Category: Economics

Linda Bilmes presented an interesting paper (not online) at the AEAs looking at the fiscal stimulus in light of Katrina, Iraq and the Big Dig.  Here are some key grafs:

Bilmes is the co-author with Joseph Stiglitz of The Three Trillion Dollar War.

Paul Krugman has some questions:

Financial
institutions that want to “get bad assets off their balance sheets” can
do that any time they like, by writing those assets down to zero – or
by selling them at whatever price they can. If we create a new
institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.

I suspect, though I’m not certain, that policymakers are once more
coming around to the view that mortgage-backed securities are being
systematically underpriced. But do we really know this? And how are we
going to ensure that this doesn’t end up being a huge giveaway to
financial firms?

Here is more detail on various plans.  I see it so:  If the assets are undervalued by the market, buying them up is an OK deal.  Presumably the price would be determined by a reverse auction, with hard-to-track asset heterogeneity introducing some arbitrariness into the resulting prices.  If these assets are not undervalued by the market, and indeed they really are worth so little, our government wishes to find a not-fully-transparent way to give financial firms greater value, also known as "huge giveaway."

Right now it seems to boil down to the original TARP idea or nationalization, take your pick.  You are more likely to favor nationalization if you think that governments can run things well, if you feel there is justice in government having "upside" on the deal, and if you are keen to spend the TARP money on other programs instead.

Here is one source:

Here is another:

One Calculated Risk commentator states:

Addendum: Do note that is the gross flow of cash from the government, not the net financial cost or the net social cost.

That's Paul Volcker's idea, namely that the way to prevent "too big to fail" is to prevent "too big."  Details are sketchy but Matt Yglesias offers some comments. 

Is there a precedent for this kind of plan working?  We have antitrust law but antitrust law doesn't actually prevent big firms from becoming big; we've had General Motors, Microsoft, Google, and others, all very large relative to their sectors.

You could imagine an absolute cap on the size of bank assets, so that above the size limit would-be loans and deposits are sent to a rival institution elsewhere by mandate.  One implication is that banks won't have to treat their customers very well, since in a growing economy (we'll get one again, sooner or later) a lot of banks will be at the cap and will be turning away extra business.  If different banks were perfect substitutes for each other, you wouldn't be seeing large banks in the first place.

A second question is whether ten little banks are safer than one larger, 10x bank.  For sure they are if the problem is one bonehead manager at the bigger bank, but what if it's systemic asset price risk?  The smaller banks could well be less safe.  In a financial crisis, would you rather be a larger country or a smaller country?

I believe the plan would require very tight restrictions on off-balance sheet activity.  Something like this may be coming anyway, and its rationale is understandable, but it is easier said than done.  We would be requiring regulators to estimate the net "size" (it's debatable whether that word even applies; what is the "size" of a naked put?) of a bank financial position when banks themselves haven't been very good at doing that.  A simple approach would be to ban all bank trading in derivatives but I believe that would increase bank risk more than decrease it, at least at this point.

By the way the 1927 McFadden Act banned interstate branch banking, in part to keep banks small, and economic historians usually consider that policy to have been a disaster which contributed to the severity of the Great Depression.

Here is a summary of where some of the debate on bank policy is at right now.

Is there a way out?

Buiter's argument — which applies just as much to the US as it does to the UK – is that the only way to get banks lending again is to nationalize them.  Otherwise, they'll simply hoard liquidity in a desperate attempt to avoid being nationalized.

That's Felix Salmon.  

It is a common shibboleth that saved funds mean a decline in aggregate demand but this doesn't have to be true.  Savings often fund investment, which boosts aggregate demand and creates jobs.

Admittedly, savings don't fund investment when the banking system is malfunctioning.  Or it may take so long to translate savings into investment that incomes are falling in the meantime and S and I follow them on the way down (Keynes's scenario).  Still, you shouldn't assume that savings translate into a collapse of aggregate demand.

Michael Mandel adds:

I believe that Obama’s $300 billion tax cut is essential to
‘recapitalize’ the American consumer, just like the banks are being
recapitalized.

With that as background, consider the tax cuts in Obama's stimulus plan.  If the money is spent, you get a boost to aggregate demand.  That was the goal.  If the money is not spent, it is a wash.  The government borrows for people (at a low rate) and people save it.  Since savings has gone up, the borrowing is sustainable and it doesn't even have to crowd out additional government spending, if that is what you want. 

Furthermore these people would have done some borrowing anyway, so their ability to implicitly borrow at a lower interest rate creates a small, positive wealth effect.  The savings also means you have supplied those people with some form of implicit insurance, and at very low risk of moral hazard.

I wouldn't expect a whole lot of recovery from these scenarios, but there's nothing problematic about having some tax cuts in the stimulus package.  If you're looking for another opinion, here is Joseph Stiglitz.

From Terry Fitzgerald at the Minneapolis Fed.

You are correct that the "mildest, median, and harshest" recession lines do
not represent single recessions. Please allow me to try to justify our
procedure. We spent considerable time weighing alternative approaches.

In drawing our timeline "length of recessions" graphs, we wanted to
illustrate where the current recession lies relative to past recessions at
each month of the recession. So for each month (or quarter), the lines
would tell you what had been the largest, median, and smallest decline in
any recession to that point.

The median line would indicate that one-half of the past recessions had
experienced larger declines, and one-half had experienced smaller declines
to that point. Similarly, no recession had a larger decline to date than
the "harshest" line. (And similarly for the mildest line.)

One feature of this approach is that the mildest, median, and harshest lines do not shift over time. So we can update just the "current" line in our graphs without all the lines shifting.

…I knew that insightful readers might wonder about this point, and I hoped that the note would at least explain what we did.

We are not trying to do anything deceptive or misleading with these charts.
Our aim is only to provide some empirical context to the current recession.

Is that too silly a question?  (And have purveyors of the liquidity trap argument been willing to make predictions?)  After all, the TED spread is now below one and there are other pieces of financial good news.  If the liquidity trap ends (assuming there was one in the first place), monetary policy will work to stimulate aggregate demand.  A big fiscal stimulus won't be necessary.

Will there still be a liquidity trap three months from now?  Six months from now?  With all those smart people in the White House and at Treasury?  What if there is a ten percent chance, each month, that the liquidity trap goes away?

The proposed fiscal stimulus is a big, irreversible investment, which may or may not be needed, and of course it takes some time to get rolling.  The traditional economist's recommendation is to apply a very high hurdle rate to such commitments.  One alternative is to wait and see if the liquidity trap ends in the near future.

I am not an optimist about the real side of the economy, but I would be surprised if we still were in a liquidity trap one year from now.

Paul Krugman writes:

…the traditional immunity of advanced countries like America to third-world-style financial crises isn't a birthright. Financial markets give us the benefit of the doubt only because they believe in our political maturity — in the willingness of our leaders to do what is necessary to rein in deficits, paying a political cost if necessary. And in the past that belief has been justified. Even Ronald Reagan raised taxes when the budget deficit soared.

But do we still have that kind of maturity? Here's the opening sentence of a recent New York Times article on the administration's budget plans: ''Facing a record budget deficit, Bush administration officials say they have drafted an election-year budget that will rein in the growth of domestic spending without alienating politically influential constituencies.'' Needless to say, the proposed spending cuts — focused only on the powerless — are both cruel and trivial.

If this kind of fecklessness goes on, investors will eventually conclude that America has turned into a third world country, and start to treat it like one. And the results for the U.S. economy won't be pretty.

Of course that's from 2004, when the budget deficit was far lower, so it holds all the more today.  Arnold Kling makes a related point.

It is, of course, still a completely coherent position to think that without a fiscal stimulus there will be no recovery and thus this default risk will be all the higher; I presume that is Krugman's position.  Still, in absolute terms, our worry about default risk should be relatively high.  And if there's anything we've learned over the last two years, it is that "once in a lifetime" outlier events can happen.

Keep in mind that banks still need a lot more money.  So that's a reason to be quite fiscally conservative on as many other things as possible.

Here are some interesting thoughts from Robert Waldmann.  (How long will the liquidity trap last anyway?)  And Greg Ip writes: "Last week, markets pegged the probability of a U.S. default at 6 percent over the next 10 years, compared with just 1 percent a year ago."

I liked this part, even though I don't think AD is always the key factor:

Some people seem to infer from this that output and income can be raised by increasing the quantity of money.  But this is like trying to get fat by buying a larger belt.  In the United States to-day your belt is plenty big enough for your belly.  It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.

That's Keynes, writing to Roosevelt.  The letter is interesting throughout, how about this part:

I put in the second place [as a priority] the maintenance of cheap and abundant credit
and in particular the reduction of the long-term rates of interest. The
turn of the tide in great Britain is largely attributable to the
reduction in the long-term rate of interest which ensued on the success
of the conversion of the War Loan. This was deliberately engineered by
means of the open-market policy of the Bank of England. I see no reason
why you should not reduce the rate of interest on your long-term
Government Bonds to 2½ per cent or less with favourable repercussions
on the whole bond market, if only the Federal Reserve System would
replace its present holdings of short-dated Treasury issues by
purchasing long-dated issues in exchange. Such a policy might become
effective in the course of a few months, and I attach great importance
to it.

That's exactly what the Fed has been stressing and what Robert Lucas has advocated as well.

Get the double entendres out of your mind:

Lola – or Rora – to give her a slightly more Japanese pronunciation – is a beauty and she knows it.

Customers pay by the hour for her company. Usually they just want to stroke her, but as a special treat for favoured clients, she will lie back in a chair, close her eyes and pose for photographs.

Lola is a Persian cat who works at the Ja La La Cafe in Tokyo's bustling Akihabara district. It is one of a growing number of Cat Cafes in the city which provide visitors with short but intimate encounters with professional pets.

When I called, there were 12 felines and seven customers, mostly single men…

It costs about £8 ($10) an hour to spend time in a Cat Cafe.

Here is the article, courtesy of Marco Haan; other Japanese markets are discussed as well, including the renting of pet beetles.

And no, this next one is not a "sexy" Markets in Everything, but it, via Megan McArdle, is still remarkable in its own way: Quilt with Matching Tote.

1. We have zombie banks.

2. There is considerable regulatory uncertainty in banking and finance.

3. There is a negative wealth effect from lower home and asset prices.

4. There is a big sectoral shift out of real estate, luxury goods, and debt-financed consumption.

5. Some of the automakers are finally meeting their end, or would meet their end without government aid.

6. Fear and uncertainty are high, in part because they should be high and in part because Bush and Paulson spooked everyone.

7. International factors are strongly negative.

8. There is a decline in aggregate demand, resulting from some mix of 1-7.

I have two simple points,  First, a large fiscal stimulus addresses factor #8 but fares poorly in alleviating the other problems.  Of course it may give a band-aid for #5 or #6 and you can tell other stories but we are in a multi-factor depression.

Second, forecasting will prove very difficult.  These factors interacted with each other in a unique manner on the way down and they may well interact in an unpredictable manner on the way back up, whenever that comes.  Just for a start, who has a good model of #1, #2, or #6?  Right now we're seeing a lot of good faith efforts to develop forecasts, but I say don't believe any of them, whether they support your point of view or not.