expect him to win until Bush left office, as I thought the Swedes wanted the resulting discussion to focus on Paul’s academic work rather than on issues of politics.  So I am surprised by the timing but not by the choice.

Here’s Krugman’s NYT column from today; there is so so much on him and by him.  Here is his blog.  Here is a short post-prize interview.  He has been influential in pushing the United States toward a bank recapitalization plan.  Here is Krugman on video, from just the other day, talking about the crisis and how bad it might get.  Krugman, of course, also called the housing bubble in advance.

Krugman is very well known for his work on strategic trade theory, as it is now called.  Building on ideas from Dixit, Helpman, and others, he showed how increasing returns could imply a possible role for welfare-improving protectionism.  Krugman, however, insisted that he did not in practice favor protectionism; it is difficult for policymakers to fine tune the relevant variables.  Boeing vs. Airbus is perhaps a simple example of the argument.  If a government can subsidize the home firm to be a market leader, the subsidizing country can come out ahead through the mechanism of capturing the gains from increasing returns to scale.  Here are some very useful slides on the theory.  Here is Dixit’s excellent summary of Krugman on trade.  Krugman himself has admitted that parts of the theory may be less relevant for rich-poor countries trade (America and China) rather than rich-rich trade, such as America and Japan.

I am most fond of Krugman’s pieces on economic geography, in particular on cities and the economic rationales for clustering.  He almost single-handedly resurrected the importance of "location theory," an all-important but previously neglected branch of economics.  Here is the best summary piece of Krugman’s work in this area.  I believe this work will continue to rise in influence.

I have my own favorite pieces by Krugman.  This include his short critique of Austrian trade cycle theory and his short piece on why the British had such bad food.

He is also, by the way, a loyal MR reader but he is not the first reader to win the prize.

Krugman’s books:

Here is my review of Conscience of a Liberal.  That book argued that politics and policy can reshape the distribution of income in a more egalitarian direction.  Peddling Prosperity is one of the best-written economics books, ever, as are also The Age of Diminished Expectations and Pop Internationalism.  The latter started a trend of Krugman as a debunker of erroneous economic claims.  The supply-siders and the low-level industrial policy advocates were early targets of his pen.  Pop Internationalism is also the work of Krugman’s most likely to be popular with market-oriented economists.  Here is a collection of Krugman’s earlier writings.  The Great Unraveling — circa 2004 — is for me too under-argued.  His book Currencies and Crises is in my view his most underrated work; it provides a very readable introduction to some of his ideas on financial crises and it has a nice use of the concept of option value.  Development, Geography, and Economic Theory is a very good and very readable introduction to his work on economic geography.  That and the currency book are my two favorites by Krugman.  Geography and Trade is useful plus here is a more technical collection on the spatial economy.

Krugman has a widely used Principles text, co-authored with his wife Robin Wells.  He also has a leading text in international economics co-authored with Maurice Obstfeld.

Here are profiles and bio pieces, none very recent.  Here is Krugman on how he works — very personal and insightful.  Some of Krugman’s thinking on the liquidity trap — a key issue today for the crisis — can be found here.

Krugman of course is a controversial figure in the blogosphere and in politics but I believe for today it is best to set those issues aside.  His Wikipedia page has lots on the critics plus some bio as well.  Daniel Klein for instance argued that Krugman should do more to speak out for freer markets in various settings.

Krugman’s early columns for Slate.com were an important model for shaping what the econ blogosphere later became.  They are models of clarity and rigor which we all would do well to emulate.  His exposition of Ricardo’s theory of comparative advantage is remarkably good and it is one of the best pieces of popular economics writing I know.

Award analysis: This was definitely a "real world" pick and a nod in the direction of economists who are engaged in policy analysis and writing for the broader public.  Krugman is a solo winner and solo winners are becoming increasingly rare.  That is the real statement here, namely that Krugman deserves his own prize, all to himself.  This could easily have been a joint prize, given to other trade figures as well, but in handing it out solo I believe the committee is a) stressing Krugman’s work in economic geography, and b) stressing the importance of relevance for economics.  Daniel Davies also sees it as a career-based award. 

Who are the big losers?  Avinash Dixit and Elhanan Helpman and Maurice Obstfeld have to feel their chances for the prize went down significantly.

Addendum: Here is Bryan Caplan on "Paul Krugman, Guilty Pleasure."

Via Matt Yglesias, Justin Fox writes:

If you borrow short and lend long, you’re effectively a bank. It’s
becoming ever less clear to me what justification there is for nonbank
borrow-short-lend-long-institutions other than regulatory arbitrage.

I cannot sign on to this principle.  Business-to-business trade credit is huge in the United States (it’s not all short term) as is commercial lending, as you might get from General Motors or for that matter Sears or Nordstrom.  Pawn shops are more common than you might think.  If we regulate these lenders like banks we presumably have to give them comparable privileges, which could mean discount window access, FDIC access, and the use of Fed Wire.  Plus they would be subject to other regulations on banks, including restrictions on affiliations with commercial firms.  I don’t want to do that and in many cases I don’t even see what it would mean to do that (how can we stop Sears from affiliating with a commercial firm?).  I conclude that we cannot escape some important legal distinction between bank and non-bank lenders.  Admittedly any such distinctions can become more problematic with the march of technology and the increasing sophistication of regulatory arbitrage.

You’ll find more here, here, and here.  Lots of people favor time series but I’m still picking Oliver Williamson and Jean Tirole.  They gave the prize to theorists last year and now they need to bring it down to earth and also they might wish to choose a Frenchman.  Such a joint prize would in my opinion be well deserved.

Let’s say a Eurozone country faces a bank failure and the debt of the failing bank is very large relative to that country’s gdp.  This could happen in many countries.  The fiscal authority of that country cannot do the bailout on its own, in part because the resources are not there and in part because the country lacks the political unity for raising taxes.  The other EU countries cannot be persuaded to ante up.  The country in question either loses its major bank, and suffers the concomitant fall out, or it creates "on the spot" monetary policy to save the bank.  That means creating a domestic currency and suddenly announcing that the accounts of the bank will be reimbursed in terms of that currency rather than Euros.

I believe the odds of this outcome are relatively small.

That said, the "easy" option is for the ECB to do the bailout in terms of Euros.  A non-unanimity-requiring procedure for this should be worked out in advance to a greater degree than is currently the case.  And such a procedure may need to be worked out soon, while it is still unclear who would be the winners and losers from such an arrangement.

Find it here.  In a nutshell:

Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property.

Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level.  Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property.

…In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.

Zingales also stresses that half-hearted attempts at bank recapitalization are unlikely to work at this time; he thinks that at least $600 billion would be needed.

This piece has many interesting points throughout, it is worth a full read.  Here is a concordance of writings of Luigi Zingales on the credit crisis.