Category: Economics

Explained here.  Excerpt:

Let’s say that Citigroup were restructured – via bankruptcy, or via
government conservatorship – in such a way that creditors did not get
all their money back. (None of this applies to FDIC-insured deposits or
to recently-issued senior debt that is explicitly guaranteed by the
government.) They might be forced to convert debt for equity, or they
might be stiffed altogether. The first-order concern is that this would
have ripple effects that could take down other financial institutions.
According to Martin Wolf,
bank bonds comprise one quarter of all U.S. investment-grade corporate
bonds; losses would be spread far and wide, hitting other banks,
pension funds, insurance companies, hedge funds, and so on. If
Citigroup did not support its derivatives positions, then institutions
that bought credit default swap protection from Citi would face further
losses. (I believe that most U.S. banks were net buyers of CDS
protection, however.) The fear is that it will be impossible to predict
how these losses will be distributed and who else might go down.

The second-order concern is bigger. After all, Lehman did not seem
to force any major financial institution into bankruptcy, although it
may have twisted the knife that AIG had already stuck in itself. Once
investors figure out that bank debt is not safe, they will refuse to
lend to any banks, and we are back in September all over again. Or
almost: it is possible that the Federal Reserve’s massive efforts to
provide liquidity to the banking system will be enough to keep banks
functioning. But who wants to take that risk?

You're comparing that to spending a great deal of extra money on credit bail-outs; choose your poison.

From Simon Johnson:

The credit default swap market is a modern Delphic Oracle.  It speaks
loudly and profoundly – these days at regular intervals – albeit using somewhat arcane terminology.

…The most plausible interpretation - and here I’m willing to debate what
the Oracle meant exactly – is that people expect the government will
force the conversion of junior bank debt into equity.  The treatment of
private preferred shareholders at Citigroup, last week, is seen as the
harbinger of further losses for investors.

…The events of mid-September 2008 were traumatic and awful to behold.  I
saw that trailer and I don’t want to see the movie.  But it is exactly
into that scary future that we now head.

Addendum: An excellent follow-up.

The always-keen John de Palma sent me this:

(…)policy multipliers
are likely to be disappointingly small compared with historical
estimates of their importance. Many of you will remember from Econ 101
the idea of the Keynesian multiplier, which is that the impact of
traditional macro policies is "multiplied" by boosting private
consumption by households and capital investment by firms as they
receive income from the initial round of stimulus(…) Policy
multipliers are greater than 1 to the extent the direct impact of a
policy on GDP is multiplied as households and companies increase their
spending due to the increased income flow they earn from the
debt-financed purchase of goods and services sold to meet the demand
generated by the initial round of stimulus. Historically, multipliers
on government spending are estimated to be in the range of 1.5 to 2,
while multipliers for tax cuts can be much smaller, say 0.5 to 1. But
these estimates are from periods when households could – and did – use
tax cuts as a down payment on a car or to cover the closing costs on a
mortgage refinance(…)With the credit markets impaired, tax cuts, as
well as income earned from government spending on goods and services,
will not be leveraged by the financial system to nearly the same
extent, resulting in (much) smaller multipliers(…)

Yves Smith offers a very good critique of the mortgage modification plan.  Excerpt:

So effectively, the borrower gets a teaser that over time adjusts to a fixed rate mortgage at current (low) interest rates.

Let's
think this through a second. The borrower is still under water (of
course, Bernanke & Co. regard this as temporary misvaluation
resulting from irrational pessimism, but the more data driven crowd
sees housing prices as having moves way out of line with incomes. And
the outlook for incomes isn't exactly rosy either). The borrower
therefore has no reason to invest in the house, including routine
maintenance (assuming he can somehow scare up the dough). If the boiler
goes, the roof leaks, he has no incentive to fix it. Similarly, if he
were to sell the house (let's say he got a good job elsewhere), he's
still faced with either negotiating a short sale or walking and leaving
the bank with the property. Thus for the bank all this does is kick the
can down the road, unless we assume a recovery from these levels.

But there is much more, read the whole thing.  In my view the plan is bad news and will not work.  It is a waste of taxpayer money and even progressives should be highly critical of this weak initiative.

I am reluctant to embrace write-downs of mortgage principal, but if you wish to consider a major plan that is the direction you must look.  John Geanakoplos and Susan Koniak had an interesting piece in the NYT today:

For these non-prime mortgages, there is room to make generous principal
reductions, without hurting bondholders and without spending a dime of
taxpayer money, because the bond markets expect so little out of
foreclosures. Typically, a homeowner fights off eviction for 18 months,
making no mortgage or tax payments and no repairs. Abandoned homes are
often stripped and vandalized. Foreclosure and reselling expenses are
so high the subprime bond market trades now as if it expects only 25
percent back on a loan when there is a foreclosure.

Again, read the whole thing and consider also the diagram.  This is a critical passage from the piece:

It shows that monthly default rates for subprime mortgages and
other non-prime mortgages are stunningly sensitive to whether a
homeowner has an ownership stake in his home. Every month, another 8
percent of the subprime homeowners whose mortgages (first plus any
others) are 160 percent of the estimated value of their houses become
seriously delinquent. On the other hand, subprime homeowners whose
loans are worth 60 percent of the current value of their house become
delinquent at a rate of only 1 percent per month.

Despite all
the job losses and economic uncertainty, almost all owners with real
equity in their homes, are finding a way to pay off their loans. It is
those “underwater” on their mortgages – with homes worth less than
their loans – who are defaulting, but who, given equity in their homes,
will find a way to pay. They are not evil or irresponsible; they are
defaulting because – for anyone with an already compromised credit
rating – it is the economically prudent thing to do.

Is that what "the ownership society" has come to?

Here is more bad economic news from Asia.  Yet those countries don't have banking crises as many other nations do.  So what exactly is up?

The usual story is that these nations are "heavily dependent upon exports."  But if I may wear my Don Boudreaux hat for a moment (or more), is not the state of Kentucky also heavily dependent upon exports?  Is not the Cowen household heavily dependent upon exports?  Why is being dependent on exports so especially bad for parts of Asia?

One answer is that Asian exports, which travel great distances, are often consumer durables and such purchases are especially easy to postpone. Services are often more robust.

Another answer is that many Asian producers have chosen high fixed costs in a way that requires steady or rising revenue over time.  That is their version of being highly leveraged without taking on much explicit debt.  Again a central lesson of this depression will be how many different ways there are to leverage.

Last week I was surprised to read this:

“For a long time, Harvard had a negative 5 position,” she said. “That
means that 105 percent of the assets are invested at most times.”

So far it seems that the least leveraged parts of the world — all things considered — are South America and sub-Saharan Africa.  Brazil, Chile, and Peru are a few of the countries which, in relative terms, are suffering least.  If you wish to understand the course of events, keep your eye on those locales. 

I hadn't known that Keynes had a brief protectionist period:

Keynes's 1933 writing on "National Self-Sufficiency" marked the furthest point of his departure from the idea that free trade promotes peace…"National Self-Sufficiency" argued against free international mobility of goods and capital on the grounds that such mobility could endanger peace; that gains from the international division of labour had diminished; and that such mobility placed individual economies 'at the mercy of world forces.'  Keynes proposed a gradual move towards greater 'economic isolation' and 'national self-sufficiency.' in goods and finance.  His motivations included his desire for Britain to fight unemployment with expansionism, which required free from 'interference from economic changes elsewhere'; and his new belief that 'economic internationalism' was inimical to peace.

That is from Donald Markwell's generally quite interesting John Maynard Keynes and International Relations: Economic Paths to War and Peace.  And you will find the essay here.  Keynes, of course, did snap out of that phase.  One thing I learned from this book is that international relations is the key topic for tracing the evolution of Keynes's thought over his entire career.

Much of the debate over fiscal policy has occurred in Keynesian terms but its worth pointing out that it's perfectly reasonable to discuss fiscal policy in a monetarist framework.  Start with the quantity theory of money MV=PY, money times velocity equals prices times real output.

In the long run we know that real GDP is pinned down by real factors (labor, capital, technology, institutions and so forth) so increases in M will increase P proportionally.  But in the short run there are plenty of reasons to think that increases in M can increase Y – this is accepted by monetarists, Austrians, rational expectation theorists (ala Lucas) for unexpected changes in money, Keynesians and new Keynesians (only originalist RBC type theorists would object.)  But M and V enter the equation in an identical fashion and thus logically must have the same effects for the same change.  Thus if you think money is potent then V must be potent as well and V is fiscal policy.

To be precise, V is how fast money turns over and we can think about shocks to V as spending shocks.  Spending shocks can be driven by consumers or by the government – this is what Brad DeLong means when he says "the government, in this respect, is just like any other group of starry-eyed optimists whose eagerness to spend pulls the economy into a high-employment, high-pressure boom."

One way of understanding the current recession is that V has fallen by a lot and it is dragging down Y (just as would a sharp fall in M).  We can counter with an increase in M (monetary policy) or by an increase in V (fiscal policy).

Now we might think that V driven by government is too slow or too wasteful (ala Kevin Murphy (pdf)) to work well or we might think that neither increases in V nor increases in M would be as effective as Keynesians imagine since there is also reverse causality (falls in Y and expectations of slower growth in Y are reducing M and V).  We could pursue the last point to its fullest and abandon the quantity theory altogether (making V an endogenous function of Y, for example, and removing it as an independent variable).  But if we hew to the basic ideas of the quantity theory–and remember, it's not a true model only a way of looking at the world!–then fiscal policy is not impossible.

Here are some slides from Michael Mandel, he says yes it was an illusion.  Matt Yglesias has a good summary of his argument.  Median wages were stagnant, the stock market was down, and health care costs were rising, without necessarily translating into better outcomes.  Mandel argues that the current collapse in part stems from the revelation that productivity growth (and no, he doesn't trust the reported numbers) was low all those years.  On top of all that perhaps productivity growth in finance was overstated as well.

My take is this: there was some productivity growth but much of it fell outside of the usual cash and revenue-generating nexus.  Maybe you will live until 83 rather than 81.5 and your pain reliever will work better.  In the meantime you will read blogs and gaze upon beautiful people using your Facebook account.  Those are gains to consumer surplus, but they don't prop until the revenue-generating sectors of the economy as one might have expected.  Given that, the rest of Mandel's argument can still work, whether or not you think the productivity gains were a mirage in some absolute sense.

The worry is that if the government cannot or will not extricate itself
from Fannie and Freddie, it will face similar problems should it
eventually nationalize some large banks.

Here is more, interesting throughout.

He has written on inflation (ha-ha), so why not Arrow-Hahn-Debreu?  The most interesting part of the paper starts here (p.29):

We can now turn finally to the role of gauge invariance in economics. The proposal that gauge theory is essential for making progress in economics was made by Malaney and Weinstein[8]. I would now like to argue that there are deep and compelling reasons why the extension of economic theory to incorporate out of equilibrium behavior should centrally involve the kinds of gauge invariances they proposed.

Here is a short essay on gauge invariance.  He also endorses agent-based modeling.  I didn’t “get” where this paper is headed (OK, you put in gauge invariance but comparative statics are still hard to predict a priori), but I’m always interested to see how top minds approach the foibles of the economic method.

I thank Michael F. Martin for the pointer.

Better than nothing:

A new internet-only exchange, the so-called Deposit Exchange, has
opened in Ukraine. It enables people whose bank deposits have been
frozen in banks of questionable solvency to sell the money in those
deposits at a discount. The buyers of the frozen deposits, although
they cannot withdraw the money, can use the full value of the deposits
to cover the value of loans issued by the banks for home, car and land
purchases on which customers have defaulted, and thereby take
possession of the repossessed property. Currently the discounts on
buying a frozen deposit are in the range 10-34% (Lenta.ru, in Russian).

I thank Matthew Bown for the pointer.

The post is here, excerpt:

My view, which I thought was pretty clear, is that the liquidity trap
is real: no matter how much the Fed increases the monetary base, it has
no effect, because it just substitutes one zero-interest asset for
another. If the Fed could credibly commit to inflation at rates higher
than the 2-ish percent target it’s already believed to have, that would
be effective. But right now I don’t see that as a realistic option,
hence the emphasis on fiscal policy and bank recapitalization.

Sumner outlines in detail a number of ways the Fed might increase aggregate demand, through monetary operations, without simply substituting one zero-interest asset for another.  So I don't yet see how Krugman has responded to or even recognized Sumner's points.  It also seems that the Fed can announce an inflation target of, say, four percent a year.  That may not be one hundred percent credible, but if presented as an alternative to the trillions of dollars of bailouts, I believe it could be reasonably credible (and indeed popular) and of course it would become more credible all the time as the Fed's monetary policy was observed.  Bennett McCallum has written persuasively on how to establish central bank credibility when such a course is welfare-improving.  Sumner himself wrote:

One key to making the policy credible (as many have already argued) is
to set an explicit nominal target, and commit to make up for any
shortfall this year with even faster nominal growth in the future (and
vice versa.)  I know that your [Krugman] expectations trap argument raises
questions about credibility.  But explicit targets tend to be more
credible because it is embarrassing for policymakers to go back on
their word–they don’t like to lose credibility (for good reasons.)  And
Bernanke, et al, already have reputations very different from the
members of the BOJ.

I don't myself agree with all of Sumner's points (especially his causal account of what happened), but again I don't see that Krugman has responded to the substance of the letter.

I should add that I don't think anyone (I'm not talking about Krugman here) has responded to the claim that quantitative easing, and other monetary reforms, could substitute for a very expensive fiscal stimulus.  (It's much more common to bash "the Treasury view.")  Usually there is simply a brush-off to the effect that we already are trying some monetary innovations.

Addendum: Arnold Kling offers comment.  Sumner responds too.

Here is the excellent Scott Sumner: an open letter to Paul Krugman.  It's also the best recovery plan I've seen so far, by far.  It's too good to excerpt, so you'll have to click through and read the whole thing.  From my point of view, right now the whole world should be beating a path to Scott Sumner's door.

He has two unpublished book manuscripts and he probably would be free to meet with President Obama as well.

Economic disaster tours in Ireland.

For the pointer I thank Adam Ozinek.  Maybe Germany should buy equity in these tours.