Category: Economics

Here is my latest column, excerpt:

The second set of solutions involves taking control of insolvent banks, either by nationalizing them or declaring them bankrupt. In the past, the Federal Deposit Insurance Corporation has used the model of rapidly shuttering failed banks, and it has usually worked.

Many
analysts cite Swedish bank nationalization, from the early 1990s, as a
model, because the Swedes later reprivatized these banks and resumed
economic growth.

But Sweden nationalized only two banks. And the
Swedish banks were much smaller and easier to run than the largest
United States bank holding companies, which combine a wide range of
complex international businesses, commercial paper operations, derivatives trading and counterparty commitments.

It
is quite possible that the reputation of a nationalized bank would be
so impaired that it would incur even greater losses as its web of
commercial dealings collapsed. These far-reaching commitments are a
reason that the F.D.I.C. model of rapid shutdowns cannot be applied so
easily here.

The most obvious problem with nationalization is the
risk of contagion. If the government wipes out equity holders at some
banks, why would investors want to put money into healthier but still
marginal institutions? A small number of planned nationalizations could
thus lead to a much larger number of undesired nationalizations.

On top of that, the government doesn’t have the expertise to run large bank holding companies like Citigroup.
There is the danger that caretaker managers, with bureaucratic
incentives, will never return the banks to profitability. And
restrictions on executive pay, already enacted into law, will make it hard to hire the necessary talent.

In
the meantime, there would be increasing pressure to politicize lending
decisions – for instance, by requiring loans to the ailing automobile
industry. Talk of taxpayers capturing an “upside” is probably
unrealistic.

The plight of the American International Group,
the giant insurer, provides a cautionary tale. The government has
already effectively nationalized A.I.G., but after a government
commitment of $150 billion, the company’s losses continue to mount, and
there is no simple way to either manage it or split it up. If the
government cannot run that bailout very well, how can it run major
banks and nurse them back to profitability?

Nationalization
also puts bank debts on the balance sheet of the government without
restoring bank solvency. Once the government takes over, it is hard to
reorganize the debts of these companies without damaging the
government’s own creditworthiness and spreading the insolvency to bank
creditors. Yet if the banks are insolvent, paying off the creditors may
cost trillions.

It is becoming increasingly clear that the question is not whether to nationalize but rather whether we can afford to make whole long-term bank creditors.  Megan McArdle has some thoughts.  How much do we gain by transferring the losses away from banks and toward Europeans, insurance companies, and pension funds?  If the worst-case scenarios really are true — and they may be — that is the next question on tap.  It is of course a very ugly question.

I wonder if it is as good a measure of economic severity as it used to be.  The greater the heterogeneity of the labor force, the greater the potential for underemployment.  Even if the downturn is bad, I am not sure unemployment will stay above ten percent for long.  New search and matching technologies, such as found on the internet, might create quicker job pairings, albeit with continuing underemployment.  Unemployment is of course important but let us not view this category in purely binary terms.

What does a Great Depression for the relatively wealthy look like?  If you spend lots of your budget on  "luxuries" — especially durables — it is easy to postpone their consumption.  This might cause gdp to fall more rapidly than if people were poorer.  If you are spending most of your money to eat and stay alive, and a negative shock comes, you have to work harder to make up the difference.

It's so, so easy to put off the purchase of a new car.  And that makes for a steep ride down, most of all for the geographically distant producers of durable goods.  Whether the steep economic plunge is worse in utility terms is debatable but maybe not because wealth buffers are better built up.

On the other hand, the presence of so many wonderful free goods allows for easy substitution into activities which do not generate much economic revenue or employment.

For these ideas I am indebted to a conversation with Arnold Kling and Seth Ditchik, just before we ate superb barbecue at Oklahoma Joe's, get the ribs and french fries.

Rather than a CDS, imagine a derivative security on the prospect of an endangered species:

Under their plan, the government would determine the cost of
protecting a species if it becomes endangered. That money would be set
aside to fund contracts with payouts pegged to species health. The
contracts would be sold to landowners and developers whose actions
directly affect the animals, though the contracts could be freely
re-sold.

Should animal numbers fall beneath a predetermined threshold,
contracts would be voided, and money devoted to anticipated recovery
programs. If the species thrives, investors would be rewarded, with
profits growing in direct proportion to species health.

"If there's a 99 percent chance that a species is going to survive," said
Mandel, "you could trade that like a high-ranking bond. You know it's
going to pay out."

I thank Adam Winski for the pointer.

This should be widely understood (which means it isn't), but it bears repeating nonetheless.  Josh Patashnik writes:

Clearly,
the projected growth rate of health care costs is unsustainable, and
finding ways to change that ought to be, far and away, the country's
top fiscal priority. But it's not as though the chunk of money going to
Social Security and "other spending" is simply an afterthought; this is
15 percent of GDP we're talking about.

The fact that, over some time horizon, Social Security nearly "pays for itself" is irrelevant when the goverment's fiscal position is viewed in a properly consolidated manner.  There is further commentary from Andrew Sullivan.  I am dismayed that some left-wing bloggers are breathing a sigh of relief that the supposed "fiscal responsibility showdown," scheduled for this past Monday, turned out to be a non-event.

Obama mentioned "universal accounts" in his coverage of social security last night and I am surprised the blogosphere has not picked up on this more.  This is probably Gene Sperling's idea and the key question is how much is "carve out" from existing benefits and how much is "add on."  In any case doing this reform at Dow = 7,000 makes more sense than doing it at Dow = 11,000.  It's even a way to boost stock prices (and possibly confidence?) though presumably it involves borrowing yet more money.

When you consider the speech as a whole, Obama is promising the largest and most ambitious attempt at rate of return arbitrage in the history of the human race.

Obama's speech was very effective but it is mostly about borrowing more money.  It is odd that in a time when capital markets and attempted arbitrage have so failed us the solution is to resort to…capital markets and attempted arbitrage.

The more events progress (what's the implicit A.I.G. liability for the
government these days? near one trillion?), the more I believe that the tax cuts in Obama's stimulus plan were a mistake.

If I were Taiwan I'd feel a wee bit more worried these days.

He is a very smart monetary economist at Bentley.  The blog is here.  Here is a very good post on Keynes's General Theory; excerpt:

When I hear people discuss the long run I am sometimes reminded of
students who mistakenly assume the term ‘long run’ means ‘the distant
future’ and ‘short run’ means ‘the present or near future.’  But that
is not at all what these terms mean.  The present, right now, is the
“long run” for policies instituted years ago.  So if Keynes believed
that in the long run nominal income is determined by monetary factors,
then he should have explained current movements in nominal income in
terms of past movements in monetary policy.  Of course that is not what
the GT does.

And this:

Krugman recognized that Keynes’ liquidity trap rested on a
foundation of sand and attempted to build a model of “expectations
traps” that was consistent with rational expectations.  I have doubts
about this model, but even if one accepts Krugman’s argument it doesn’t
really help the GT very much.  Krugman argued that temporary increases
in the money supply will be hoarded, leaving AD almost unchanged.  But
this would apply even more strongly to budget deficits, which unlike
money supply increases, must be temporary.

If a transitory budget deficit will have no long run impact on
nominal spending (holding money constant) then its effect on current
spending will be even weaker than otherwise.  There is a reason why
modern graduate macro texts place so little emphasis on the ideas that
Keynes developed in the GT, they are very hard to justify in a model
with rational expectations.  What puzzles me is why concepts such as
the MPC, the multiplier, the paradox of thrift, and fiscal stimulus
have recently become so widely debated among economists.  Do these
concepts help us understand movements in nominal spending?  And if so,
what is the model that justifies that view?

It is worth reading every single one of his (twenty-two, so far) posts, even though you must click to get under the fold.

He was a giant of business cycle theory.  Here is an appreciation, with links.

This is what I call deleveraging:

It used to be that credit-card companies lured customers with cash rewards. Now American Express
Co. is paying to get rid of them. The card issuer is offering selected
customers a $300 AmEx prepaid gift card if they pay off their balances
and close their accounts.

Addendum: Megan McArdle adds commentary.

Felix Salmon has an excellent article; here is one excerpt:

"The corporate CDO world relied almost exclusively on this copula-based correlation model," says Darrell Duffie,
a Stanford University finance professor who served on Moody's Academic
Advisory Research Committee. The Gaussian copula soon became such a
universally accepted part of the world's financial vocabulary that
brokers started quoting prices for bond tranches based on their
correlations. "Correlation trading has spread through the psyche of the
financial markets like a highly infectious thought virus," wrote derivatives guru Janet Tavakoli in 2006.

Read them here.  I liked the Chinese on Hillary.

Greg Mankiw points us to this article by Sachs, excerpt:

President
Barack Obama’s economic team is now calling for an unprecedented
stimulus of large budget deficits and zero interest rates to counteract
the recession. These policies may work in the short term but they
threaten to produce still greater crises within a few years. Our
recovery will be faster if short-term policies are put within a
medium-term framework in which the budget credibly comes back to
balance and interest rates come back to moderate sustainable levels….

We need to avoid
reckless short-term swings in policy. Massive deficits and zero
interest rates might temporarily perk up spending but at the risk of a
collapsing currency, loss of confidence in the government and growing
anxieties about the government’s ability to pay its debts. That outcome
could frustrate rather than speed the recovery of private consumption
and investment. Deficit spending in a recession makes sense, but the
deficits should remain limited (less than 5 percent of GNP) and our
interest rates should be kept far enough above zero to avoid wild
future swings.

I received my third one Friday and it is called Economic Policy.  A few weeks ago I received a macro journal and another journal which I can no longer remember the theme of (micro maybe?).  In case you don't know these multiple journals have supplemented the one-size-fits-all American Economic Review, which was a single issue every three months.

I don't intend any criticism of the editors, as it seems (based on a mere perusal) they have done a good job in each case.  But the coming of the American Economic Review was for me an event to look forward to.  Now it feels like a bunch of journals are crossing my desk and I wish to be done with them.  If they are going to expand, I would rather get just one more additional journal.  Maybe it's not actually an advantage that they can publish more articles; somehow they all seem less important and I feel as if the real quantity of research — defined in part by its salience to a broad community — has gone down. 

Interfluidity has an idea:

There's another way to generate price transparency and liquidity for
all the alphabet soup assets buried on bank balance sheets that would
require no government lending or taxpayer risk-taking at all. Take all
the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100
par value claims, put all extant information about the securities on a
website, give 'em a ticker symbol, and put 'em on an exchange. I know
it's out of fashion in a world ruined by hedge funds and 401-Ks and the
unbearable orthodoxy of index investing. But I have a great deal of
respect for that much maligned and nearly extinct species, the
individual investor actively managing her own account. Individual
investors screw up, but they are never too big to fail. When things go
wrong, they take their lumps and move along. And despite everything the
professionals tell you, a lot of smart and interested amateurs could
build portfolios that match or beat the managers upon whose conflicted
hands they have been persuaded to rely. Nothing generates a market
price like a sea of independent minds making thousands of small trades,
back and forth and back and forth.

Via Thomas Barker, here is an even more radical idea.

I continue to see many bloggers suggesting that bank nationalization is a fait accompli and that anyone who isn't on board right now is in denial.  It is far less common that bloggers give serious consideration to the difference between a bank and a bank holding company.  In fact I usually don't see that critical distinction mentioned at all.

If the government nationalized (or "pre-privatized"…whatever) Citibank, Citicorp would go bankrupt and we would be back at a Lehman Brothers scenario again.  So the government would have to take over Citicorp too.  That goes way, way beyond anything the Swedes did or for that matter it goes well beyond WaMu. Shall I turn the mike over to Wikipedia?

Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate Travelers Group on April 7, 1998.
Citigroup Inc. has the world's largest financial services network,
spanning 107 countries with approximately 12,000 offices worldwide. The
company employs approximately 300,000 staff around the world, and holds
over 200 million customer accounts in more than 100 countries. It is
the world's largest bank by revenues as of 2008.

You can read about Travelers Group here.

Thinking through the implications of said nationalization for the counterparty positions of a bank holding company, or its role in the commercial paper market, is mind-boggling.  Neither the FDIC (which generally does an OK job) nor any other government agency is in any way prepared for this kind of management task.  It has very little to do with standard FDIC procedures.  All I hear about is "bank" this, "bank" that, etc. but again little or no talk of the bank holding company.

Of course this is only a problem for the five or six biggest financial institutions but those are precisely the issue at hand.

On nationalization, Bernanke is very much on the ball.  He said this:

Federal Reserve Chairman Ben Bernanke said this week, is “that you tend
to lose the franchise value, that the counterparties and others don’t
want to deal with you because they don’t know your future.”

I usually don't like to speak so negatively, but it's the advocates of nationalization who are in denial.  There is a belief that Obama, Bernanke, and/or Geithner are somehow spineless or in the pocket of the banking lobby.  The sadder truth is that they understand just how ill-prepared the U.S. government, or the Fed, would be to run such an enterprise.

I do understand that if all the water runs out of the sink, as it may, nationalization will come in some form or another, however disastrous that may be.  But the desire to postpone it until the last possible moment, and the desire to pursue even a small chance of avoiding nationalization, are signs of wisdom, not cowardice.

When you read about nationalization, and see only the word "bank," and not "bank holding company," be very afraid of the advice on tap.

Addendum: Here is a different but related piece on banks vs. bank holding companies.

I saw a sign today that might fill your markets in everything and countercyclical assets categories.

"Foreclosure Bus Tours

800-XXX-XXXX"

The availability of the tours is the market is anything.

Equity in the tour company will be the asset.