Economist's View

"I Blame the Wine"

Tim Duy takes a wrong turn:

I Blame The Wine, by Tim Duy: Tonight I am ensconced in my preferred Portland hotel in anticipation of an early morning presentation. A good opportunity to work in the holiday-decorated lobby bar, listening to Christmas music while logging some quiet work hours throughout the evening.

How quickly, however, a quiet evening can become unsettled. A second glass of wine and an inadvertent click on a link brought me to Larry Kudlow’s webpage. Drawn in, not recognizing the danger, I clicked again and again, and landed in the Wall Street Journal’s op-ed section. The horror of a Peggy Noonan column greeted me:

One of the weirdest, most perceptually jarring things about the economic crisis is that everything looks the same. We are told every day and in every news venue that we are in Great Depression II, that we are in a crisis, a cataclysm, a meltdown, the credit crunch from hell, that we will lose millions of jobs, and that the great abundance is over and may never return. Three great investment banks have fallen while a fourth totters, and the Dow Jones Industrial Average has fallen 31% in six months. And yet when you free yourself from media and go outside for a walk, everything looks . . . the same.

Everyone is dressed the same. Everyone looks as comfortable as they did three years ago, at the height of prosperity. The mall is still there, and people are still walking into the stores and daydreaming with half-full carts in aisle 3. Everyone's still overweight... Nothing looks different.

It won’t be a real recession until we are all covered in nothing but rags. Still, look at the bright side – we will have finally cured the obesity epidemic. We may be poor, but at least we will be thin.

I hear this kind of commentary frequently: “Of course we are not in a real recession – look at all the cars at the mall!” Yes, people continue to shop – they shopped during the Great Depression as well. They even went to movies. Economies generally don’t spiral into oblivion. And on any given day, we generally don’t see “everyone.” Mall traffic is the worst of the anecdotal evidence. It tells you nothing about the composition of spending. Does Noonan know if the shopper has downgraded from Nordstrum’s to the Gap? Or if they purchased only one shirt when they normally would have purchased three? And what exactly does a sale of only one shirt imply for the firm’s business model?

It is simply much more complex than the number of cars at the mall. Noonan forges on:

In the Depression people sold apples on the street. They sold pencils. Angels with dirty faces wore coats too thin and short and shivered in line at the government surplus warehouse. There was the Dust Bowl, and the want of the cities. Captains of industry are said to have jumped from the skyscrapers of Wall Street. (Yes, those were the good old days. Just kidding!) People didn't have enough food.

Suicide is funny, right? And again with the food. Perhaps Noonan, so convinced that people are still eating, should have stopped by the Eugene Register Guard website this weekend:

Given the widespread and escalating economic hardship throughout Oregon and the nation, it’s no surprise to see it trickling down to schools.

The most easily quantifiable measure is the number of students signing up for free and reduced-price meals through the National School Lunch program. Though statewide numbers aren’t yet available, the number of children receiving subsidized meals in the Eugene district is up 8 percent over this time last year. In Bethel, Fern Ridge, Creswell and Springfield, it’s up by at least 10 percent.

“I think the biggest thing we noticed during registration this time was a lot more families moving in together to lower living expenses,” said Jim Crist, principal at Springfield’s Ridgeview Elementary School, which saw the percentage of students signed up for free or reduced meals swell from 31 percent last October to 43 percent this October.

Cafeteria manager Sharon Gregory said the change has been especially dramatic at breakfast, served before school for 95 cents for kids who pay in full.

Apparently more people don’t have enough food compared to this time last year. Just not the people Noonan associates with.

Noonan continues:

I asked an economic expert a few weeks ago if a second Great Depression would come to look at all like that, like a catastrophe, and he said no, not at all. In 1930 we had no safety net. Unemployment benefits, food stamps, welfare, an interlocking system of city, state and federal services—these things will keep it from being so bad.

Not a bad answer. But after acknowledging the benefits of a social safety net, Noonan then laments the potential widening of that same net:

But in tough times we will surely expand unemployment benefits, and welfare, and food stamps and housing assistance, which will mean more and greatly accelerated spending, which will mean bigger and steeper deficits, and higher taxes, with the one feeding on the other, which may mean an economic death spiral comparable to, say, Britain in the decades after World War II, its economy mired and held down by government control and demands. It continued more than a quarter century, until the change of economic thinking encapsulated in the phrase "the Thatcher years." Is that what this will be?

The safety net has so far prevented economic calamity but will cause an economic calamity if expanded. No thought given to the possibility that a safety net designed for a typical postwar business may be, and is likely, insufficient to cushion the blow from a deeper and longer recession. Just a quick leap from a 26 week extension of unemployment benefits to the crushing weight of socialism.

Noonan concludes that the recession is all in our heads:

So where is GDII happening? Right now mostly in conversations between wives and husbands, in families and among friends, about selling, about digging in, about layoffs, and not taking chances, and reduced income, and fear.

So the 11.8% of the workforce unemployed by the U-6 measure, or the 500k+ filing for unemployment insurance each week are not having conversations with their families about where the next rent payment or trip to the grocery store is coming from? Would Noonan be happier is that number was 15%?

You get the idea….

Fed Watch: A Step Towards Explicit Quantitative Easing

Tim Duy thinks about where the Fed is headed next:

A Step Towards Explicit Quantitative Easing, by Tim Duy: Dull times these are not – Monday was another whirlwind that culminated with another steep drop in equity markets, despite clear indications that Bernanke & Co. are ready for a broader campaign of quantitative easing.

The day brought more recession news, of the official variety as the NBER declared the recession began in December 2007. My own estimation was closer to the middle of this year, consistent with the research of our colleague Jeremy Piger, but differing with the NBER is pointless. Typically, I would take an odd comfort in the NBER’s declaration, thinking that it would presage an end to the recession in the near future. In the current environment, such comfort is lacking as data that we typically see closer to the beginning of recession is just emerging. Case in point – the steep drop over the past three months in the ISM index. As expected, the low headline reading of 36.2 for November pretty well summarizes the sad state of US manufacturing. Moreover, the details were weaker almost across the board. About the only good take away is that it can’t get much worse. Maybe. Hopefully.

The early news provided an appropriately sanguine backdrop for the speech delivered by Federal Reserve Chairman Ben Bernanke. The Fed chief summarized the near term outlook with a simple paragraph:

The likely duration of the financial turmoil is difficult to judge, and thus the uncertainty surrounding the economic outlook is unusually large. But even if the functioning of financial markets continues to improve, economic conditions will probably remain weak for a time. In particular, household spending likely will continue to be depressed by the declines to date in household wealth, cumulating job losses, weak consumer confidence, and a lack of credit availability.

This is an outlook that calls for additional easing, but of what variety? Bernanke admits what all realized long ago:

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.

With traditional policy at an end, Bernanke provides a glimpse of his next moves:

The Bailout: Expenditure or Investment?

With respect to estimates concerning the total cost of the various bailouts, etc. for the financial system, in particular whether the spending should be treated as an expenditure or an investment, Steve Waldman says:

Expenditure vs investment — thinking clearly: ...Paul Kedrosky is a reasonable fellow, and takes care to note that the numbers "are in current dollars, and all treat expenditures and investments as equivalent." Kevin Drum is even more reasonable:

This stuff has gotten completely out of hand, with "estimates" of the bailout these days ranging from $3 trillion to $7 trillion even though the vast bulk of this sum comes in the form of loan guarantees, lending facilities, and capital injections. The government will almost certainly end up spending a lot of money rescuing the financial system (I wouldn't be surprised if the final tab comes to $1 trillion over five years, maybe $2 trillion at the outside), but it's not $7 trillion or anything close to it. People really need to stop throwing around these numbers as if the bailout is comparable to World War II or something. That's not reality based, folks.

But reasonable and right are sometimes different... We have some idea what we paid for, for example, with the $851,000,000,000 for NASA. We bought space shuttles, satellite systems, a moon shot, planetary probes, a lot of research and development, some air bases and research facilities.

What are we buying when the government purchases mortgage-backed securities, or buys preferred shares of banks that can only pay if a portfolio of real-estate loans does not totally sour? We are buying "paper", right?

No. We are not buying paper. ... All of the iffy securities that are weighing down the banking system represents money already spent on real projects or consumption. When the government purchases a security, it is taking the place of the party that originally fronted money for that expenditure. Every penny of government "investment" is retroactive expenditure on housing, real-estate, consumer credit, whatever.

If a government were to borrow funds in order to build a new stadium, we'd call that an "expenditure", even if we fully expect use fees and incremental tax revenues to eventually turn a profit for the fisc. Politicians supporting the project would call it an "investment", quite justifiably. But the project would still count as government spending.

If a private party builds the same stadium, and then is reimbursed by the government in exchange for rights to future revenue, that doesn't change the economic substance of the transaction at all. But in the second case, the government would buy "paper" — it would enter into a contract trading current government funds for future revenues. That "security" doesn't make the transaction any more or less an investment than if the government had purchased the stadium itself.

So, in economic substance, the government is currently spending through a financial time machine on the exurban subdivisions and auto loans of several years past. ...

I hope that the infrastructure we build next year turns out to be a wise investment, both in financial and use-value terms. It might be, but just because we hope to recoup the cost, we won't pretend that no money was actually spent. We'll call the whole thing an expenditure, even though that will probably overstate the ultimate burden. But if a power grid counts as an expenditure on government books, so should a security derived from a mortgage or credit card loan made two years ago. You ... can't claim that securities are "investments" while a power grid, or NASA, or even World War II are mere "expenditures". ...

Figures of 7 or 8 trillion dollars recently bandied about by the Communists at Bloomberg are overstated, since they do not distinguish between expenditures and guarantees, which are contingent liabilities. The government's contingent liabilities aren't usually counted as spending until the contingency has been triggered. But the amount of money already spent or committed on "financial investments" to date is more than $3 trillion dollars, and it is perfectly right to call that government spending on the financial bail-out.

The scale of the largely unlegislated current government program to save the financial system is breathtaking and quite unprecedented. Taxpayers might be made whole, in financial terms, or might reap sufficient dividends in terms of suffering avoided to justify the program. But don't let anyone convince you that the scale of this intervention is "overstated" because it is all "investment". NASA and the Marshall Plan were investments too, and pretty good ones.

But shouldn't the example be a little different? If the private sector builds, say, a stadium and then the government buys it, then yes, that is expenditure. But suppose the government purchase comes with a clause that says it will sell the stadium back to the private sector at a date certain (or by a date certain). It's still an expenditure of the same amount in the present, but the purchase price does not represent the expected long-run burden of the transaction, and isn't that what we really care about? The government plans to sell the financial paper, not hold it forever, and what really matters is how much the paper will be worth in the future (if the stadium value falls to zero, then the current expenditure does represent the long-run burden; however, the value of the government holdings will not fall to zero or anything even close to that).

So I don't care what you call it, expenditure, investment, a repo, temporary custody of a volatile asset, whatever, what I care about is how much the bailout will cost once the government has disposed of all of the assets it has purchased. That's not something we can know with certainty, but unless the value of the securities the government is holding falls much, much further than anyone expects, the amount of the current expenditure greatly overstates the long-run burden.

Do You Believe?

Bluematter says rational agents shouldn't be struggling right now:

If you believe in Ricardian equivalence, you don't believe in recessions: The same rational, non-credit constrained individual that will save a tax rebate in anticipation of higher taxes in the future is the same rational, non-credit constrained individual that will save something extra in the good times so he can maintain his consumption level unchanged during recessions - as much a certainty in life as death and taxes.

If you believe that fiscal stimuli are pointless, then you don't believe in recessions as we know them.

links for 2008-12-02

• Treasury Finance Policy - knzn
• Investors Sue Countrywide Over Modified Loans - NYTimes.com
• Bailout Monitor Sees Lack of a Coherent Plan - NYTimes.com
• A Team of Whizzes - NYTimes.com
• Time for monetary authorities to jump into the liquidity trap - Willem Buiter
• Two perspectives on commercial and central bank solvency - Nick Rowe
• Where I Was Wrong About The Current Economic Crisis - Barkley Rosser
• The Great Crash of 2008 - Robert Reich
• Fiscal Policy Puzzles - Greg Mankiw
• Dow plunges again, Friedman fans despair - Andrew Leonard
• Paulson's Remarks on the U.S. Economy - Real Time Economics
• Summers, Geithner Have Baggage, Not Fatal Flaws - John M. Berry
• Obama's A-Team Economists Can Start With ABCs - Caroline Baum
• Cost and Benefits from a Fiscal Stimulus - pgl
• It's official - Econbrowser
• It's official: We're in a recession - How the World Works
• Infrastructure - The Bellows
• A note on Japan’s experiment with quantitative easing - Credit Writedowns
• Government spending is correct response to the economic crisis - Dean Baker
• The Great Slump of 1930 - John Maynard Keynes

"The Return of Depression Economics"

Brad DeLong reviews the second edition of Krugman's "The Return of Depression Economics":

'The Return of Depression Economics and the Crisis of 2008,' by Paul Krugman, Book Review by Brad DeLong., LA Times: A decade ago, Paul Krugman wrote a little book warning us that economists' triumphalism was misplaced -- that advances in economic knowledge ... had not, after all, banished the prospect of big depressions from the global economy. "The Return of Depression Economics" sank with barely a ripple. ...

Now Krugman is back ... with ... a second edition in "The Return of Depression Economics and the Crisis of 2008."... His thesis makes me want to say "no" and "yes." No, Krugman is wrong when he worries that the disease of the business cycle "long . . . considered conquered . . . had reemerged in a form resistant to all the standard" remedies. The standard remedies still do work. Yes, he is right in his claim that "depression economics" is very relevant to economic discourse and policymaking today...

If liquidity is king What is "depression economics"? ...The capital stock of our economy ... consists of the semiconductor fabrication facilities of Applied Materials, the patents of Merck, the roadbed of CSX -- not at all the kind of things that command money on short notice in the consumer marketplace.

Now what happens when everybody -- or a small but coordinated subset of everybodies -- decides that they want liquidity (their money now...) or safety...?

More Unsurprising News

Since we are noting the obvious today (yes we are in a recession), here's something else that won't surprise anyone:

Bush Says He was 'Unprepared for War', by Steve Bennen: We've heard Bush express some various regrets in recent years, but I think this one is a first.

Looking back on his eight years in the White House, President George W. Bush pinpointed incorrect intelligence that Iraqi President Saddam Hussein had weapons of mass destruction as "biggest regret of all the presidency."

"I think I was unprepared for war," Bush told ABC News' Charlie Gibson in an interview airing today on "World News."

"In other words, I didn't campaign and say, 'Please vote for me, I'll be able to handle an attack,'" he said. "In other words, I didn't anticipate war. Presidents -- one of the things about the modern presidency is that the unexpected will happen." ...

The president added, "I wish the intelligence had been different, I guess." Asked if he would have gone to war if he knew Iraq did not have stockpiles of weapons of mass destruction, Bush said, "That is a do-over that I can't do." ...

Nah, there was nothing in the 2000 election about Bush being strong on national defense:

In the 2000 election George W. Bush, who had shirked military service, succeeded in presenting himself as more reliable on national security than Al Gore. This was despite Gore's service in Vietnam, his seven years on the Senate Armed Services Committee, his four years on the House Intelligence Committee, his help in brokering a deal to dismantle the nuclear arsenal of former Soviet republics, and his creation of binational commissions with Russia, South Africa, Egypt, Kazakhstan, and Ukraine to deal with issues ranging from AIDS to disarmament.

He didn't say the exact words "Please vote for me, I'll be able to handle an attack," that's true, but he certainly implied it:

Bush's 2000 Acceptance Speech: ...We will give our military ... a commander-in-chief who ... earns their respect. A generation shaped by Vietnam must remember the lessons of Vietnam: When America uses force in the world, the cause must be just, the goal must be clear, and the victory must be overwhelming.

I will work to reduce nuclear weapons and nuclear tension..., my administration will deploy missile defenses to guard against attack and blackmail. Now is the time not to defend outdated treaties but to defend the American people.

By his own admission, he got fooled by false evidence, evidence he wanted to believe in so he did, then he went to war based upon that evidence even though he was not prepared to do so.  But as I said, we are noting the obvious today. [Update: comments say what is obvious is that he knew the evidence was false, but used it anyway.]

Update: Thinking it over, what were they prepared for? War? Hurricanes? An economic crisis? And worse, in every case, even after the event occurred they seemed to have great trouble coming up with a plan of action, let alone having plans ready in advance. Broadly, and again obviously, they were unprepared to govern.

Bernanke: Federal Reserve Policies in the Financial Crisis

Ben Bernanke does not expect further interest cuts to have much of an impact on the economy, so they will have to rely upon other policy tools

Federal Reserve Policies in the Financial Crisis, by Ben Bernanke, Federal Reserve: ...[O]ur nation ... is being tested by economic and financial challenges. Those challenges and the Federal Reserve's policy responses are the topic of my remarks today.

Federal Reserve Policies during the Crisis
As you know, this extraordinary period of financial turbulence is now well into its second year. ...

The Federal Reserve's strategy for dealing with the financial crisis and its economic consequences has had three components.

When Did the Recession Begin?

As noted in the post below this one, the NBER has dated the beginning of the recession as December 2007. Brad DeLong says that "I think that this was the right way to call it..." However a colleague, Jeremy Piger, has a recession dating model that indicates it wasn't exactly clear when the recession began. His recession probabilities are:

200705	1.2%
200706	1.4%
200707	1.8%
200708	2.9%
200709	4.6%
200710	7.3%
200711	10.4%
200712	17.1%
200801	23.6%
200802	33.1%
200803	37.4%
200804	42.7%
200805	47.7%
200806	54.9%
200807	66.0%
200808	96.2%
200809	99.2%

According to these numbers, one could reasonably put the peak anywhere from October 2007 to May of 2008. Here's a graph of the recession probabilities from June 1967 through September 2008:

Are We in a Recession?

In case you had any doubt, according the the NBER's Business Cycle Dating Committee, yes, we are in a recession and it began a year ago in December 2007 [update: more from Jeff Frankel - a member of the Dating Committee - here]:

Determination of the December 2007 Peak in Economic Activity, NBER: The Business Cycle Dating Committee of the National Bureau of Economic Research met by conference call on Friday, November 28. The committee maintains a chronology of the beginning and ending dates (months and quarters) of U.S. recessions. The committee determined that a peak in economic activity occurred in the U.S. economy in December 2007. The peak marks the end of the expansion that began in November 2001 and the beginning of a recession. The expansion lasted 73 months; the previous expansion of the 1990s lasted 120 months.

Paul Krugman: Deficits and the Future

Deficit hawks who are complaining about the stimulus package have it all wrong:

Deficits and the Future, by Paul Krugman, Commentary, NY Times: Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall. Others, however, worry about the burden that large budget deficits will place on future generations.

But the deficit worriers have it all wrong...; strong fiscal expansion would actually enhance the economy’s long-run prospects.

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that ... reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.

But circumstances right now are anything but normal. Consider what would happen ... if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans. ... Fiscal austerity ... would reduce, not increase, private investment...: it’s exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

The second episode took place ... in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.

Just to be clear, I’m not arguing that trying to reduce the budget deficit is always bad for private investment. You can make a reasonable case that Bill Clinton’s fiscal restraint in the 1990s helped fuel the great U.S. investment boom of that decade...

What made fiscal austerity such a bad idea both in Roosevelt’s America and in 1990s Japan were special circumstances: in both cases the government pulled back in ... a liquidity trap, a situation in which the monetary authority had cut interest rates as far as it could, yet the economy was still operating far below capacity.

And we’re in the same kind of trap today — which is why deficit worries are misplaced.

One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run.

Should the government have ... permanent ... budget deficits? Of course not. Although public debt isn’t as bad a thing as many people believe — it’s basically money we owe to ourselves — in the long run the government, like private individuals, has to match its spending to its income.

But right now we have a fundamental shortfall in private spending: consumers are rediscovering the virtues of saving at the same moment that businesses ... are cutting back on investment. That gap will eventually close, but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more.

The bottom line, then, is that people who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action, both for today’s workers and for their children, is to do whatever it takes to get this economy on the road to recovery.

Fed Watch: New Month, New Data, Same Story

Tim Duy says the Fed needs to be more definitive about the type of policy rule it is following:

New Month, New Data, Same Story, by Tim Duy: The new month brings forth fresh data to gauge the health of the US economy. But no one expects the patient to wake from his coma just yet. Indeed, the deluge of depressing data will likely prompt the Fed to cut the Fed Funds target at least 50bp, although it is not obvious that anyone believes further cuts will have any practical impact at this point. As the Fed repeatedly proves, the action is on the balance sheet side of policy. And even there, monetary policymakers are now fighting a rearguard action, simply trying to prevent the financial tailspin from taking the economy further into the abyss.

The data flow during the last two weeks of November was nothing but bleak; the numbers speak clearly of a deepening recession. If you had any doubt that the credit crunch is causing firms to shelve capital expenditure plans, you had only to look at the durable goods release. New orders of nondefence, nonair capital goods slid 4% in October, extending what is now a three month decline. This number also likely reflects slowing export activity as the global slowdown pulls one of the last rugs out from under the US economy. Not surprisingly, regional surveys suggest manufacturing weakness extended into November, a hypothesis that is likely to be confirmed by this morning’s ISM report. The question is not whether the report will be bad; it is how bad it will be.

The underpinnings of consumer spending continued to deteriorate as well. Via the Case-Shiller numbers, we learned what most suspected - housing prices continue to decline seemingly unabated in September, a decline that likely reflects only the early stages of the most recent phase of the credit crunch. The Fed made an attempt to lean against this trend, announcing a plan to purchase agency debt in an effort to pull down mortgage rates. This will provide some marginal support to housing, if at a minimum by raising affordability slightly, but I doubt anyone expects it to work miracles. A larger impact is likely to come through the reported wave of refinancing the Fed’s action triggered – support for those who are not underwater on their mortgages.

Still, any refinancing gains, which extend the boost from lower gas prices, will be fighting against rising joblessness. Indeed, jumping initial claims in November foreshadow a dismal employment report Friday. The weight of the deteriorating labor market is revealed by the October Personal income and Outlays report; revised figures on private wage and salary disbursements revealed stagnant income growth. The multiple weights on consumers – housing markets, inflation in the first half of the year, declining equity markets, higher unemployment, and reduced access to credit – finally broke the fabled US consumer, with personal consumption expenditures now down for five consecutive months.

As household balance sheets deleverage, saving rates are edging up, rising from 0.6% in August to 2.4% in October. Ultimately, a sustained rise in household saving rates works to the benefits of households, providing an economic cushion, etc. In the short run, however, it plays havoc with the economy, especially if firms too are postponing spending. A simple, yet powerful argument for fiscal stimulus – the credit crunch in the second half of the year has opened a gap in activity that the federal government can reasonably fill. Being a deficit hawk is unproductive now; if the stimulus is too much, financial markets will send the appropriate signal via higher interest rates. Policymakers just need to listen; in theory, policy should be able to pull back if necessary.

links for 2008-12-01

• Enter, Pursued by a Bear - James Surowiecki
• There she goes again. - The Edge of the American West
• The forgotten side of FDR - Dani Rodrik
• Exchange rate flexibility does not speed current account adjustment - VoxEU
• How to Squeeze the Most Out of a Stimulus Plan - NYTimes.com
• Lessons from the Crisis - Michael Spence - PIMCO
• Oh, how COOL - U.S. Food Policy
• Flashback 2004: Art Laffer denies the housing bubble - Bubble Meter
• The greatness of Keynes … - Paul Krugman

Sad News

Calculated Risk:

Tanta Passes Away: My dear friend and co-blogger Doris “Tanta” Dungey passed away early this morning. I would like to express my deepest condolences to her family and friends. ... David Streitfeld at the NY Times: Doris Dungey, Prescient Finance Blogger, Dies at 47 ... This is a very sad day...

Bigger is Better

Joe Stiglitz:

A $1 Trillion Answer, by Joseph E. Stiglitz, Commentary, NY Times: What President-elect Barack Obama will need to do is horribly complicated but also very clear.

First, he must stop the economy from going deeper into recession. Then he needs to bring about a robust recovery, preferably in ways that support the long-term needs of the United States: by repairing our neglected public works, invigorating our technological leadership, making our society greener, fixing our health care problems, healing our social and economic divide, and restoring our social compact.

It will not be easy. President Bush’s legacy of debt and the opposition of those who benefit from the status quo present major obstacles.

There is an emerging consensus among economists that a big — very big — stimulus is needed, at least $600 billion to $1 trillion over two years. Mr. Obama’s announced goal of 2.5 million new jobs by 2011 is too modest. In the next two years, almost four million workers will enter the labor force — or would if there were jobs. Combined with the loss of employment this year, that means we should be striving to create more than five million jobs.

links for 2008-11-30

• The Housing-Bubble and the American Revolution - NYTimes.com
• You’re Leaving a Digital Trail. What About Privacy? - NYTimes.com
• Industrial agglomeration and entrepreneurship - voxeu.org
• Rubin's Teflon Finally Wears Off - Felix Salmon
• Sometimes the refs really do suck - Economic Policy Review
• Why does unrest spread? - UnderstandingSociety
• Deflation Can Happen - knzn
• Changes in money-wages and Amity Shlaes - Paul Krugman
• Krugman vs. Shlaes–Not A Fair Fight - The Big Picture

The Need for Reliable Information

There has been much debate about whether the financial crisis is driven by lack of liquidity or from fears about lack of adequate capital and solvency, but I'm starting to think a third component is important as well, the complete breakdown of traditional information flows, and a loss of confidence in the models used to evaluate that information. Markets need information to work properly, and the information financial markets need is not available.

For example, investors can no longer trust what ratings agencies tell them. A crucial piece of information, information designed to break informational asymmetries between firms and investors, turned out to be unreliable. In addition, investors can no longer believe the numbers they see on bank books. The numbers might say the bank is solvent, but how reliable are those numbers?  And even if the numbers are meaningful today, will they be meaningful tomorrow? Is there any way to actually value the assets a lot of these banks have on their books when there is essentially no market for them, no way to engage in price discovery? Investors no longer trust analysts and the models they use. They watched the business channel dutifully and all they heard was about the gold mine in housing. Sure, there were a few voices on the other side, but they were in the minority and mostly marginalized. All that bullish advice about housing turned out to be wrong. And there's no reason investors should trust the models used to process information either. The models used for risk assessment turned out to be far wide of the mark - a costly deviation - and if you go back and look at the Fed's forecasts of coming economic conditions (or the forecasts coming from the regional banks), it's very clear the models were underestimating the severity and length of the downturn, enough so to be relatively useless. At a more individual, face to face level, I suspect their are many homeowners who believed what their real estate or mortgage broker told them are now wondering how they could have been so foolish. They won't believe them next time. They won't know what to believe.

As I think through each stage of the mortgage process and what has gone wrong, it seems to me that the traditional information flows that are needed for people to make economic decisions, especially risky ones, are no longer present, or if they are present, simply not believed. And without the information people need to make decisions, the markets freeze up.

It's the feeling you have when you suddenly discover that everything you thought you knew about something, something you believed and relied upon for years, is wrong (like when you find out something your parents told you just isn't so). Those are moments that can stop you in your tracks while you reevaluate and figure out what it all means, while you take time to figure out how you should respond in the future.

We have recognized that liquidity and solvency are problems, and we have directed policy to try to address those problems, but I am not sure we are devoting enough attention to repairing the collapsed information structure. You can get around the problem through government guarantees or other types of insurance, but those create other problems, so it's best to avoid this if possible. However, it's going to be difficult to convince people they can trust this information again, people won't easily believe a ratings agency, real estate agent, risk assessment model, etc. just because someone announces that the problems are all fixed now, models can't be repaired overnight, so on some fronts time may be the only real solution. But on other fronts, perhaps we can do better. This is not my area, so maybe what we can do is limited here too, but is there more that the government could do, for example, with accounting standards or required disclosures that would help people evaluate the stability of a particular institution? Are there changes that could be made to give buyers and sellers more confidence that the people acting as their agents in the transaction have the right incentives? Is there some way to immediately change the regulation and structure of the ratings agencies that can help to restore confidence in their assessments of risk? The point is that we need to move now to start repairing the problems that are limiting the availability of information needed for these markets to function.

Perhaps the most important thing the government could provide is confidence in bank balance sheets. There are lots of ways to do this, e.g. the government could purchase toxic assets through auctions, and the auctions would serve as value discovery mechanisms, the government could flood the banks with capital so that there was no doubt about their solvency, or it could simply put a price floor under some of the assets on the books, i.e. say that they stand ready to buy any and all of a particular class of asset at a pre-set price (heavily discounted). People could then put a lower bound on the value of the asset side of the balance sheet, and they wouldn't have to worry that the banks own actions or events outside the institutions control - an unanticipated failure of another bank that undermines a class of assets in its portfolio - won't suddenly change it's balance sheet position beyond a known amount. Somehow people need to be able to evaluate the bounds of the risks they are taking.

Big shocks don't necessarily shake the informational foundations of markets. There can be an event that occurs in the tail of the distribution of possible events that is viewed as just that, an unusual, costly event, but not one that fundamentally upsets our understanding of how the world works while at the same time undercutting the informational flows we use to understand these markets. I don't think the dot.com  crash, for example, caused us to question the reliability of the information we receive the way this episode has. After the crash, we still thought we understood how to use models to process reliable information. But this crisis has destroyed confidence in the information and the models we use, and it won't be easy to bring this back.

As noted above, while there may be some steps the government can take to help, solving this problem won't be easy, it will take time to repair the models and the information flows. That will eventually happen, but in the short-run the government must find some way around the problem. One way, the best way I can think of, is through insurance (e.g. the price floor above) and I hope we will see more movement along these lines. The deal with Citibank can be viewed as a step in this direction (there is a 29 billion dollar deductible and a 10% copay in the insurance they were provided - see the update at the end of this post), but more can be done - more must be done - to overcome the lack of reliable information in these markets.

"The Road to Depression"

Brad DeLong says two big mistakes made the crisis worse:

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying..., above all, to avoid a deep depression.

They have also had three subsidiary objectives:

• Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
• Prevent the princes of Wall Street ... from profiting from the systemic risk that they created.
• Ensure that homeowners and small investors do not absorb too much loss, for their only "crime" was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess...

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse... The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished...

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail...

In retrospect, this was a major mistake. ... With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion..., but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called "lemon socialism," creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

links for 2008-11-29

• Was the Great Depression a monetary phenomenon? - Paul Krugman
• Friedman, revisited - Free exchange
• William Kristol on Economic Theory and Practice - Econbrowser
• Markets Don't Make Bubbles, People Do - washingtonpost.com
• Consumers still adding leverage to income - News N Economics
• What Would Keynes Have Done? - NYTimes.com
• The Keynesian moment - Paul Krugman

Krugman: What to Do

More from Paul Krugman. This is from the New York Review of Books (there's much more in the original):

What to Do, by Paul Krugman, NY Review of Books: What the world needs right now is a rescue operation. The global credit system is in a state of paralysis, and a global slump is building momentum as I write this. Reform of the weaknesses that made this crisis possible is essential, but it can wait a little while. First, we need to deal with the clear and present danger. To do this, policymakers around the world need to do two things: get credit flowing again and prop up spending.

The first task is the harder of the two, but it must be done, and soon. Hardly a day goes by without news of some further disaster wreaked by the freezing up of credit. ...

Even if the rescue of the financial system starts to bring credit markets back to life, we'll still face a global slump that's gathering momentum. What should be done about that? The answer, almost surely, is good old Keynesian fiscal stimulus. ...

I believe not only that we're living in a new era of depression economics, but also that John Maynard Keynes—the economist who made sense of the Great Depression—is now more relevant than ever. Keynes concluded his masterwork, The General Theory of Employment, Interest and Money, with a famous disquisition on the importance of economic ideas: "Soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

We can argue about whether that's always true, but in times like these, it definitely is. The quintessential economic sentence is supposed to be "There is no free lunch"; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work. The true scarcity in Keynes's world—and ours—was therefore not of resources, or even of virtue, but of understanding.

We will not achieve the understanding we need, however, unless we are willing to think clearly about our problems and to follow those thoughts wherever they lead. Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.

Paul Krugman: Lest We Forget

Financial reform and regulation of the shadow banking system cannot wait:

Lest We Forget, by Paul Krugman, Commentary, NY Times: A few months ago I found myself at a meeting of economists and finance officials, discussing — what else? — the crisis. There was a lot of soul-searching going on. One senior policy maker asked, “Why didn’t we see this coming?”

There was, of course, only one thing to say...: “What do you mean ‘we,’ white man?”

Seriously, though, the official had a point. Some people say that the current crisis is unprecedented, but ... there were plenty of precedents... Yet these precedents were ignored. And the story of how “we” failed to see this coming has a clear policy implication — namely, that financial market reform ... shouldn’t wait until the crisis is resolved. ...

Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories?

Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world?

Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer ... is that nobody likes a party pooper. While the housing bubble was still inflating, lenders[, investment banks, and money managers] were making lots of money... Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?

There’s also another reason the economic policy establishment failed to see the current crisis coming. ... [T]he crisis of 1997-98... showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World”... who “prevented a global meltdown.” In effect, everyone declared ... victory..., while forgetting to ask how we got so close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears,... investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed ... prudential regulation of the financial system.

Now we’re in the midst of another crisis, the worst since the 1930s. For the moment, all eyes are on the immediate response to that crisis. ...

And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be ... regulating the “shadow banking system” at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost.

So here’s my plea: even though the incoming administration’s agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.

The Need for a Lender of Last Resort

How important is the lender of last resort role played by central banks?:

Financial markets and a lender of last resort, by Eric Hughson and Marc Weidenmier, voxeu.org: The recent subprime mortgage crisis raises serious questions about the role of a lender of last resort and the appropriate role of monetary policy. Academics, policymakers, and the financial press have debated the extent to which central banks should intervene in the marketplace, provide liquidity, and even purchase the non-performing assets of troubled financial institutions. Although economists, Washington insiders, and the media may debate the extent to which the lender of last resort function should be intensified in wake of the current financial market meltdown, proponents and opponents of monetary policy generally agree that it is very difficult to identify the effect of the lender of last resort function on financial markets.

Fortunately, history provides some insight into the importance of a lender of last resort in dealing with a financial crisis, especially the provision of liquidity by financial institutions to help cash-strapped firms in the short run. Following the Panic of 1907, which was accompanied by one of the shortest but most severe financial crises in American history, the US Congress passed two important pieces of legislation that established a lender of last resort: (1) the Aldrich Vreeland Act of 1908 which allowed banks to temporarily increase the money supply during a financial crisis, and (2) the Federal Reserve Act of 1913 which replaced Aldrich-Vreeland and established a public central bank in the US (Moen and Tallman, 2000).

The two acts were designed to increase the elasticity of the money supply, which was largely fixed by the supply of gold and the requirement that banks could only issue notes if they were sufficiently backed by US government bonds. The money supply was especially inelastic during the fall harvest seasons when the financial markets tended to be illiquid as cash moved from the money centre banks to the interior to finance the harvesting of crops. The financial stringency made New York financial market vulnerable to banking and financial crises in the fall as financial institutions were often forced to call in stock market loans in response to large unexpected withdrawals of cash in response to a greater than expected harvest season. Indeed, several of the largest financial crises of the National Banking Period (1870-1913) occurred during the fall harvest season including 1870, 1890, 1893, and 1907 (Kemmerer, 1910; Miron, 1986; Sprague, 1910).

links for 2008-11-28

• Radical Solutions For A Crazy Crisis - Roubini - Forbes.com
• Hoocoodanode? - Calculated Risk
• Rescue Plan Strained by Lack of Staff - WSJ.com
• Too many cooks in Obama’s economics kitchen - Willem Buiter
• The more the merrier - Econbrowser
• Dying of Consumption - Roach - NYTimes.com
• Thanksgiving: The Spin Statistics Theorem - Discover Magazine
• Shiller: Crisis May Run for `Years and Years' P1 - YouTube
• Climate change puts forests and people at risk - EurekAlert
• Recession vs inflation targeting - Stumbling and Mumbling
• How Geothermal Heat Pumps Could Power the Future - Yahoo! News
• India should hold a $1 trillion in foreign exchange reserves - voxeu.org
• The importance of pressing ahead with Doha - Comment is free
• Unorthodox monetary policy: Central banks as “stabilising speculators” - voxeu.org

Giving Thanks for Economists. Or Not.

Martin Wolf says " one of the big lessons of this experience is that economics is too compartmentalized":

A time for humility, Speech by Martin Wolf, FT: Last year I enjoyed telling a number of entirely unfair jokes about economists. This year, I looked at the same source and found only one joke about the profession’s involvement in depressions. Here it is:

Such a severe depression and banking crisis could not have been achieved by normal civil servants and politicians, it required economists’ involvement.

This, in short, is a time for humility. Why did we mostly get “it” so sensationally wrong? ... It is a pretty good question. It is a pretty embarrassing one, too. It is one everybody I meet now asks. ...

Perhaps this was more than could reasonably be expected. But I do think we need to ask ourselves whether we could have done a better job of understanding the processes at work.

The difficulty was that we all tend to look at just one bit of the clichéd elephant in the room. Monetary economists looked at monetary policy. Financial economists looked at risk management. International macroeconomists looked at global imbalances. Central bankers focused on inflation. Regulators looked at Basel capital ratios and even then only inside the banking system. Politicians enjoyed the good times and did not ask too many questions. And what of commentators? Well, they tended to indulge in the fantasy that the above knew what they were talking about. I am embarrassed to admit this.

I am not seeking to deny that a few people saw important pieces of the emerging puzzle and some saw more than a few pieces. ... But I would insist that one of the big lessons of this experience is that economics is too compartmentalised and so, too, are official institutions. To get a full sense of the risks being run, we needed to combine the worst scenarios of each sets of experts. Only then would we have had some sense of how the global imbalances, inflation targeting, the impact of China, asset price bubbles, financial innovation, deregulation and risk management systems might interact.

Alternatively, we could have spent more time studying the work of Hyman Minsky. We could also have considered the possibility that, just as Keynes’s ideas were tested to destruction in the 1950s, 1960s and 1970s, Milton Friedman’s ideas might suffer a similar fate in the 1980s, 1990s and 2000s. All gods fail, if one believes too much. Keynes said, of course, that “practical men … are usually the slaves of some defunct economist”. So, of course, are economists, even if the defunct economists are sometimes still alive.

These might seem idle thoughts: these errors are now bygones. But what if we are now making new and even bigger errors in rushing back to Keynes? The thought worries me. What if now that households in the US and UK are no longer able, or willing, to borrow any more, we are set on breaking the back of taxpayers, instead? Is the end of this crisis the destruction of the credit of some of the world’s most creditworthy governments? It is a thought I would like to suppress. But it haunts me. It should haunt you, too. ...

One might not expect much from economists, but one would surely expect them to warn us of a crisis on this scale. Some humility is in order. That is going to hurt. A humble economist? Surely not.

links for 2008-11-27

• The financial meltdown is an academic crisis too - voxeu.org
• $7.8 Trillion and Counting - The Baseline Scenario
• Gold Standard Does Not Always Bring Credibility - NBER
• Are Useful Projects Really Better than Useless Ones? - knzn
• Obama Picks Volcker to Head New Economic Panel - NYTimes.com
• The (Tuna) Tragedy of the Commons - NYTimes.com
• Food Prices Expected to Keep Going Up - NYTimes.com
• The Return of Larry Summers - NYTimes.com

"The Moral Stage of Wall Street"

George Packer wants Wall Street executives to grow up and apologize for their behavior:

The Moral Stage of Wall Street, by George Packer: Swiss bankers are not known as paragons of transparency and moral accountability, so it’s a nice surprise to read that the top officials of UBS, the foundering financial institution recently bailed out by the Swiss government, will forgo twenty-seven million dollars in compensation and bonuses. It appears that these Swiss bankers have a faint pulse of shame.

It has not gone remarked upon enough that their American counterparts apparently have none. Having brought the American and global economy to its knees through their reckless, short-sighted, downright stupid investments, and then looked to the government for a very expensive lifeline, the leaders of Citigroup, A.I.G., Goldman Sachs, Morgan Stanley, Lehman, and other financial giants are maintaining a carefully nonchalant public posture. Andrew Cuomo, New York’s Attorney General, had to hold a threatening press conference on Wall Street in order to frighten A.I.G. into announcing that raises, bonuses, and lavish retreats will be suspended. But fear is not the same thing as shame. Morally speaking, it’s inferior.

The moral code of these Wall Street executives corresponds to stage one of Lawrence Kohlberg’s famous stages of morality: “The concern is with what authorities permit and punish.” Morally, they are very young children. The Swiss bankers are closer to stage four, most common among late teens, where a concern for maintaining the good functioning of society takes hold. Stage six, an elaboration of universal moral principles based on an idea of the good society, is a distant dream for the titans of global finance.

In private life, extreme indebtedness, bankruptcy, the ruin of those close to you, and dependence on the government dole are generally thought to be causes for anguish, self-denial, and a degree of shame. But if you’re a financial executive with an exalted title, a big enough salary, a deep enough debt, and a vast enough handout, these same disasters entitle you to go on living and feeling about yourself much as you did before. You even have a right to think that the taxpayers owe it to you—that it’s for their own good, not yours. You don’t have to explain yourself; you certainly don’t have to apologize.

I would like to see these malefactors of great wealth apologize to the country. I would like to see them organize their own press conference in a lineup on Wall Street and, in the manner of disgraced Japanese officials, bow low to the pavement, express contrition, and beg their countrymen’s forgiveness. Such a scene would go some way toward cleansing the smell of the financial crisis.

Of course, nothing like this is going to happen. So instead, like the parents of two-year-olds, the next Congress should summon them to Washington and publicly punish these executives who, in Kohlberg’s terms, “see morality as something external to themselves, as that which the big people say they must do.”

Update: Arnold Kling comments:

I tend to agree with Tyler Cowen that individual moral propensities are less important than overall social context. To borrow from a different branch of social psychology, I would say that Packer is committing the Fundamental Attribution Error.

In my view, the problem comes from trying to use what I call letter-of-the-law regulation in finance. Call it L regulation. With L regulation, the regulator lays down specific, quantitative boundaries (think of risk-based capital requirements, with fixed numerical weights for various types of assets). The managers of financial institutions are told to stay within those boundaries.

In contrast, think of something I might call S regulation, for spirit of the law. With S regulation, the manager of a financial institution that enjoys some government protection would take an oath to maintain the safety and soundness of the institution. With S regulation, it is wrong to just tiptoe along the edge of the quantitative boundaries, without considering the potential risk to the firm.

Suppose we take it as given that government is going to protect some of the liabilities of some institutions, because of deposit insurance, implicit guarantees, "too big to fail," or other reasons. I would like to see such institutions be covered by S regulation even more than by L regulation.

I would like to see managers of government-protected institutions take an oath to safeguard the soundness of their companies. I would like to see them subjected to prison terms for violating that oath. The oath is a general promise, not satisfied simply by staying within the boundaries of L regulation.

I believe that S regulation would change the motives of bank managers. They would be looking for ways to avoid failure, rather than for ways to stay within the letter of the law.

There can be plenty of risk-taking institutions in our society. But they should not at the same time be institutions that enjoy government protection when they fail.

"The Rebirth of Keynes, and the Debate to Come"

Robert Reich on the question of tax cuts versus government spending as a stimulus measure:

The Rebirth of Keynes, and the Debate to Come, by Robert Reich: The economy has just about come to a standstill... Consumer spending has fallen off a cliff. Investment is drying up. And exports are dropping because the recession has now spread around the world.

So are we about to return to Keynesianism? Hopefully. Government is the spender of last resort, which means the new Obama administration should probably be considering a stimulus package in the range of $600 billion, roughly 4 percent of national product -- focused on building and repairing the nation’s crumbling infrastructure, providing help to states to maintain services, and investing in new green technologies in order to wean the nation off oil.

But between now and late January, when the stimulus package will be voted on, we're likely to be treated to a great debate over the wisdom of Keynesianism. ...

Conservative supply-siders ... will call for income-tax cuts rather than government spending, claiming that people with more money in their pockets will get the economy moving again more readily than can government. They're wrong, too. Income-tax cuts go mainly to upper-income people, and they tend to save rather than spend.

Even if a rebate could be fashioned for the middle class, it wouldn't do much good because, as we saw from the last set of rebate checks, people tend to use extra cash to pay off debts rather than buy goods and services. Besides, individual purchases wouldn't generate nearly as many American jobs as government spending on infrastructure, social services, and green technologies, because so much of we as individuals buy comes from abroad.

So the government has to spend big time. The real challenge will be for government to spend it wisely -- avoiding special-interest pleadings and pork projects such as bridges to nowhere. We’ll need a true capital budget that lays out the nation’s priorities rather than the priorities of powerful Washington lobbies. How exactly to achieve this? That's the debate we should be having between now and January 20 or 21st.

Fed Intervention: Managing Moral Hazard in Financial Crises

"Moral hazard has its costs, but it also has its benefits":

Fed Intervention: Managing Moral Hazard in Financial Crises, by Harvey Rosenblum, Danielle DiMartino, Jessica J. Renier and Richard Alm, Economic Letter, FRB Dallas: Editor’s note: Federal agencies and regulators have taken decisive steps to combat the financial crisis that began in the summer of 2007 and continued into the fall of this year. This Economic Letter focuses on key Federal Reserve actions through early October.

At the end of September 2008, U.S. policymakers had been working for more than a year to contain the shock waves from plunging home prices and the subsequent financial market turmoil. For the Federal Reserve, the crisis has given new meaning to the adage that extraordinary times call for extraordinary measures. The central bank has dusted off Depression-era powers and rewritten old rules to address serious risks to the global financial system.

The spreading financial crisis has led the Fed to pump liquidity into the economy and expand its lending beyond the commercial banking sector. In March, it assisted with J.P. Morgan Chase’s buyout of Bear Stearns, a cash-strapped investment bank and brokerage. Six months later, the Fed took direct action again, with an $85 billion bridge loan to prevent the disorderly failure of American International Group (AIG), a giant global company heavily involved in insuring against debt defaults.[1]

These Fed actions—part of a broader U.S. government effort to contain the financial crisis—call to mind two earlier financial interventions: in the case of Long-Term Capital Management (LTCM) in 1998 and in the aftermath of the Sept. 11, 2001, terrorist attacks.

In both episodes, the Fed felt compelled to protect the financial system from severe shocks and the overall economy from spillovers that might produce serious downturns. Inherent in the Fed’s moves was a natural by-product of intervention—moral hazard and the controversy that flows from it.

Concern about moral hazard helps explain why the Fed has traditionally intervened only rarely and reluctantly, trying to do what’s necessary, but as little as necessary, to achieve financial stability. Markets generally should and do self-correct. When potential financial problems arise, the Fed’s default reaction has usually been to do nothing and let the markets work their way through the difficulties.

On rare occasions, however, the markets themselves are at risk of failure. In such cases, the Fed can’t fulfill its obligation to promote financial stability without direct action. Two factors have strengthened the case for central bank intervention in the past decade—the financial system’s increased globalization and the untested nature of the new and complex financial instruments that have come under stress.

The escalation of what’s now recognized as a global financial crisis has changed the modus operandi of Fed interventions. The guiding principle of do what is necessary, but as little as necessary, has been replaced by the recognition—reinforced by actions—of the importance of doing whatever it takes to break the downward spiral in the financial and credit markets that has contaminated the overall economy. With a broad understanding of the consequences of inaction, the Fed has taken a hard turn toward intervention in an atmosphere in which fear of moral hazard has been displaced by the reality of systemic risk’s unacceptable consequences.

Why Did Forecasters Missed the Crisis?

Dean Baker will wonder why he was left off this list:

The vision thing, by Chris Giles, Commentary, Financial Times: It has been a bad year for economic forecasters. So bad that royalty wants to know what went wrong. “Why did no one see it coming?” Britain’s Queen Elizabeth asked during a visit to the London School of Economics this month. ...

Though there is great entertainment in looking back at the silly things e