sheer hypocrisy of many Congressional Republicans who, having never uttered a peep about the huge deficits under George W. Bush

TO BE NOTED: From the NY TIMES:

"It’s No Time to Stop This Train

By ALAN S. BLINDER

CONTRARY to what you may have heard from some doomsayers, 2009 is not 1930 redux. What we must guard against, instead, is 2010 or 2011 becoming another 1936.

Realistically, there is little danger that the economy is heading toward a repeat performance of the Great Depression — when real gross domestic product in the United States declined 27 percent and unemployment soared to 25 percent. What we have is bad enough: our worst recession since the 1930s. But unless our leaders behave unbelievably foolishly, we will not repeat the tragic slide into the abyss of 1930 to 1933 — for two main reasons.

First, our economy has many built-in safeguards that did not exist back then — like unemployment insurance, Social Security and federal deposit insurance, to name just three. These programs serve as safety nets that cushion the fall. And while they are certainly not strong enough to prevent recessions, they should be enough to prevent another depression.

The more important reason is that Barack Obama, Timothy F. Geithner and Ben S. Bernanke are not Herbert Hoover, Andrew Mellon and Eugene Meyer. (Who’s that? Mr. Meyer was the Federal Reserve chairman from September 1930 to May 1933.) In stark contrast to the laissez-faire crowd that ruled the roost in 1930 and 1931, our current economic leaders are not waiting for the sagging economy to right itself. Rather, they have taken numerous extraordinary steps already — and stand ready to do more if necessary.

That’s the good news. But even if another depression is next to impossible, there is still the danger that next year, or the year after, might turn into 1936. Let me explain.

From its bottom in 1933 to 1936, the G.D.P. climbed spectacularly (albeit from a very low base), averaging gains of almost 11 percent a year. But then, both the Fed and the administration of Franklin D. Roosevelt reversed course.

In the summer of 1936, the Fed looked at the large volume of excess reserves piled up in the banking system, concluded that this mountain of liquidity could be fodder for future inflation, and began to withdraw it. This tightening of monetary policy continued into 1937, in a weak economy that was ill-prepared for it.

About the same time, President Roosevelt looked at what seemed to be enormous federal budget deficits, concluded that it was time to put the nation’s fiscal house in order and started raising taxes and reducing spending. This tightening of fiscal policy transformed the federal budget from a deficit of 3.8 percent of G.D.P. in 1936 to a surplus of 0.2 percent of G.D.P. in 1937 — a swing of four percentage points in a single year. (Today, a swing that large would be almost $600 billion.)

Thus, both monetary and fiscal policies did an abrupt about-face in 1936 and 1937, and the consequences were as predictable as they were tragic. The United States economy, which had been rapidly climbing out of the cellar from 1933 to 1936, was kicked rudely down the stairs again, and America experienced the so-called recession within the depression. Real G.D.P. contracted 3.4 percent from 1937 to 1938; the total G.D.P. decline during the recession, which lasted from mid-1937 to mid-1938, was even larger.

The moral of the story should be clear: Prematurely changing fiscal and monetary policies — from stepping hard on the accelerator to slamming on the brake — can be hazardous to the economy’s health.

Wow, we’ve learned a lot since the ’30s, right? Well, maybe not. For the echoes of 1936 are being heard right now, even before the current recession hits bottom.

If you’ve been paying attention, you know that a number of critics of the Fed are sounding alarms over the huge stockpile of excess reserves it has created — more than $775 billion at last count. What these critics are fretting about now is exactly what goaded the Fed into action in 1936: that the vast pool of loose money will ultimately be inflationary. The clear inference is that some of it should be withdrawn before it’s too late.

On the fiscal side, many of President Obama’s critics are complaining vociferously about the huge federal budget deficits. Try to ignore, if you can, the sheer hypocrisy of many Congressional Republicans who, having never uttered a peep about the huge deficits under George W. Bush, are suddenly models of budget probity. But whatever the motives, the worries of today’s deficit hawks sound eerily reminiscent of Roosevelt in 1936 and 1937.

FORTUNATELY, Mr. Bernanke is a keen student of the Great Depression who will not allow the Fed to repeat the errors of 1936-37. But his critics, both inside and outside the Fed, are already branding his policies as dangerously inflationary, and no Fed chairman wants to be called an inflationist.

Similarly, I hope and believe that President Obama will not transform himself from the spendthrift Roosevelt of 1933 to the deficit-hawk Roosevelt of 1936 — at least not until the economy is back on solid ground. That said, a growing flock of budget hawks are already showing their talons. They will have their day — but please, not yet.

To avoid a replay of the policy disasters of 1936-37, both the Fed and our elected officials must stay the course. Mark Twain once explained that, while history does not repeat itself, it often rhymes. We don’t want any rhymes just now.

Alan S. Blinder is a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve. He has advised many Democratic politicians."

It is almost a zero-sum game: the government or the bondholders?

TO BE NOTED: From the NY Times:

"Talking Business
Same Data, Conflicting Forecasts

By JOE NOCERA

So where were we?

In the month since I last wrote in this space, there has been a surge of financial optimism. Banks that are supposed to be in deep trouble have reported profits (though there were a few too many accounting gimmicks for my taste). Some of them, like Goldman Sachs and JPMorgan Chase, are talking about wanting to give back their government bailout money. Bank stocks, moribund not so long ago, have been rising a bit. Other economic indicators suggest that, if the economy hasn’t exactly turned around, at least the pace of decline is slowing. There has been talk of “green shoots” from the Federal Reserve chairman, Ben Bernanke, and “glimmers of hope” from President Obama.

So perhaps the better question to ask this week is where are we? Can we come out of our financial fallout shelters yet, or are there more economic bombs still to drop? Will the results of the stress tests, due out next week, make things better or worse? Have the Obama administration and the Federal Reserve managed to stop the bleeding? Can we start breathing a little easier?

Because Wednesday was the 100th day of the Obama presidency, you could scarcely turn around without bumping into people at a conference or symposium asking, more or less, those same questions. This week, I dropped in on a few of them.

•

Wednesday morning, the Regency Hotel, New York. A liberal group called the Franklin and Eleanor Roosevelt Institute is holding a breakfast in which the featured speakers are the Columbia University economist (and Nobel laureate) Joseph Stiglitz, the M.I.T. economist (and Nobel laureate) Robert Solow, and the former Senate Banking Committee chief economist, Robert Johnson.

Mr. Stiglitz, though a supporter of the president, has been a vocal critic of the administration’s response to the banking crisis, and he doesn’t let up here. “Obviously, I think there is a better way to deal with the crisis,” he says. “Banks made bad loans, and the question is: who is going to pay for those losses? It is almost a zero-sum game: the government or the bondholders?”

He goes on to suggest that the government should stop trying to protect bondholders and instead force them to convert their debt into equity. This would help bolster the banks’ capital without tapping any further into taxpayers’ funds. It is also an idea that the Treasury Department stiffly opposes, fearing that it will create a new round of bank panic, and make it even harder for banks to raise private capital.

Mr. Solow, meanwhile, criticizes the stimulus package as too small. “The drop in consumer spending was too big, and probably couldn’t be filled with a good $800 billion package, and this one was festooned with things that weren’t going to stimulate spending soon.”

Later, at a brief press conference, I ask Mr. Stiglitz how he would grade the new administration’s efforts. To my surprise, he says, “Compared to what went before, I would say it’s an A plus plus.” Then he lapses back into his complaint about the administration’s coddling of bondholders. I then put the same question to Mr. Solow, who says he thinks the administration has done “extraordinarily well” — and then complains that it should be doing more for individual homeowners. Do they really mean it? Or is that “A plus plus” a form of political grade inflation?

•

Wednesday afternoon, the Princeton Club, New York. The American Society of Magazine Editors is holding a luncheon panel on the financial crisis, with Allan Sloan of Fortune, Mark Zandi of Moody’s Economy.com, and, er, me. Mr. Zandi is practically overflowing with optimism. “I think the totality of the policy response has been excellent,” he tells me after our panel has finished. “Aggressive. Creative. With a few tweaks it will ultimately work.” He predicts that the stimulus will kick in this summer — though he says that he would have favored a tax holiday. (“If they had eliminated the payroll tax for the second half of 2009,” he says, “it would have been a tremendous boost for both employers and employees.”) He sees a “massive refinancing boom” under way, which will save homeowners $25 billion on mortgage costs, and might prevent a few foreclosures. He thinks the stress test results — according to news accounts, six banks will require more capital — will bring about renewed confidence in the banking system because we’ll finally be able to see what the truth is. He thinks Treasury Secretary Timothy Geithner “has found his footing.”

On the way home, I pick up the latest copy of The Economist. It warns against “the perils of optimism,” and suggests that if we become too complacent about the prospect of better times, it will “hinder recovery and block policies to protect against a further plunge into the depths.” Sigh.

•

Thursday morning, Drexel University, Philadelphia. A group called the Global Interdependence Center is holding a half-day conference on the financial crisis. First up, Christopher Whalen of Institutional Risk Analytics. He has been a scathing critic of the banks. “My friends are all telling their clients the worst is over, it is time to buy,” he says. “My response is: what are you buying?”

He adds that bondholders need to take some pain, and echoes Mr. Stiglitz’s proposal to make the bondholders convert their debt to equity. A month ago, nobody was talking about this. Now it has become the idea du jour.

Nancy A. Bush, a longtime bank analyst, says that the Troubled Asset Relief Program is “the most destructive thing I have ever seen. The government has ensured mediocrity in the banking industry. It has done enormous damage in the eyes of investors, who are no longer sure that a bank is a safe investment anymore.” She calls it the TARP Trap.

Just then, the moderator takes the stage to announce that Chrysler has filed for bankruptcy. So much for optimism.

Next panel: Robert A. Eisenbeis of Cumberland Advisors gives a talk titled “Are things really that bad?” His answer is, no. “We are far from the Great Depression,” he declares, and he has the charts to prove it. When measures like gross domestic product and corporate profits are charted against other recessions, this one looks pretty bad. But when they are charted against the Great Depression, they look like a piffle. In the depths of the Depression, for instance, G.D.P. dropped by a staggering 50 percent, compared with the current drop of 2 percent or so. “The people who are fear-mongering are not looking at the data,” Mr. Eisenbeis concludes.

He is followed by a funny, fast-talking woman named Diane Swonk, the chief economist at Mesirow Financial. “We’ve gone from a sense of free fall in the fourth quarter of 2008 to a point where we have pulled the ripcord and the parachute has opened. But we don’t know where we are going to land, or whether it is going to be in enemy territory,” she says. “There are three areas where consumer spending has increased,” she remarks at another point. “Guns. Condoms. And alcohol.” In between jokes, she says the deleveraging of America is going to be a painful process.

Finally, the former St. Louis Federal Reserve president William Poole, now a senior fellow at the Cato Institute, gives a keynote speech arguing “too big too fail” is a concept that has done enormous harm. He wants to see some market discipline imposed on the banks — so that if they mess up again, we won’t have to come to their rescue. Who can disagree?

•

Thursday evening, the Metropolitan Museum, New York. The big guns are out tonight, on a panel sponsored by The New York Review of Books and PEN World Voices: Niall Ferguson of Harvard, Paul Krugman of Princeton (and The New York Times), Nouriel Roubini of New York University, former Senator Bill Bradley and George Soros, among others. The Met’s big auditorium is packed.

This is doom-and-gloom central. Lots of talk about zombie banks, failures to understand history, regulatory foolishness. Mr. Bradley, who speaks first, suggests that if the government’s plan to save the banks doesn’t work, it should simply buy Citibank — “its current market cap is about $17 billion,” he said — clean it up, and spin it off to the American people in a rights offering. Mr. Ferguson, a provocative historian, keeps saying that the United States is becoming akin to a Latin American economy: “At what point do people stop believing in the dollar as a reserve currency?” he asks ominously.

“The scale of the crisis has overwhelmed the response,” Mr. Krugman says. To the extent there are green shoots, he added, “it means that things are getting worse more slowly.” Mr. Roubini practically scoffs at the notion that we might see positive economic growth in the second half of the year. Mr. Soros says that “we are currently facing a deflationary situation. But when credit restarts, the fear of deflation will be replaced by fear of inflation, and there will be pressure for interest rates to rise.” Something to look forward to, I suppose.

I can’t say that I left the Metropolitan Museum with any more clarity than when I began my little symposia tour. I’d heard some good ideas, and cheery news among the dire forecasts. What it did cause me to realize is that all these smart economists and forecasters are looking at the same set of data, and coming to radically different conclusions based on their politics, their temperament and their idiosyncratic reading of history. Just like the rest of us.

Next week, the results of the stress tests will be unveiled, and we’ll see it all over again. Some of the same people I saw on stage this week will say the tests are a whitewash, while others will claim that they’re an important step on the road to recovery. Both sides will marshal persuasive data and strong arguments, providing plenty of fodder for the next round of conferences.

At least that much is certain."

During most of our lifetimes, the prices of things we buy have generally increased over time.

From Casey Mulligan:

"Deflation – Let’s Not Try That Again!

Copyright, The New York Times Company

The Great Depression years 1929-33 featured a large and prolonged deflation. January 2009 reversed a deflation pattern for 2008 that was ominously similar to 1929’s.

During most of our lifetimes, the prices of things we buy have generally increased over time. We can name some exceptions, such as toys over the last decade and computer equipment over the last couple of decades, but otherwise most items (even houses) have prices that are higher now than they were ten, twenty, or thirty years ago.

This general increase in consumer prices – often called inflation – has become familiar. Employees expect regular pay raises, and employers can normally afford them because they are increasing the prices of the products they sell.

Just as important, familiarity with inflation comforts lenders who offer loans to consumers and businesses under assumption that those borrowers will tend have incomes that rise together with all other prices. That is, lenders typically arrange for repayment at regular intervals in specific dollar amounts – such as the regular monthly payment on a home mortgage – and inflation helps borrowers “grow into” their loan payments.

On rare occasions, consumer price trends suddenly change directions.

Nineteen twenty-nine was one of those occasions. Consumer prices were pretty constant during the 1920s. The chart below picks up the story in January 1929 with the red line. That line measures the (seasonally unadjusted) consumer price index in each month through July 1930, normalized so that October 1929 is 100 (for example, the value of 97.9 in April 1929 means that prices then were 2.1 percent lower than they would be in October).



Prices were heading up in the spring and summer of 1929, during which time lenders might have expected that the typical home owner would obtain a pay raise and the typical farmer would someday fetch more for his crops – in both cases making it easy to pay back their respective mortgages.

In the fall of 1929, the inflation stopped (incidentally, the stock market crashed in late October of that year) and prices headed down, falling almost every month for almost four years. By the spring of 1933, this deflation brought prices down almost 50 percent from their 1929 peak. It was difficult for homeowners and farmers to make their mortgage payments when their paychecks had been cut in half.

The blue series in the chart shows the consumer price index for 2008 and 2009. Like the 1929 series, the 2008 series is normalized so that October is 100.

The chart shows how consumer prices also rose in the spring and early summer of 2008. Inflation had stopped by the fall (there was a stock market crash in October 2008, too), and consumer prices headed down. In fact, the deflation at the end of 2008 brought prices down more than four percent in a couple of months, as compared to the one percent drop at the end of 1929.

Price reductions since the summer of 2008 have been credited to declines in prices of commodity– such as fuel and food. That’s not the whole story, because other prices (notably housing prices) were falling in 2008. Moreover, the role of commodity prices adds to the similarity between 1929 and 2008, because commodity prices were falling in 1929-33 too.

If the Great Depression consumer price parallel were to continue beyond 2008, we would be in for a sustained deflation until the year 2012. At that point, with most borrowers earning less than half of what they were when they applied for the loan, today’s mortgage problems would seem minor. Thus, January’s C.P.I. report released on Friday was a welcome return to something familiar: inflation.

Posted by Casey B. Mulligan at 5:06 AM "

Me:

Don said...

You're correct. One of the main reasons that Deflation is a disaster is that it's disorienting, and causes people to panic, as if they're in a foreign and unfriendly landscape with no way out. It's a panic magnifier.

Don the libertarian Democrat

February 25, 2009 8:14 AM

"The real threat to capitalism and democracy, however, is depression and unemployment"

From the FT comes some Burkean sense:

"Is your recession really necessary?

Published: January 2 2009 18:53 | Last updated: January 2 2009 18:53

What a bleak midwinter. It is still hard to see where any green shoots of recovery will break through the permafrosted ground. The recession seems especially unnerving given the length and scale of the good times which preceded it – years in which the current malaise was brewed. It is, therefore, tempting to believe that the world deserves and needs recession to pay for those excesses and to rid ourselves of our unnecessary indulgences. This view, however, is wrong( I AGREE ).

In the past few years, the world economy stumbled out of kilter. House prices were unsustainably bloated by cheap money( NO. POOR LENDING PRACTICES. ). Deficit countries, such as the UK and the US, borrowed frantically to sustain their consumption. Surplus countries, such as China and Germany, grew rich by sating their bingeing. ( THIS WAS THE SYSTEM. REPLACING IT WILL BE HARD WITHOUT SOME SOCIAL DISLOCATIONS. )

These imbalances had been allowed to grow to enormous sizes, nourished by dangerous financial magic. Mortgage straw was not respun, but rather packed into bails and relabelled as triple-A gold( NONSENSE. IT WAS FRAUD, NEGLIGENCE, FIDUCIARY MISMANAGEMENT, AND COLLUSION. ). The financial services industry engorged itself, ran up large profits and paid its staff huge bonuses( AND COMMITTED... ). But the pro-cess also contributed handsomely to government budgets( A HYBRID ) and created enormous demand.

Having lived beyond our means( THIS IS SILLY. ), some economists, notably disciples of the Austrian School, would say that we need recession( WE NEED SOCIAL DISLOCATION AS WELL I SUPPOSE. ). The “malinvestment” of the past few years must be liquidated away. The inefficient, along with charlatans and fraudsters, must be exposed. In 1934, during the Great Depression, Ludwig von Mises wrote that policymakers should have been “raising the rate of interest and restricting credit and so giving free play to the purging process( IT'S LIKE A COLONIC. ) of the crisis”.

To von Mises, policy that aimed to “bolster up undertakings that would otherwise have succumbed to the crisis, and on the other hand to give an artificial stimulus to economic life by public works schemes ... eliminated just those forces which in previous times of depression have ... paved the way for recovery( AND REVOLUTION )”.

Such liquidationism makes a fine morality tale: you reap what you sow. It should be little surprise that many prominent members of the Austrian School – and most of its key adherents – are and were socially conservative. But it took the genius of a man whose inhibitions were informed by life in the Bloomsbury Set to fully explain why this is so very wrong.

One of John Maynard Keynes’ great insights was to understand how, in a crisis, demand would not necessarily fall back to the desired sustainable level. If all market actors pull in their horns( A PANIC ), the result is the paradox of thrift: demand will dry up, and economic activity will crack and crumble with it. Crisis will certainly arrive, and it may not leave. Once demand has evaporated, economies can slide into a low-employment, low-growth equilibrium. Governments must respond by supporting demand with loosened monetary and fiscal policy( TRUE ).

These weapons are slow-acting blunderbusses; they do not allow for rapid responses or fine-tuning. But they are preferable to von Mises’ harsh prescription, which could deepen the recession. It is not possible to liquidate the malinvestment without risking allowing unemployment to spiral out of control and demand to fall with it. Such a plan would be less a healthy purgative, and more an acid bath( VERY TRUE ).

Businesses can, and should, still fail( TRUE ). Politicians must not subsidise existing companies( THEY WILL ). Nor should they seek to prevent necessary( ? ) adjustments which must take place. If this is what John Maples, the UK conservative MP meant when he said the “recession has to take its course”, then he is right. But governments must work together, internationally, to sustain demand. They must not sit idly by.

The allure of the Austrian story lies in its devotion to the free market. The real threat to capitalism and democracy, however, is depression and unemployment( AND REVOLUTION AND TOTALITARIANISM ). It is not countercyclical fiscal policy."

"When it comes to macroeconomic stimulus measures, however, policy is in disarray. "

Richard Baldwin on Vox:

"No one knows exactly how to stop the global economic crisis, but all agree that fiscal stimulus has a key role to play( NOT EVERYONE ). By reducing the length and depth of the recession, it should reduce bankruptcies, foreclosures, and further asset-price drops( THAT'S THE HOPE ). This column presents the main logic in a recent IMF paper authored by one of the world’s leading macroeconomists, Oliver Blanchard, and others.

There is near consensus among economists that fixing the world’s economy will involve at least these two steps:( 1 ) repairing the financial sector, and( 2 ) restarting economic growth. When in comes to financial sector policies, governments are already “on the case”. Much more surely needs to be done but governments are already deploying( PLEASE STOP ) all the policies( YEP. THAT'S HOW WE DO THINGS ON PLANET EARTH, AS OPPOSED TO PLANET THEORY. ) that eventually fixed every financial crisis since the dawn of the financial sector.

When it comes to macroeconomic stimulus measures, however, policy is in disarray( EXCEPT FOR THE MILDLY HELPFUL IDEA THAT KEYNES IS BACK IN VOGUE ). The US, UK and Japan have committed to fiscal stimulus, but other nations, such as Germany, don’t see the urgency of the situation – or, according to a more cynical interpretation – are hoping to free ride on the fiscal stimulus of others( THE SAVER COUNTRIES DO NOT WANT TO END THE CURRENT SAVER/SPENDER SYMBIOSIS. THE FREE RIDE IS TRYING TO GET OUT OF THIS CRISIS WITHOUT THE SYMBIOSIS COMING APART. ). Indeed, some economists question fiscal policy’s effectiveness.( TRUE )

The IMF’s paper on fiscal policy in the crisis

Given the lack of clarity on fiscal policy, the IMF paper released on 29 December 2008, “Fiscal Policy for the Crisis”, presents some very welcomed words of wisdom. Written by one of the world leading macroeconomists – Olivier Blanchard (who also happens to be the IMF’s chief economists) – with 3 coauthors, the report distils the lessons of five of the most relevant crises, namely the( 1 ) Great Depression,( 2 ) the Japanese 1990s banking crisis,( 3 ) the 1997 Asian crisis,( 4 ) the US 1980s S&L crisis, and the( 5 ) 1990s Nordic crisis.( DIDN'T ROGOFF AND REINHART SURVEY 800 YEARS? )

Why the drop in aggregate demand?

The paper starts by reminding us that there are indications that this recession could be deeper than any since the Great Depression. The sources of the decline in aggregate demand are:

· Drops in real and financial wealth( FROM THE FORECLOSURE AVALANCHE AND CALLING RUN );

· An increase in precautionary saving( FEAR AND AVERSION TO RISK ) on the part of consumers,

· A wait and see attitude on the part of both consumers and firms( FEAR AND AVERSION TO RISK ); and

· Increasing difficulties in obtaining credit( FEAR AND AVERSION TO RISK ).

Things that won’t work

The specific features of this crisis mean that two of the standard anti-crisis macro tools are ineffective.

· The global synchronisation of recession means export-promotion policies – such as devaluations ( DON'T EXACTLY AGREE. PRINTING MONEY MIGHT HELP. )– cannot work for the major economies (and they risk making thing much worse if the ‘echo chamber’ of beggar-thy-neighbour policies starts resonating). ( GOOD LUCK. IT'S HAPPENING )

· The financial source of the crisis weakens the link between policy rates and banking lending – thus rending the traditional( YES. WE'VE TRIED THAT. ) monetary transmission mechanism much less effective.

In any case, key nations have very little room to lower policy rates, so fiscal policy is the best last policy option for avoiding a deepening of the recession which could well exacerbate the financial sector crisis.

Optimal fiscal policy in the crisis

Based on lessons extracted from past crises, the IMF argues that fiscal stimulus should be

· Timely (as there is an urgent need for action),( TRUE )

· Large (because the drop in demand is large),( TRUE )

· Lasting (as the recession will likely last for some time),( NOT SO SURE )

· Diversified (as there is uncertainty regarding which measures will be most effective),( OK )

· Contingent (to indicate that further action will be taken, if needed),( OK )

· Collective (all countries that have the fiscal space should use it given the severity and global nature of the downturn), and( HERE THERE'S A PROBLEM. )

· Sustainable (to avoid debt explosion in the long run and adverse effects in the short run).( TRUE )

The challenge facing each national government is to gauge the right balance between these features – particularly, large-and-lasting actions versus fiscal-sustainability.

Lessons from earlier crises

The IMF paper provides a survey of five well‑known crisis: Korea in 1997, Japan in the 1990s, the Nordic countries in the early 1990s, the Great Depression in the 1930s, and the US during the Savings and Loans crisis in the 1980s.

Countries have reacted to these downturns quite differently, thus providing us with some evidence on how best to manage fiscal policy in a crisis. The key lessons are:

· Successful resolution of the financial crisis is a precondition for achieving sustained growth.( MAKES SENSE )

The counter-example is Japan where fiscal policy failed because financial sector problems were allowed to fester. By contrast, prompt and sizeable support to the financial sector by the Korean authorities limited the duration of the macroeconomic consequences thus limiting the need for other fiscal action.

· The solution to the financial crisis always precedes the solution to the macroeconomic crisis.( OK )

· A fiscal stimulus is highly useful (almost necessary) when the financial crisis spills over to the corporate and household sectors with a resulting worsening of the balance sheets.( OK )

· The fiscal response can have a larger effect on aggregate demand if its composition takes into account the specific features of the crisis( THIS I AGREE WITH ).

In this regard, some of the tax and transfer policies implemented early in the Nordic crises did little to stimulate output.

Composition of a fiscal stimulus

Governments around the world are struggling with how to apply fiscal stimulus. The IMF’s analysis points out two features of the crisis that are important when thinking about the nature of the fiscal stimulus.

First, this crisis is here for while, so slow-acting fiscal spending can be part of the picture( INFRASTRUCTURE SPENDING IS FINE. ). (In the usual recession, the simulative spending often( MIGHT HAPPEN HERE AS WELL ) kicks in after the recession is past and thus become part of the problem rather than part of the solution.) Moreover, expenditure measures have the advantage of directly stimulating demand rather than give money to consumers and companies who might not spend it( THAT'S THE REASON FOR GOVERNMENT SPENDING THE MONEY. ).

Second, the usual macroeconomic conditions mean existing estimates of fiscal multipliers are less reliable guides to the relatively effectiveness of various fiscal policies. This is why the IMF argues for fiscal policy diversification.( IT'S A GOOD IDEA )

Direct government spending

While each government will have to deal with national concerns, constraints and circumstances, the IMF offers some general words of wisdom.

· Governments should make sure that existing programs are not cut for lack of resources.( OK )

This bit of advice is aimed particularly at the US states, many of whom operate under constitutional balanced-budget rules that are forcing them to cut back spending on current programmes. (See Krugman’s column for examples.)

· Look for spending programs can be started or restarted quickly.

For example, the state could up its share in private-public partnerships for projects that would otherwise be suspended for lack of private capital. Public sector wage increases should be avoided as they are not well targeted, difficult to reverse, and similar to transfers in their effectiveness. Nevertheless, a temporary increase in public sector employment associated with some of new programs and policies may be needed( A JOBS BILL ).

· Public perceptions matter.( VERY IMPORTANT )

Much of this recession is coming from the sharp deterioration in expectations, and the sharp increased in perceived uncertainty about the economy’s prognosis( ABSOLUTELY. THE FEAR AND AVERSION TO RISK.). A few high profile programs – especially those good long-run justification and strong externalities – could help restore consumers’ and firms’ belief that things will get better. Such confidence can itself improve aggregate demand by reducing wait-and-see behaviour.( I WOULD ARGUE THAT THIS IS IN FACT THE SOLUTION )

Stimulus aimed at consumers

Getting consumers to spend again faces three crisis-specific factors: 1) wealth reductions are a key cause of reduced consumption ( TRUE. BUT PERCEPTIONS OF IT VARY. ); 2) credit constraints( REALLY THE FEAR AND AVERSION TO RISK. ) in some nations are forcing consumption reductions; and 3) uncertainty has spawned a wait-and-see attitude that results in the delay of planned purchases( THE MOST IMPORTANT REASON ).

These factors suggest two broad recommendations: Tax cuts should target consumers who are most likely to be credit constrained( I AGREE ), and should aim at restoring consumer confidence by committing to do ‘whatever it takes’( I AGREE. THAT'S WHY GOVERNMENT GUARANTEES ARE SO IMPORTANT, AS WELL AS INCENTIVES TO ALLEVIATE THE FEAR AND AVERSION TO RISK. ). The goal is to overcome the waiting-and-see attitudes( EXACTLY ).

Fiscal stimulus aimed at firms

The high degree of uncertainty surrounding this crisis fosters a wait-and-see attitude when it comes to firms’ investments. Consequently, subsidies are unlikely to have much effect( I BELIEVE THAT TAX INCENTIVES MIGHT ). While acknowledging the political economic pitfalls, the IMF argues that there is also some scope for governments in supporting firms that are facing particularly difficult problems, could survive through restructuring, but find it difficult or impossible to receive the necessary financing from dysfunctional credit markets. Sector-wide policies like the US auto bailout are bad idea( THIS WAS DONE FOR SOCIAL REASONS, WHICH ARE IMPORTANT IN RESTORING CONFIDENCE. ).

Sustainability concerns

While the IMF’s call for deficit spending is unusual, the authors stay true to form in arguing that questions about debt sustainability would, especially in nations starting from weak fiscal postures, undercut the stimulus via adverse effects on financial markets, interest rates, and consumer spending( A GOOD WARNING ). A fiscally unsustainable path can eventually lead to sharp adjustments in real interest rates, and these in turn can destabilize financial markets and undercut recovery prospects.( A PROBLEM GOING FORWARD )

The IMF suggests a number of things that could help:

Measures should be reversible or have clear sunset clauses( WHICH IS WHY I FAVOR A SALES TAX DECREASE OR PAYROLL TAX REDUCTION ) contingent on the economic situation;

Measures that increasing the scope of automatic stabilizers are useful;

Pre-commitments to future policies that help shore up fiscal accounts are useful.( I AGREE )

Pre-commitment to unwinding stimulus measures either at a specific date (like lowering VAT for just two years as the U.K. recently did) or on a contingent basis (reversing the VAT cut once GDP growth has risen above a certain level) are a good idea;( I AGREE )

Strengthening fiscal governance by, for example, setting up an independent fiscal council( NOT SO MUCH );

Coordination: The G20’s role

Sizable fiscal stimulus is required at the global level since this crisis is global. However not all nations are in a position to widen government deficits. Many low income and emerging market countries are constrained volatile capital flows, high public and foreign indebtedness, and large risk premia – features that plague some advanced countries as well.

Given that some countries cannot pump up demand with fiscal policy, the IMF argues that it is imperative that the nations who can do. This includes some large emerging economies such as China. As fiscal stimulus is a policy that suffers from the classic free-rider externality, it is exactly one area where international coordination by the G20 nations would yield great benefits."( THE SAVER COUNTRIES AND STIMULUS PROBLEM )

Some good points.

"to control its price by buying and selling blocks of shares on the open market."

An alternative to Bagehot's Principles from the FT:

"By Roger E.A Farmer

The US recession that began in December 2007 resulted in 403,000 lost jobs in September, 320,000 in October and 533,000 jobs in November. Projections for 2009 are ominous( BUT THEY ARE PROJECTIONS ).

The global financial system is undergoing a meltdown that has not been seen since the 1930s and nobody seems to know what to do about it. How did we get to this point and how can we move forward?

Since world war two, economic policy in most western democracies has been based on Keynesian economics.( I WOULD SAY THAT WE HAVE WELFARE STATES, WHICH ARE GOVERNMENT/PRIVATE SECTOR HYBRIDS. )

But although policy makers still rely on Keynes’ ideas, academics gave up on his theories 40 years ago and went back to classical economics( THEY ARE BOTH RELEVANT AND USEFUL. THERE'S NO NEED FOR A CHOICE BETWEEN THE TWO. ): Keynesian theory( THAT WHAT IT IS: A THEORY ) could not explain how unemployment and inflation can coincide. The result has been 40 years of disconnect in which policy makers are tinkering with the engine without a manual( SILLY ANALOGY ).

The US stock market has lost 40 per cent in the past three months and this is a good performance by the standards of many global markets.

In classical economics, the prices of stocks are determined by fundamentals and the fundamentals of the economy are sound. The US had the same stock of factories and machines in August that it had in July and the US workforce has not been afflicted by a sudden attack of contagious laziness. Although Keynes didn’t manage to work out all of the details of his theory he was right on one point: In the real world; psychology matters for the behaviour of markets!( WHICH IS WHAT I CALL A HUMAN AGENCY EXPLANATION )

When households believe that assets are not worth much, they spend less; unemployment increases and the belief becomes self-fulfilling( THIS IS TRUE. BELIEFS INFLUENCE BEHAVIOR. ). This is why households and firms are not spending today; they are forecasting further falls in asset prices and there is a real danger that these gloomy forecasts may turn out to be correct( SEE THE RECENT NEWS N ECONOMICS POST ).

We have seen economies stagnate for a decade or more in the past – the UK in the 1920s, the US in the 1930s and Japan in the 1990s – and it would be presumptuous to think that this cannot happen again when the existing dominant paradigm says that it could not happen in the first place( CHEAP SHOT ).

Classical economists argue that falling wages will restore equilibrium; but this is based on the belief that the labour market works like an auction in which employment is determined by demand and supply.( THE MODEL IS OF SOME USE. HERE, IT SHOWS THAT EMPLOYER'S HAVE BEEN PROACTIVELY LAYING OFF WORKERS WHILE DEMAND REMAINS HIGHER THAN THEY ARE ASSUMING. )

It ignores the very real frictions( TRUE. IT'S SIMPLY A MORE OR LESS USEFUL MODEL. NOT REALITY. ) involved in searching for a job by both households and firms that can lead to many possible equilibrium employment levels just as Keynes argued in the General Theory.

For much of the post-war period, the US Federal Reserve has been relatively successful at combating recessions by lowering the interest rate to stimulate aggregate demand. The policy was unavailable in the 1930s because the interest rate on treasury securities was already near zero, just as it is today( ZIRP ). It is this fact( ONE OF THE ONLY ONES, AND EVEN IT IS AN ABSTRACTION FROM THE REALITY AND CONTEXT OF THE TIME. ) that makes the current crisis more like the Great Depression than any other of the post-war recessions.

So where do we go from here? The only actor large enough to restore confidence in the US market is the US government( UNFORTUNATELY, I AGREE. AND THAT IS ITS JOB. ). The current policy of quantitative easing by the Fed is a move in the right direction but it does not, as yet( OK ), go nearly far enough.

It is time for a greatly increased role for monetary policy through direct intervention of central banks in world stock markets to prevent bubbles and crashes( IMPLEMENT BAGEHOT'S PRINCIPLES ). Central banks control interest rates by buying and selling securities on the open market( NO ).

A logical extension of this idea is to pick an indexed basket of securities: one candidate in the US might be the S&P 500, and to control its price by buying and selling blocks of shares on the open market.( A VERY BAD AND BLUNT INSTRUMENT )

Even the credible announcement that a policy of this kind was being considered should be enough to boost( SCARE ) the markets and restore consumer and investor confidence in the real economy( I DON'T AGREE ).

Critics will argue that this policy is dangerous socialist meddling( NO. IT'S BAD POLICY. ). But I am not arguing that the government should pick winners and losers( ACTUALLY, IT WILL HAVE A SLIGHT EFFECT ON THAT I'M AFRAID. ): only that it should stabilise( FIX THE PRICE ) a broad basket of stocks.

This policy would still allow poorly run firms to fail but it would not allow all firms to fail at the same time( BUT WE MIGHT HAVE LESS FIRMS. ). Although the free market is very good at deciding how many left and right shoes to produce( TRUE ), it cannot prevent systemic risk( BANK OR CALLING RUNS ) that arises from the psychology of herd behaviour( I AGREE THAT THE FEAR AND AVERSION TO RISK AND ACCOMPANYING FLIGHT TO SAFETY ARE SUCH BEHAVIOR. ). This is a job for Uncle Sam.( BY IMPLEMENTING BAGEHOT'S PRINCIPLES. ACTUALLY, FDIC INSURANCE HAS HELPED STOP BANK RUNS. BAGEHOT'S PRINCIPLES OFFER SIMILAR AID IN PREVENTING CALLING RUNS. THIS IDEA IS SIMPLY TOO BLUNT AN INSTRUMENT. )

Prof Roger E. A. Farmer is vice chair for graduate studies in the department of economics at the University of California Los Angeles and the author of two forthcoming books on economics: Expectations, Employment and Prices and How the Economy Works and How to Fix it When it Doesn’t"

"If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad."

Tyler Cowen approaches my view in the NY Times:

"Bailout of Long-Term Capital: A Bad Precedent?

By TYLER COWEN

THE financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad( I TOTALLY AGREE ).

Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.

Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses.( ALL TRUE )

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis( WE SHOULD HAVE DEALT WITH THE ISSUE EXPLICITLY ). Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.( THAT'S MY POSITION )

Of course, there were many reasons for the reckless lending and failures of risk management that led to the most recent systemic credit shocks( TRUE ). And we have now entered the realm of trillion-dollar bailouts, vast contagion across financial institutions, rapid deleveraging of banks and an economic crisis that some people are starting to compare to the Great Depression.

The Long-Term Capital episode looks small when viewed against all of that. But it was important precisely because the fund was not a major firm( YES ). At the time of its near demise, it was not even a major money center bank, but a hedge fund with about 200 employees. Such funds hadn’t previously been brought under regulatory protection this way. After the episode, financial markets knew that even relatively obscure institutions — through government intervention — might be able to pay back bad loans.( THAT'S MY POSITION )

The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.( EXACTLY )

What would have happened without a Fed-organized bailout of Long-Term Capital? It remains an open question. An entirely private consortium led by Warren E. Buffett might have bought the fund, but capital markets might still have frozen because of the realization that bailouts were not guaranteed.( HERE'S WHERE I DISAGREE. WE SHOULD HAVE BAILED THEM OUT, BUT IMMEDIATELY CHANGED THE SYSTEM EXPLICITLY )

And Fed inaction might have had graver economic consequences, especially if a Buffett deal had fallen through. In that case, a rapid financial deleveraging would have followed, and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.( IT'S A FAIR POINT )

In 1998, there was no collapsed housing bubble, the government’s budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.( I HAVE TO AGREE )

The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew( THAT'S IT ). Decisions are made as to whether a merger is possible, whether a consortium can be organized, what kind of loan guarantees can be offered and what kind of concessions will be extracted in return. So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.( THAT'S IT )

While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery. ( ALL TRUE )

John Maynard Keynes famously proclaimed that “in the long run we are all dead.” From the vantage point of 1998, today is indeed the “long run.”

We’re not quite dead, but we are seriously ailing. As we look ahead, we may be tempted again to put off the hard choices. But perhaps the next “long run,” too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed."

My only disagreements are:
1) The S & L Bailout was more important, both because of its size and the poor record of prosecuting crimes associated with it.
2) Because LTCM was relatively small, it simply added to the strength of the guarantee.
3) LTCM could have been handled differently, penalizing creditors to some extent. Then, we should have developed Bagehot's Principles into an explicit policy.

However, I'm beginning to believe that LTCM should have been allowed to fail, because it might have made a difference. And yet, there were other government interventions, and the S& L Crisis was still on the books, so to speak. That's the point at which we should have developed an explicit policy based on Bagehot's Principles.

"But don't kid yourself that the sentiment might not spread. "

Yves Smith on Beggaring Thy Neighbor:

"Has Beggar Thy Neighbor Started? ( MY THESIS IS THAT IT IS HAS BEEN GOING ON ALL ALONG, ALTHOUGH NOT FULL BLAST, BUT MODERATED. I CONSIDER ENGLAND'S ACTIONS TOWARD ICELAND BEGGARING THY NEIGHBOR, OR, BETTER YET, BUGGERING. ALSO, CHINA , JAPAN ( WITH CURRENCY AND STIMULUS ISSUES ), AND GERMANY( WITH STIMULUS ISSUES ), HAVE PLAYED A MODERATE FORM. HOWEVER, ONE COULD ARGUE THAT THEY'RE SIMPLY BUYING TIME TO GET IN A BETTER POSITION TO DEAL WITH TOUGH ISSUES.)

One of the ugly features of the Great Depression that in many (but not all) cases worsened the severity of the contraction was that countries adopted "me first" policies with little regard to their broader ramifications. The poster child of this pattern is Smoot Hawley. Although there is some dispute among economists as to whether it was as deleterious as sometimes claimed, the US increased tariffs to protect domestic employment. This proved to be short-sighted, since the US was the biggest exporter, and had a great deal to lose when other countries retaliated.

Similarly, England left the gold reserve comparatively early, in 1931. Currency devaluation proved a great help in escaping the worst of the Depression. However, competitive devaluations also limited the benefits for any one player.

We are now seeing what looks to be "devil take the hindmost" behavior. China has quietly gone back to a hard peg against the dollar (as opposed to letting the RMB do what it would otherwise do, appreciate). This is very detrimental, since it means that China is going to try to continue to rely on exports to see its way through this downturn, rather than use more aggressive fiscal stimulus( TRUE, BUT THEY HAVE A PROBLEM WITH THE STIMULUS BEING A SAVER COUNTRY ). It also means that China is trying to prop up the system of global imbalances (Chinese savings glut, US overconsumption and borrowing from China et. al.) that helped create this mess( THEY LIKE THE SYSTEM. I'VE ALREADY BLOGGED ABOUT THAT ). We need to collectively find our way out of this smoky airplane, but everyone seems to want to go back to their seats and strap themselves in.

In a very good Financial Times piece, Wolfgang Munchau in passing mentions "unsynchronised monetary policies" and suggests that the Fed's aggressive move to quantitative easing (oh, we don't dare call it that, the Fed insists its flavor is different) will force the ECB to follow suit to a fair degree. Munchau does not consider this to be a plus( I HAVE POSTED ABOUT THIS POST ):

I am sceptical about the benefits of the Fed’s new policy of quantitative easing. We do not have a liquidity crisis, but a solvency crisis, which expresses itself in large spreads and dysfunctional money markets. I cannot see how adding more and more liquidity to the system solves this problem.

Instead of propping up each bank, and swamping the market with cash, we need to restructure and shrink the banking system, as a first step to a sustainable solution to this crisis. Quantitative easing without deep structural financial reform could cause lot of trouble in the long run.

I think, however, there is a case for temporary interest rate cuts in Europe, but only on condition that this policy would be forcefully reversed once credit markets start to recover, and once the economy emerges from the slump.

But we should not delude ourselves into thinking that monetary policy can save the world. It can play a useful role, especially since we do not have the stomach for an optimal fiscal policy response. But it will not prevent the worst slump of our generation.

Ambrose Evans-Pritchard chronicles a rise in good old garden variety protectionism, so far limited to secondary and emerging economies. But don't kid yourself that the sentiment might not spread( VERY TRUE ).

It is important to keep in mind that cartoon extremes often cloud the debate. How smart is it to advocate open trade when some countries stack the deck by having artificially cheap currencies? That is tantamount to an export subsidy( BY KEEPING THE PRICE OF THEIR GOODS LOW ), but we haven't done much except jawbone China very late in the game (and the yen has been awfully cheap until recently too, and Japan has remained an export powerhouse, but we never gave them a hard time due to the sorry state of their domestic economy). Similarly, we consider it completely reasonable to restrict exports of advanced military technology, and acquisition of strategic assets.

Again, I am not saying trade is a bad thing, merely that we have often been faced with counterparties with mercantilist objectives, and our responses appear not to have served us well in the long term( TRUE ).

From Evans-Pritchard:

We are advancing to the political stage of this global train wreck. Regimes are being tested. Those relying on perma-boom to mask a lack of democratic or ancestral legitimacy may try to gain time by the usual methods: trade barriers, saber-rattling, and barbed wire...

Russia has begun to shut down trade...It has imposed import tariffs of 30pc on cars, 15pc on farm kit, and 95pc on poultry (above quota levels). "It is possible during the financial crisis to support domestic producers by raising customs duties," said Premier Vladimir Putin.

Russia is not alone. India and Vietnam have imposed steel tariffs. Indonesia is resorting to special "licences" to choke off imports...

There have been street protests in Moscow, St Petersburg, Kaliningrad, Vladivostok and Barnaul. Police crushed "Dissent Marchers" holding copies of Russia's constitution above their heads in Moscow's Triumfalnaya Square.

"Russia has not seen anything like these nationwide protests before," said Boris Kagarlitsky from Moscow's Globalization Institute....

The omens are not good in China either...

Exports fell 2.2pc in November. Toy, textile, footwear, and furniture plants are being closed across Guangdong, now the riot hub of South China. Some 40m Chinese workers are expected to lose their jobs. Party officials have warned of "mass-scale social turmoil".

The Politburo is giving mixed signals. We don't yet know how much of the country's plan to boost domestic demand through a $586bn stimulus package is real, and how much is a wish-list sent to party bosses in the hinterland without funding.
Shortly after President Hu Jintao said China is "losing competitive edge in the world market", we saw a move towards export subsidies for the steel industry and a dip in the yuan peg...

Such raw mercantilism can only draw a sharp retort from Washington and Brussels in this climate.

"During a global slowdown, you can't have countries trying to take advantage of others by manipulating their currencies," said Frank Vargo from the US National Association of Manufacturers. ( IT ISN'T GOOD, NO )

It is a view shared entirely by President-elect Barack Obama. "China must change its currency practices. Because it pegs its currency at an artificially low rate, China is running massive current account surpluses. This is not good for American firms and workers, not good for the world," he said in October. The new intake of radical Democrats on Capitol Hill will hold him to it.

There has been much talk lately of America's Smoot-Hawley Tariff Act.... The relevant message of Smoot-Hawley is that America was then the big exporter, playing the China role. By resorting to tariffs, it set off retaliation, and was the biggest victim of its own folly( TRUE ).

Britain and the Dominions retreated into Imperial Preference. Other countries joined. This became the "growth bloc" of the 1930s, free from the deflation constraints of the Gold Standard. High tariffs stopped the stimulus leaking out.

It was a successful strategy - given the awful alternatives - and was the key reason why Britain's economy contracted by just 5pc during the Depression, against 15pc for France, and 30pc for the US...

This crisis has already brought us a monetary revolution as interest rates approach zero across the G10. It may overturn the "New World Order" as well, unless we move with great care in grim months ahead. This is where events turn dangerous( COULD BE ).

The last great era of globalisation peaked just before 1914. You know the rest of the story." ( YES WE DO )

"conversion, whereby, for example, all existing mortgage debts could be wholly or partly converted into long-term, low and fixed-interest loans"

Niall Ferguson on FT talks about Leviticus:

"In the Old Testament Book of Leviticus, God commands the children of Israel to observe a jubilee every 50 years. Nowadays we tend to associate the word with celebrations of royal anniversaries such as Queen Elizabeth’s golden jubilee in 2002. But the biblical conception of a jubilee was more precise: that of a general cancellation of debts.

This point is spelt out in Deuteronomy: “Every creditor that lendeth ought unto his neighbour shall release it; he shall not exact it of his neighbour, or of his brother; because it is called the Lord’s release.” ( I BELIEVE THAT THIS WAS ALSO TO ENSURE THE LAND REMAINED IN THE POSSESSION OF EACH TRIBE )

Such injunctions may strike the modern reader as utopian. How could any sophisticated society function if all debts were cancelled twice a century – much less, as Deuteronomy seems to suggest, every seven years? Yet we know that such general cancellations of debt really did happen in the ancient world. In 1788 BC, for example, about 500 years before the time of Moses, King Rim-Sin of Ur issued a royal edict declaring all loans null and void, wiping out some of history’s earliest known moneylenders. ( WHY NOT HAVE SAVER NATIONS LIKE CHINA AND GERMANY CANCEL DEBT, AND THEN THE SPENDER NATIONS CAN START SPENDING AGAIN AND EVERYONE IS HAPPY AND DOING WHAT COMES NATURALLY TO THEM? )

The idea of a generalised debt cancellation is not wholly unknown in modern times. The late Gerald Feldman, the world’s leading authority on the German hyperinflation of 1923, drew a parallel between the ancient Hebrew yovel and the wiping out of all paper mark-denominated debts as a result of the collapse of the German currency (though, as he was quick to point out, those whose savings were wiped out were far from jubilant).

In the hope of avoiding the mark’s meltdown, the economist John Maynard Keynes had repeatedly called for a general cancellation of the war debts and reparations arising from the first world war. Though no such intergovernmental jubilee was ever proclaimed, debt cancellation was effectively what happened after 1931, beginning with President Herbert Hoover’s one-year moratorium on both war debts and reparations.

As 2008 draws to a close, there are many people on both sides of the Atlantic who yearn for such a simple solution to the problem of excessive indebtedness. Parallels with the interwar period are not inappropriate. It is all but inevitable that we shall see serious political and geopolitical upheavals in 2009, as the recession takes its toll on weak governments (Thailand and Greece are already reeling) and raises the stakes in inter-state rivalries (India-Pakistan). In the words of Hank Paulson, the US Treasury secretary: “We are dealing with a historic situation that happens once or twice in 100 years.” The stakes are high indeed. Has the time arrived for a once-in-50-years biblical jubilee?

Excessive debt is the key to this crisis ( BUT WHAT CAUSED IT? ); it is the reason we are confronting no ordinary recession, curable by a simple downward adjustment of interest rates. It is the reason we still have to fear, if not a second Great Depression, then very likely the biggest recession since the 1930s. We are living through the painful end of an age of leverage which saw total private and public debt in the US rise from about 155 per cent of gross domestic product in the early 1980s to something like 342 per cent by the middle of this year.

With average household debt rising from about 75 per cent of annual disposable income in 1990 to very nearly 130 per cent on the eve of the crisis, a large proportion of American families are submerging under the weight of their accumulated borrowings. British households are in even worse shape.

Looking back, we now see just how big a proportion of US growth since 2001 was financed by mortgage equity withdrawals. Without that as a means of financing consumption, the economy would barely have grown at 1 per cent a year under President George W. Bush. Looking forward, we see just how hard it will be to stabilise property prices and the prices of the securities based on them. Already, at the end of September, one in 10 American home owners with a mortgage was either at least a month in arrears or in foreclosure. One in five mortgages exceeds the value of the home it was used to purchase.

The financial sector’s debts grew even faster as banks sought to bolster their returns on equity by “levering up” ( THIS IS TRUE ). According to one recent estimate, the total leverage ratios (on- and off-book assets and exposure divided by tangible equity) for the two biggest US banks were 88:1 for Citibank and 134:1 for Bank of America. The bursting of the property bubble caused such ratios, which were already too high on the eve of the crisis, to explode as off-balance-sheet commitments and pre-arranged credit lines came home to roost. Only by borrowing from the Federal Reserve on an unprecedented scale have the banks been able to stay in business( THE BANKS CONSIDER IT INSURANCE AND WERE COUNTING ON IT ).

With estimates of total losses on risky assets now ranging from $2,800bn (£1,850bn, €1,960bn) to $6,000bn, a chain reaction is under way that will leave no sector of the world economy untouched. The American economy is contracting at an annualised rate of 5 per cent ( WE NEED TO WAIT ON THAT ). Commercial property is following the residential market into freefall. The Standard & Poor’s 500 index is down 43 per cent since its peak in October last year. The market for credit default swaps is pointing to a surge in defaults on corporate bonds( I BELIEVE THIS IS OVERDONE ). The automotive industry is already (against the will of Congress and the original intention of the Treasury) on life support. The US is at the centre of the crisis but Europe and Japan may suffer even larger aftershocks. As for the much feted emerging market “Brics” – Brazil, Russia, India and China – their stock markets have been dropping like, well, bricks.

What makes this crisis of burning interest to financial historians is the knowledge that we are witnessing a real-time experiment with not one but two theories( THEY'RE NOT MUCH HELP ) about the Depression.

On one side, Ben Bernanke, Fed chairman, is applying the lesson of Milton Friedman’s and Anna Schwartz’s A Monetary History of the United States, which argued that the Depression was in large measure the fault of the central bank for failing to inject liquidity into an imploding financial system. Mr Bernanke has not merely slashed the federal funds rate to below 0.25 per cent. He has lent freely to the banks against undisclosed but probably toxic collateral. Now he is buying securities in the open market. ( HE'S DOING WHAT LOOKS LIKE THE LEAST AWFUL ALTERNATIVE )

The result has been an explosion of the Fed’s balance sheet and of the monetary base. With assets approaching $2,263bn and capital of less than $40bn, the Fed increasingly resembles a public hedge fund, leveraged at more than 50:1. ( THE ASSETS OF THE AMERICAN PEOPLE BACK THIS )

On the other side, Mr Paulson has emerged as an unwitting disciple of Keynes, running a huge government deficit in an effort not merely to bail out the financial sector but also to provide a public sector substitute for sharply falling private sector consumption. Even before President-elect Barack Obama launches his promised infrastructure investment programme, estimates of next year’s deficit run as high as 12.5 per cent.

Once, monetarism and Keynesianism were considered mutually exclusive economic theories. So severe is this crisis that governments all over the world are trying both simultaneously ( THAT'S BECAUSE WE'RE NOT SURE WHAT TO DO ).

Although commentators like to draw parallels with Franklin Roosevelt’s New Deal, in truth the measures taken since the crisis began in August 2007 more closely resemble those taken during the world wars ( AND? ). After 1914, and again after 1939, there was massive government intervention in the financial system. Banks and bond markets were reduced to mere channels for the financing of huge public sector deficits. That is what is happening today, but without the stimulus to manufacturing that the world wars provided. We are having war finance without the war itself.( THANK GOD )

Yet the effect of these policies is essentially to add a new layer of public debt to the existing debt mountain. Added together, the loans, investments and guarantees made by the Fed and the Treasury in the past year total about $7,800bn, compared with a pre-crisis federal debt of about $10,000bn. The Treasury may have to issue as much as $2,200bn in new debt in the coming year. ( IT'S A PROBLEM, BUT NOT INSURMOUNTABLE )

For the time being, the distress-driven demand for dollars and risk-free assets is pushing down the cost of all this borrowing. Treasury yields are at historic lows. But it is not without significance that the cost of insuring against a US government default has risen 25-fold in little over a year ( THIS MIGHT WELL BE OVERDONE ). At some point ( WHAT POINT? ), with most big economies adopting the same fiscal policy, global bond markets are going to start choking.

Is it really plausible that the cure for excessive leverage in the private sector is excessive leverage in the public sector ( YES IT IS. IT'S PARADOXICAL, BUT MUCH OF LIFE IS ) Might there not be a simpler way forward? When economists talk about “deleveraging” they usually have in mind a rather slow process whereby companies and households increase their savings in order to pay off debt. But the paradox of thrift means that a concerted effort along these lines will drive an economy such as that of the US deeper into recession, raising debt-to-income ratios.

The alternative must surely be a more radical reduction of debt. Historically, such reductions have been done in one of four ways:( 1 ) outright default,( 2 ) restructuring (for instance, bankruptcy), ( 3 )inflation or ( 4 ) conversion. At the moment, more and more American households are choosing the first as a way of dealing with the problem of negative equity, while more and more companies are being driven towards bankruptcy. But mass foreclosures and bankruptcies are not a pretty prospect.( BUT THEY MIGHT HELP )

Inflation, by contrast, is hard to worry about in the short term, not least because the Fed’s expansion of the monetary base is leading to no commensurate expansion of the broad money supply; the banks would rather shrink than expand their balance sheets.( SO WHY NOT USE IT? )

That leaves conversion, whereby, for example, all existing mortgage debts could be wholly or partly converted into long-term, low and fixed-interest loans, as recently suggested by Harvard’s Martin Feldstein. (In his scheme, the government would offer any homeowner with a mortgage the option to replace 20 per cent of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. The annual interest rate could be as low as 2 per cent and the loan would be amortised over 30 years ( THEY DO HAVE TO PAY THE MONEY BACK ).

At the very least, this would rescue many homeowners from the nightmare of negative equity. A similar operation might also be contemplated for the debts of those banks that have been partially or wholly recapitalised by the state. This would not add to the federal debt in net terms and would reduce the interest burden, if not the absolute debt burden, of households.

Such radical steps would naturally represent a haircut for creditors ( FINE WITH ME, SINCE THE HOUSES THEY WOULD FORECLOSE ON WOULD BE WORTH LESS ), notably the holders of mortgage-backed securities and bank bonds. Yet they would surely be preferable to the alternatives ( NOT IF THEY FEEL THAT THEY CAN GET A BETTER DEAL FROM THE GOVERNMENT. ALSO, ARE YOU GOING TO MANDATE THIS? ). And they would certainly be a less extreme solution than the general debt cancellation envisaged in the Old Testament.

Financially, 2008 has been an annus horribilis. The answer may be to make 2009 a true jubilee year.

To be honest, I don't think he made a case for any of the four alternatives. It's an interesting plan, but it is dubious that it can be made to work in practice, due to a number of factors leaving lenders and borrowers to prefer other alternatives.

How fallow years led to a golden jubilee

Every seven years, God told Moses, the children of Israel should neither sow their fields nor prune their vineyards – a kind of self-imposed recession. After seven such sabbatical years, the trumpet of jubilee should be sounded: “And ye shall hallow the fiftieth year, and proclaim liberty throughout all the land unto all the inhabitants thereof: it shall be a jubilee unto you; and ye shall return every man unto his possession.”

Land that had been sold was to be redeemed or returned to the original seller and the poor were to be relieved: “If thy brother be waxen poor, and hath sold away some of his possession, and if any of his kin come to redeem it, then shall he redeem that which his brother sold ... If thy brother be waxen poor ... then shalt thou relieve him: yea, though he be a stranger ... Take thou no usury of him ...” In addition, Jews who were slaves were to be set free.

To modern eyes, however, the most striking of these divine injunctions was that debts were to be cancelled as part of “the Lord’s release”.

"The fact that we are having a recession while productivity is growing tells us a LOT about why we have a recession"

Casey Mulligan on Productivity:

"It looks like employment will be one percent lower in 2008Q4 than it was in 2008Q3. There is not much uncertainty about this, because October and November employment are already known.

Work hours per employee will also be lower -- maybe also about one percent. Thus, total work hours will be 1-2 percent lower, probably closer to 2 percent.

Productivity growth is the percentage change in GDP minus the percentage change in total work hours. I have seen forecasts that GDP 2008Q4 will be 1.25 percent lower than for 2008Q3. Thus, the forecasts imply further productivity GROWTH. Productivity also grew 2007Q4 through 2008Q3 (about 1.9 percent). The fact that we are having a recession while productivity is growing tells us a LOT about why we have a recession, and why it is so different from the 1981-82 recession or the Great Depression. More on this over the next week....

For those 136 million who still have jobs, productivity growth is VERY good news because productivity determines how much you ultimately get paid."

I tend to agree.

"what will the federal budget look like, as evaluated by the budget deficit and tax revenue as a share of GDP? "

Greg Mankiw offers a version of what I call the "Ratcheting Theory Of Govern Intrusion", which believes that:
1) While government intrusion into the economy can grow, it cannot decline.
2) Crises increase government intrusion into the economy.

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Click on the figure to enlarge.

The above figure (reprinted from my favorite textbook) shows government revenue as a percent of GDP. The most noteworthy feature of this data is the substantial growth of government from 1929 to 1945. It is easy to understand why the size of government grew so much during this period: The nation was responding to the crises of the Great Depression and, especially, World War II. But what is noteworthy is that while these crises were transitory, the increase in the scope of government was permanent.

This historical episode is one reason why advocates of limited government are rightly worried about the fiscal stimulus package that the incoming administration is going to propose. Rahm Emanuel, the new White House chief of staff, is reported to have said, "You don't ever want to let a crisis go to waste: It's an opportunity to do important things that you would otherwise avoid." It is not entirely clear what he meant by this. But one interpretation is that he is going to use a temporary crisis as an excuse to engineer a permanent increase in the size of government.

Here is the question reporters should focus on when evaluating the proposed plan: Five or ten years from now, when the economy is presumably at some normal level of employment and growth, what will the federal budget look like, as evaluated by the budget deficit and tax revenue as a share of GDP?"

I agree with 2, but not 1. Why? Here's my theory:
1) Now that Socialism and Communism are effectively debunked, leaving the Welfare State, the Left will drift more and more towards the center, where the center is Socially Liberal and Economically Conservative.

That's my thesis. Call it the "Leftward Drift Towards The Center" thesis.

"The risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility."

After saying that mining the Great Depression for clues on how to get us out of this current problem is of minimal use, I find this post by Tim Duy on the Economist's View interesting:

"But to be a real Dollar rout, we would expect to see Treasuries come under severe pressure, which has not exactly been a recent trend. So perhaps there really is nothing to fear. Indeed, I have argued that that if the stimulus is too excessive, that excess should reveal itself in the Treasury market, and policymakers can simply back off. No problem – ease away. Build those bridges.

This assumes that policymakers back off. What if rising Treasury rates encourage the Fed to double down, expanding quantitative easing to hold rates low and stimulative. What if years of research on the Great Depression have left even the best and the brightest with tunnel vision such that they could not accept that they were wrong?

Bottom Line: The Fed is headed to the zero mark, with another 50bp almost certain this week. It is widely expected that they will give some guidance as to their next steps, pointing us in the direction of an explicit policy of quantitative easing. Fed policy, as well as fiscal policy, assumes that the Great Depression is the most accurate analogy. This assumption ignores the external position of the US, which stubbornly refuses to adjust. If that failure to adjust is relevant, then recent Dollar stability was simply a head-fake. We should see pressure on the Dollar and, ultimately, Treasuries. Policymakers could adjust, but would they? With pursuit of the Great Depression case as the baseline scenario, it seems prudent to keep in mind the risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility."

I think that Printing Money is simply the clearest option that we have. It has little to do with the Great Depression. The problems this could lead to are serious, and we'll be in for a rough ride. But the fact that the policy of Printing Money is Assessable makes it a good choice. I doubt that anyone in this mess is going to hold to a failing policy for too long. Rather, I would fear that we do not give these policies a chance to be assessed.

As to the point about the usefulness of the Analogy with the Great Depression, I agree.

"Americans, to be sure, are always reluctant to undertake ambitious government initiatives. "

John Judis with a post that I sort of disagree with, via Clive Crook:

"If Obama and the Democrats in Congress act boldly, they can not only arrest the downturn, but also lay the basis for an enduring majority. As was the case with Franklin Roosevelt, many of the measures necessary to combat the recession--such as spending money on physical and electronic infrastructure, adopting national health insurance--will also help ensure a Democratic majority. The rural South remained Democrat for generations because of Roosevelt's rural electrification program; a similar program for bringing broadband to the hinterland could lead these voters back to the Democratic Party. And national health insurance could play the same role in Democrats' future prospects that Social Security played in the perpetuation of the New Deal majority.

Americans, to be sure, are always reluctant to undertake ambitious government initiatives. This is, as historian Louis Hartz once demonstrated, a country founded on Lockean liberalism. But as Roosevelt discovered when he was elected, a national crisis creates a popular willingness to entertain dramatic initiatives. Obama and the Democrats will also not face the same formidable adversaries that Jimmy Carter or Bill Clinton had to face. The Republican Party will be divided and demoralized after this defeat. Just as the Great Depression took Prohibition and the other great social issues of the 1920s off the popular agenda, this downturn has set aside the culture war of the last decades. It wasn't a factor in the presidential election. And the business lobbies that blocked national health insurance in 1994 will incur the public's wrath if they once again try to buy Congress.

If, on the other hand, Obama and the Democrats take the advice of official Washington and go slow--adopting incremental reforms, appeasing adversaries that have lost their clout--they could end up prolonging the downturn and discrediting themselves. What could have been a hard realignment could become not merely a soft realignment, but perhaps even an abortive one. That's not the kind of change that America needs or wants--and, hopefully, Obama and the Democrats understand that."

Here's my problem, where he's specific, I happen to agree with him:

1) Infrastructure spending in the stimulus

2) National health

Why I support 2 is a long story which I've already talked about, but not here. 1 I've talked about a number of times lately.

However, the rest of the post I disagree with. Liberal programs would not work, and, hence, would not end up being popular in terms of economics. Of course, if they were enacted and worked, I wouldn't worry about it, because their working would decide the issue.

I'm not too worried, because it wasn't Judis who was elected.