It looks to me like a very normal cyclical development.

From The Angry Bear:

"Yield Curve

By Spencer:

The yield curve is strongly positive, and this is getting all kinds of blog comments.

They range from Arnold Kling saying "in my view, this is perfectly rational, and it shows that the short-run effect of the fiscal stimulus is negative"

To Greg Mankiw saying "that it signals future economic growth. In many ways, however, this is an unusual downturn, so it is not entirely clear to what extent historical relationships are a useful guide going forward'


It looks to me like a very normal cyclical development. For example according to this traditional indicator of what drives the yield curve the surprise ought to be that the yield curve is so flat.

I'm inclined to go along with Mankiw on this one and can not understand how this support Kling's conclusion that this demonstrates that the impact of fiscal stimulous is negative.

After responding in the comments section I thought I would add this chart to demonstrate my point. At the bottom in December the bond market was discounting a deflationary, depression.
Now it is discounting an economic recovery. It is a normal cyclical development.

Posted by spencer"

Me:

Don the libetarian Democrat says:

Today, 3:33:25 PM

“I don't understand the problem. From the point of incentives, you want: 1) Short term rates to stay low, giving investors a disincentive to buy govt bonds, but rather stocks and corporate bonds. 2) Longer term interest rates to be rising, so that investors will buy longer term bonds and feel confident about a recovery. Both of these are designed to attack the Fear and Aversion to Risk, which Bernanke believes is central to this crisis. I don't know what people expected, but that's what's happening, and I think that it's working. Slowly. Similarly, infrastructure investment is meant to show confidence in the future. A tax break for investment would presumably also be to attack the Fear and Aversion to Risk, by providing an incentive to invest now. I also favored a Sales Tax Holiday, to give people an incentive to spend now. I can see people disagreeing with my views, but I don't see that they are a priori false. By the way, this seems to follow from remarks by investors like James Grant, who see the current situation as a buying and investing opportunity, especially for Value Investors. Don the libetarian Democrat says: Today, 7:03:34 AM “"Rising long term interest rates will stifle both the economy and corporate profitability." It 'will' at some point, but we are nowhere near those rates of interest yet. "both could be happening at the same time. "I think it is probably a little bit of both, discounting the supply of new debt, but I detect...there is a pick up in confidence about the future," said Fisher." Thanks for the reference. That's what I'm saying. This is how it's going to work. We've just gone through a panic. Investors are still overreacting at the slightest doubt, which is why they're worried about much higher interest rates going forward. Yet, it is also showing confidence about the future, which is how it's supposed to work. The connection with interest rates on home loans is a little more problematic. It doesn't mean that they'll have to shoot up immediately, but, eventually, they will rise. By the way, I don't think holding down mortgage rates is a good idea.

article clearly shows that the Fed was aware of regulatory capital arbitrage (RCA)and it paints a largely sympathetic picture of the phenomenon

From The Baseline Scenario:

"New Forms of Internet Communication

with 3 comments

Arnold Kling has developed a new form of communication across the Internet: he wrote a blog post entitled “Paging Simon Johnson and James Kwak,” pointing to a 2000 paper by a Federal Reserve economist on the usage of securitization and off-balance sheet entities to effectively lower banks’ capital requirements for the same level of asset exposure. According to Kling, “the article clearly shows that the Fed was aware of regulatory capital arbitrage (RCA)and it paints a largely sympathetic picture of the phenomenon.”

I haven’t sprung for the $31.50 to download the full article yet, but it is going on my reading list.

Kling also said he is “researching the history of capital regulation,” which is something I would also look forward to reading.

Update: One of my friends pointed out that my university has online access to lots of journals, including the one this paper was published in, so I now have a copy.

By James Kwak

Written by James Kwak

May 14, 2009 at 6:15 pm"

Me:

I think that this is the same thing, more or less:

http://www.defaultrisk.com/pp_super_15.htm

Is there any doubt that lower capital standards are the main reason for CDSs and CDOs on a large scale? I thought that it was understood that the need was to get around capital requirements, and CDSs and CDOs happened to fit the bill. I’m talking here about the sellers. The buyers are another matter.

There were also extra fees and slicing advantages as well, of course.

Incentives matter. That is central to economics. It also is important for political economy

TO BE NOTED: From EconLog:

"More Thoughts on Masonomics

Arnold Kling

Tyler and Alex have new textbooks on micro and macro. Both begin with the same anecdote.

In 1787, the British government had hired sea captains to ship convicted felons to Australia...On one voyage, more than a third of the males died and the rest arrived beaten, starved, and sick...

Instead of paying the captains for each prisoner placed on board ship in Great Britain, the economist suggested paying for each prisoner that walked off the ship in Australia. In 1793, the new system was implemented and immediately the survival rate shot up to 99 percent.

That is economics on one foot--incentives matter.

What to do, then, about macroeconomics? In crude Keynesian economics, incentives do not matter. Consumption depends on income, investment depends on animal spirits, and prices have no impact. Much of the post-Keynesian synthesis has been devoted to bringing incentives back into the picture. The results have satisfied neither hard-core microeconomists nor hard-core Keynesians. Tabarrok and Cowen devote some space to Real Business Cycle theory, which is all about incentives. They also devote some space to the sticky-price version of New Keynesianism, in which incentives are combined with imperfect price flexibility.

I think a more promising approach is to look at the macroeconomic impact of signaling. Workers view wage rates as signals of their employer's long-term commitment to their welfare. Thus, a wage cut is a particularly negative signal, and it is difficult to cut wages in a downturn without causing major problems. See Lectures on Macroeconomics, number 4.

Also, as I have been arguing in recent posts, financial markets depend crucially on signaling. Perfect transparency in financial intermediation is impractical--if you can see through the intermediary you could have done without the intermediary and invested yourself. Thus, investorrs necessarily rely on signals when dealing with financial intermediaries. Under those circumstances, it is easy for confidence to fluctuate. We saw in recent years that there was extreme over-confidence in the financial engineering related to home mortgages. Now that confidence is gone. When confidence is high, financial intermediaries enlarge their balance sheets and economic activity expands. See lecture number 9.

So, here are some thoughts on Masonomics in general.

1. Incentives matter. That is central to economics. It also is important for political economy--Masonomics uses public choice, which says that government officials, rather than acting as benevolent omniscient stewards, respond to incentives.

2. Signaling matters. It matters in education, health care, finance, politics, marketing, and personal relationships. I would suggest that if there is to be a Masonomics perspective on macro, then signaling should be central.

3. Institutions matter. Formal and informal rules shape economic behavior, for better or worse. For example, differences across countries in the standard of living are determined largely by institutions.

4. Evolution matters. When others see a lack of planning or central direction as chaos, Masonomists see Hayek's spontaneous order. A system of decentralized trial-and-error decisions works better than many people realize. Central regulation works less well than many people expect."

What we want is unlimited access to medical procedures without having to pay for them.

From Econlog/Arnold Kling:

"Next Thursday, I will be debating Robert Kuttner in Burlington, Vermont. To be precise, 4-5:30 p.m. on April 23 in the Grand Maple Ballroom of the Dudley H. Davis Center on the University of Vermont campus.

Ezra Klein writes,

The hypothesis I'm going to offer is not definitive, and is not meant to be. But my read of the evidence is that at the root of our health care problem is an almost pathological aversion to making hard choices -- an aversion that has, in its steadiness and implications, become the most consequential choice of all.

...There is no budget. We don't want one. We're profoundly uncomfortable saying that a person's life, or health, is not worth the price of a particular procedure.

What we want is unlimited access to medical procedures without having to pay for them. What we get is extravagant use of medical procedures with high costs and low benefits. This is unsustainable and it will stop. The debate should be about how the cost-benefit trade-offs and rationing will take place. I will argue that most health care spending should be paid for out of pocket, with insurance reimbursement only for very large expenses over a multi-year period. With consumers paying out of pocket, they will take price into account in making their choices, and they will self-ration. The alternative is to have government officials make the choices about what treatments people are to obtain. I do not think that this is a one-sided debate, in which one position is clearly better than the other. But I hope that Kuttner and I can have this debate, rather than go off into red herrings like drug company profits."

Me:

Don the libertarian Democrat writes:

This sounds like a good debate because you and Kuttner are both excellent. My view conforms with Milton Friedman's about health care in this interview he did with Kuttner:

"RK: But, you know, physicians incomes relative to other highly skilled professionals are relatively lower in the western countries that have universal health insurance, so I think it is kind of indeterminate.

MF: We have the worst of all of all worlds on that score

RK: I couldn't agree with you more. We have the worst mix of government and private, I could not agree with you more.

MF: We ought to have much more private or much more government. ( NB I AGREE COMPLETELY- DON )

RK: Well, to the extent that government is involved at all it ought to be doing a better job than its doing now. I am entirely in agreement.

MF: But there is no formula for doing it. Every area where the government gets involved, whether its education, whether its medicine. If government were to take over the industry of running retail grocery stores, that would be a major problem. The post office is a problem. And if Medicare and Medicaid had never been passed, it may well be, probably would be, that expenditure on health would have gone up, maybe to seven, eight, nine percent of GDP, because as we get to be a richer country, it's a product that people want to have more of. And there is nothing wrong with that. In fact there's nothing wrong with medical spending being 20 percent of national income.

RK: If people want it, sure.

MF: But what happens when the government takes over, spending goes up while the government involvement grows, but when the government takes the whole thing over, then spending goes down. Look at what happened in Great Britain or in Canada, they spend much less, That's because of government rationing. Allen Wallace once wrote an article about the effect of government taking over an activity, and he pointed out that spending goes up while they're taking something over, then it goes down afterwards because that's where they can get money for another venture.

RK: Well, I guess the basic disagreement is that I think there are more sectors of the economy than you do that for a variety reasons aren't either self-regulating in terms of how they operate, or get the right resources.

MF: I think the real difference is that you have more confidence in government than I do.

RK: No, I don't have necessarily have confidence in government, but I think rather than just concluding that the remedy for healthcare not being a good subject for the free market, is just to say well that's too bad, I think you've got to work harder at having the government to do what is has to do better. And I think, ironically enough, the Federal Reserve is one of the proofs of the pudding, because that, after all, is part of the government, and it has learned some things over 70 years.

MF: Wait another 10 or 20 years. I trust the government to behave like a government."

I would like us to choose one way or the other. The hybrid approach is a disaster. My own view is like Charles Murray's view, and that is that we should have a guaranteed income out of which universal health care insurance is paid.

"Lopez: At one point you talk about possibly increasing the grant size if you estimate on health-care-cost needs turned out to be off? What’s to say that in implementation the grant size doesn’t skyrocket?

Murray: The passage you’re talking about was intended to anticipate critics who present elaborate data to prove that my $3,000 allocated annually to health care is not precisely right. I’m close, but I don’t want to spend the next year arguing about whether the right number is $3,300 or $3,500 instead of $3,000. In effect, I’m saying to the reader: “Okay, for purposes of reading the other chapters in the book, assume that the grant size is their number for health care plus $7,000.” The debate about the Plan shouldn’t get sidetracked over a few hundred dollars, because small dollar differences are irrelevant to the main argument. Suppose, for example, that the right figure for the annual health care allocation is as high as $3,8000 instead of $3,000. All that means is that the projected costs of the Plan cross those of the current system in 2015 instead of 2011. "

I just thought I'd mention it since no one besides me is going to. Otherwise, as I say, we should choose anything but a middle of the road hybrid.

Posted April 19, 2009 3:17 PM

they didn't sell enough risk

TO BE NOTED: From The Atlantic Business Channel:

"Mar 28 2009, 8:17 am by Charles Davi

The Kling and I on credit default swaps

Arnold Kling and I will probably never agree when it comes to credit default swaps (CDS). Kling and I have had words in the past over CDS, and so have Kling and Felix Salmon. But so long as spirited debate proves interesting to us and our readers, I'm happy to participate in that hallowed, nerd-sport-of-choice: arguing over the internet.

Kling seems convinced that because he cannot conceive of a way to hedge credit risk using the long end of a CDS (the protection seller's end) it follows that CDSs have no "natural seller." In short, his position is the following:

"[N]o institution was in a position to sell credit default swaps as a natural hedge against its other business."

Why would both ends of a CDS need to hedge some risk in order for the CDS to be economically beneficial? I fail to see how hedging is the sine qua non of economic utility. If that were the case, who is a natural buyer of bonds? I'm sure Kling is incapable of answering that question because as a matter of pure logic, any answer to that question is an answer to his, since selling protection through a CDS is economically equivalent to buying the underlying bond (ignoring CDS collateral, which complicates the matter).

In any case, it seems futures and forwards are acceptable means of speculation, but CDS are not. In the case of fuel and other energy and commodity derivatives, there are those in the market who have bona fide economic exposure to the underlying risk. For example, an airline might enter into a swap or a forward contract to lock in a price for fuel, so that it can plan around that price and won't be brutalized by volatility in fuel prices. The other end of the trade could very well be an entity with no bona fide economic exposure to fuel prices. Rather, that entity wishes to speculate on the movement of energy prices. Both benefit through contract in that both get what they want: the airline wants stable fuel prices and the speculator wants the opportunity to profit by expressing a view on the movement of fuel prices.

The same applies to CDS. Certain entities in the market have bona fideeconomic exposure to credit risk. For example, banks. In order to shed this risk, banks will contract with another party, the protection seller, to absorb this credit risk. The bank wants to unload its credit risk and the other party wants to speculate as to the probability of default on and, more generally, the movement of credit spreads relative to the underlying credit. And so, both parties get what they want and the transaction is, at a minimum, economically useful ex ante."

And Felix Salmon:

"CDS: The No-Natural-Seller Meme

I was on a panel last night with Simon Constable of Dow Jones Newswires, and I'm sure that to our lay audience a peculiar exchange in the middle of the conversation must have sounded a bit like dolphin squeaks. He was trying to demonize credit default swaps, and said with great finality and self-assuredness that if you wanted proof positive that they were the spawn of the devil, all you needed to do was examine them objectively, as he had done, and you'd see that they had no natural seller.

I then interjected that of course credit default swaps have natural sellers: any bond investor is a natural seller of CDS protection. We started going around in ever-decreasing circles of mutual incomprehension, until the moderator happily put an end to that particular discussion and moved us on to the next topic. But now Arnold Kling has resuscitated the meme:

There is no institution which, in the ordinary course of its business, takes a position for which selling credit default swaps is a natural hedge...
Credit default swaps allow companies to trade the default risk on, say, a mortgage-backed security. The holders of that security have a natural interest in buying protection. But nobody has a natural interest in selling protection.

I thought I'd dealt with this back in December, but evidently not, so let me try again, this time quoting a little of my Wired article on the Gaussian copula function:

If you're an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. Either way, you get a regular income stream--interest payments or insurance payments--and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn't constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly.

The point is that there are a lot of very sophisticated bond investors out there, and much of the time they could replicate the risk and return of buying a bond by putting together certain trades in the CDS market -- and get much better liquidity that way. It's not easy to find bonds from certain issuers, but you can always find a broker willing to buy credit protection on any given name.

A bond investor isn't really hedging anything, so it's true that if and when a bond investor starts selling default protection, then he isn't offsetting some opposing risk. But it's simply not true that in order to make a derivatives market work, both sides have to be hedging something. In the CDS market, you can simply have one person, who doesn't want risk, selling that risk to another person, who does want it.

Generally speaking, it's a good thing for banks to sell down their risk, even as it's also a good thing for institutional fixed-income investors to buy risk: that is, after all, their job. Part of the problem in this financial crisis, as I was talking about earlier, is that banks started persuading themselves that they'd sold so much risk that there wasn't any left, even as the amount of risk they had on their balance sheets continued to balloon. That was a serious failure of risk management: they didn't sell enough risk, largely because they couldn't find any buyers (except for AIG, sometimes) for the super-senior risk tranches that they were prone to keeping on their books.

But those buyers weren't absent because there were no natural sellers of CDS; they were absent because the yields on offer on those super-senior tranches were so ridiculously low that no one in their right mind wanted to buy them. So long as there are bond buyers, there are natural sellers of default protection. They might not be hedging anything, in a narrow sense, but they are large, and numerous, and extremely useful when it comes to providing liquidity and price discovery. By all means regulate the CDS market; by all means move CDS trading onto an exchange. (Although that might not make as much of a difference as many people hope.) But let's not kid ourselves into believing that there was no reason for the CDS market to exist in the first place."

The opportunity for "just-so" stories strikes me as too great.

TO BE NOTED: From EconLog:

"In Be the Solution, Michael Strong writes (p. 66-69),

Are altruists occupationally prone to anger? Well,, it turns out that they are, in fact, biologically inclined to be angry and punitive toward those who they perceive to be not being helpful.

Evolutionary psychologists believe that status is correlated with perceived community altruism because in part it was in our evolutionary interest to prevent free riders...

we are willing to punish those who do not contribute to collective action even at a cost to us, another finding that is inconsistent with rational choice...

Thus, the very fact that we have moral impulses to support the public good is necessarily intertwined with the facdt that we have moral impulses to punish those who do not (and to punish those who do not punish those who do not, and so on)...

This instinct is especially harmful when used to punish those who are perceived not punishing free riders. This is the source of the bigotry against market economics among the do-gooders: It is believed that those who describe the positive outcomes of free enterprise are not doing their job to behave punitively toward free riders, and that therefore they, too, must be punished.

In other words, because economists do not want to punish rich people, altruists believe we must be punished.

But it's worse than that. You can signal that you are an altruist not by engaging in altruistic acts, but simply by expressing a desire to punish others. For example, by taking away AIG bonuses, you do a great deal to signal altruism, even though the actual social gains from taking the bonuses away are miniscule (the gains may even be negative).

This topic of signaling and deception is worth some extended remarks, below.

1. Tyler Cowen and Robin Hanson both think that signaling and deception are very important. If you listened to their bloggingheads and cannot remember anything about signaling and deception, then you need to listen again.

2. The most original idea that Robin Hanson has about health care expenditures is not that much spending is wasted--many other economists believe that. The original insight is his explanation for high spending, which is that we encourage the health care spending of others in order to show that we care. This hypothesis has the added bonus of helping to explain why so much of health care spending is paid for by "insurance."

3. I thought that the most fascinating parts of Tyler's Discover Your Inner Economist where the parts on self-deception. I wish that Tyler would do a whole book on deception and signaling. Alternatively, maybe I should do a book on Masonomics, and include a large chapter on the importance to Masonomists of deception and signaling.

4. I think that signaling and self-deception are in the back of Tyler's mind in his blogging heads with Peter Singer. (Note that Singer's debating technique is to begin by appearing to concede Tyler's points, and then to push back. I call this the "Yes, but" approach.)

5. A reason to focus on deception and signaling is that they appear to have great evolutionary survival value. Even stupid plants have evolved powerful tools for deception and signaling, looking tasty when it is helpful and looking unappetizing when that is helpful. Animals have many behaviors that are designed to deceive--think of animals that appear more fierce than they are, for example. But in all of nature, the most powerful tool for signaling and deception is the human brain.

It is plausible that a great deal of the evolution of the brain has been to make us better players of the game of deception. Think about that.

6. A lot of mating behavior involves signaling and deception.

7. A lot of political behavior involves signaling and deception.

8. Perhaps a lot of economic behavior (think of marketing and sales) involves signaling and deception.

9. As we become wealthier, perhaps signaling and deception increase. We do not have to focus as much on meeting basic needs, so we have more energy to devote to competition for status, which is mostly a matter of signaling and deception.

10. Michael Strong suggests that altruists may be particularly inclined to punish alleged free riders. But it could be that you signal altruism by showing an inclination to punish. You don't necessarily have to be an altruist if you want to take away AIG bonuses. You could be very selfish, but coming out against AIG bonuses is a cheap way to signal your altruism.

11. On the other hand, what is being signaled by those who are skeptical of taking away AIG bonuses?

12. I am not as comfortable as other Masonomists are with using signaling explanations. The opportunity for "just-so" stories strikes me as too great. "Counter-signaling" seems to me to take signaling completely out of the realm of testable theory and into the realm of nonfalsifiability. If a peacock growing a useless tail can be explained as a signal, then what would falsify the theory of signaling?

CATEGORIES: Behavioral Economics and Rationality , Books: Reviews and Suggested Readings"

Such frippery makes Arnold Kling shudder

From Felix Salmon:

"New York Employment Datapoint of the Day

From Richard Florida's Atlantic cover story:

Financial positions account for only about 8 percent of the New York area's jobs, not too far off the national average of 5.5 percent. By contrast, they make up 28 percent of all jobs in Bloomington-Normal, Illinois; 18 percent in Des Moines; 13 percent in Hartford; 10 percent in both Sioux Falls, South Dakota, and Charlotte, North Carolina.

Florida's article is provactive throughout; he says that New York's density and velocity will serve it well in the creative industries which will end up powering future growth, even if they're not financial. Certainly if a talented financial-industry professional wants to go off and do something completely different right now, the opportunity cost has never been lower. And New York is a center for many industries, not just finance:

Currid measured the concentration of different types of jobs in New York relative to their incidence in the U.S. economy as a whole. By this measure, New York is more of a mecca for fashion designers, musicians, film directors, artists, and--yes--psychiatrists than for financial professionals.

Such frippery makes Arnold Kling shudder:

I hate the Mets. I find the heavy-handed sensory overload of New York tiring and ultimately unpleasant, in the same way that I find Las Vegas or Disney World unpleasant...
I don't think that the arts are all that important. To me, creative innovation that matters is somebody in a lab at MIT coming up with a more efficient battery or solar cell. It is somebody at Stanford coming up with a way to make computers smarter or cancer more preventable. I just can't get excited about some frou-frou fashion designers and the magazines that feature their creations.

Florida does say that not only New York but also Boston and Silicon Valley will be winners in the new geography which will emerge from the current crisis. And "heavy-handed sensory overload" is something very closely related to Florida's density-and-velocity.

What's more, frou-frou fashion designers and the magazines that feature their creations are genuinely economically important. If Arnold Kling can't get excited about them, that's fine. But if "mattering" is judged in terms of value-added or jobs created, then the fashion industry matters a lot, and New York should be very grateful that a large part of it is based right here.

The artsier creative industries are also a huge comparitive advantage for New York over, say, Palo Alto. Someone with the skills of Sergei Brin is in high demand from Sao Paulo to Shanghai. But where will the next Stephen Sondheim head, if not New York?"

Me:

This discussion does remind me of the famous quote that I heard as a child, " Wherever there is Haute Couture, there will be be a need for mannequins".

By DonthelibertarianDemocrat Posted: Feb 15 2009 7:56pm ET

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What I mean is that a post-nationalized system could consist of two types of bank.

From Stumbling And Mumbling:

"Nationalization and free markets

Could nationalization of the banks pave the way for a free market banking system? A suggestion in this post by Arnold Kling makes me wonder.
What I mean is that a post-nationalized system could consist of two types of bank.
One would be the nationalized banks. These would be plain utilities, a bit like old building societies. They’d take in guaranteed deposits and make vanilla loans to firms and households. They’d use money markets to smooth liquidity conditions, but not to fund their businesses.
The second type would be unregulated banks which could operate as they please, but with no government protection for depositors or investors.
Mightn’t this system give us the best of both worlds - there are guaranteed deposits for those who want them, but there’s also a source of innovation and dynamism?
What would be the drawbacks?
One is the sheer practical difficulty of getting from here to there. How do we slough off RBS’s risky operations to leave us with its utility-style business? In current conditions, with investors acutely risk averse, how would non-regulated banks raise funds to start?
Another problem is whether the free market system would be a danger to the wider economy. What if a large bank fails? Free market optimists might say that the contingency is a remote one, as the market would regulate them, by starving risky banks of funds in the first place. Or they could argue that the only losers would be depositors and counterparties who knew the risks they were taking and staked only money they could afford to lose. The wider economy might suffer from a dip in demand as there’s a modest adverse wealth effect, but nothing catastrophic.
Pessimists, however, could argue that there’s systemic risk here, as those who lost from this bank failure are unable to meet their obligations to third counterparties.
A third problem is the classic adverse selection problem. Good borrowers would prefer to borrow from the nationalized utility banks as their guaranteed deposits mean they can offer cheaper loans. Private sector banks are then left with only the riskier prospects.
You might think that this point raises a fourth difficulty - that the nationalized banks have such advantages that free market ones would be unable to compete. I’m not sure. If the free market is as dynamic and innovative as its supporters claim, then it’ll find a way. And if it isn’t, then nationalized banks aren’t as bad as they claim.
Feel free to add other difficulties.
But the question isn’t: would this system be ideal? Perfection is unobtainable. It is: would this system be better than a heavily but imperfectly regulated industry? Could it be that state ownership, far from being the enemy of private enterprise, might in this case be a precondition for it?

February 11, 2009 | Permalink"

Me:

I like the idea, but I think that narrow/limited purpose private banks could also be a possibility:

See here from the FT:

http://blogs.ft.com/economistsforum/2009/01/putting-an-end-to-financial-crises/#more-315

"What will change this behaviour is to not let it happen. Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 per cent-down and payments below 25 per cent of income.

The government, via the Federal Financial Authority, would use tax records to verify loan payment-to-income ratios. It would also spot check collateral. Once approved, the banks would bundle and sell “their” loans within mutual funds.

Again, traditional bank runs wouldn’t arise. And today’s bank runs, which entail lenders and equity investors avoiding risky banks, wouldn’t either. Why? Because banks would bear zero risk. Mutual fund owners would bear risk, but not the banks. And these lenders would know they were buying government-approved AAA-rated loans, not Bear Stearns‘ CDOs.

This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.

With limited purpose banking, financial crises would largely disappear. Banks would never fail, never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs - like gas stations.

The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.

Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 per cent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode."

Check it out.

Posted by: Don the libertarian Democrat | February 11, 2009 at 10:56 PM

a sort of golden era for economic policy, because it involved high economic growth with relatively little inequality

From Arnold Kling:

"Brink Lindsey has written a paper criticizing Paul Krugman's view that the period from 1950-1970 was a sort of golden era for economic policy, because it involved high economic growth with relatively little inequality. Lindsey instead sees the immediate postwar era as one of lazy cartels, in which firms faced too little in the way of competition or creative destruction to warrant bidding up the price of executive talent.

I'm tempted to joke that we will know that Lindsey has succeeded if Krugman issues a bitter, personal attack on Lindsey. My own thoughts are as follows.

In my view, Lindsey only focuses on two of the four causes of inequality that Nick Schulz and I presented. We talk about technology, immigration, winners-take-most markets, and family structure. Lindsey puts a lot of weight on the first two. He alludes to winners-take-most markets in entertainment, but my view is that such markets have emerged in other areas as well--look at Microsoft or Google. Finally, I think that the family structure issue is more than just smaller household sizes. I think that Betsey Stevenson/Justin Wolfers marriages are another big factor. That is, when highly-educated men start looking for wives who are stimulating companions as opposed to kitchen floor-moppers, this reduces cross-class marriages and thereby raises inequality.

The big puzzle here is that of executive pay. Krugman has a simple story--executives will take as much pay as social norms will allow, and until the Reagan era social norms would not allow them to take very much. Lindsey's story is that a more competitive, dynamic business environment caused executive pay to rise.

Both of these sound to me like just-so stories. Either one may be right (or both--they are not mutually exclusive), but I don't think we have anything like smoking-gun evidence. My gut instinct actually leans more in the direction of Krugman. I look at the salaries of college presidents, for example, and I see them affected more by norms than by a tough competitive environment.

I think that there are plenty of people, mostly men, who have extreme cravings for status. In academics, this shows up as professional jealousy of all sorts. In politics, it shows up in the insatiable desire to expand authority. And in business, it shows up as a desire for ridiculously high pay. Maybe in a perfect world, these status cravings would be better reined in.

I would side with Krugman in the sense that I think that if norms were changed to reduce the size of executive pay, there would be little or no loss of economic efficiency. But I would not side with Krugman in jumping to the conclusion that we really ought to put a lot of effort into changing norms. Even assuming that executives are paid way above their marginal products, the fact that executives get a large share of the pie does not reduce my share of the pie by enough for me to care."

Me:

Don the libertarian Democrat writes:

"view that the period from 1950-1970 was a sort of golden era for economic policy, because it involved high economic growth with relatively little inequality. Lindsey instead sees the immediate postwar era as one of lazy cartels, in which firms faced too little in the way of competition or creative destruction to warrant bidding up the price of executive talent."

1) If high economic growth and relatively little inequality aren't good, what are they?
2) It sounds like we should be in favor of lazy cartels.

At best, Lindsey says that the times weren't as great as Krugman believes. But, given the last thirty years, many people might conclude that these have been even worse economically, although not socially. My own belief is that small government advocates need to focus on income inequality and income growth for the entire population. I think that this is an essential problem to work on if we want less government.

Only under conditions where the middle class believes that it is a middle class, and not one tiny step over serious problems, and the lower class believes that it is not being ignored, will less government ever be truly possible. Without addressing those concerns, I believe that Krugman's arguments will prove very popular.

Taleb, like me, wants to get rid of risk-taking by banks

From Arnold Kling:

"Over at econtalk, Russ Roberts interviews Daron Acemoglu. Self-recommending, as Tyler would say.

Also, here is a video featuring Daniel Kahneman and Nassim Taleb. Taleb, like me, wants to get rid of risk-taking by banks, and leave non-insured institutions free to take whatever risks they want, as long as they are not creating risks for others. His solution is to nationalize banks. (me: why would this mean that they would not take risks? Suppose that Freddie Mac and Fannie Mae had been fully nationalized as of three years ago. Would they have taken more risk or less risk?)

Kahneman tells a story of Swiss army men who got lost in blizzard in the Alps. When they finally find their way back, they are asked, "How did you find your way?" They say, "We had a map." But the map is of the Pyrenees! Kahneman's point is that people have a lot more confidence if they have maps, even if those maps are wrong.

Taleb does not explicitly dispute this point, but he clearly does not like the notion. It would imply that you want a doctor to think he is correct, even if he is wrong, because the doctor is giving you a map. Taleb says that religion succeeded because when people had faith, they stayed away from doctors, who were wrong. (He makes those sorts of comments a lot, as you know.) He wants business schools to stop giving students the "map" of financial modeling, because he thinks those models are wrong.

In my Lost History of Macroeconometrics, I say that macroeconometrics tries to satisfy the need for a map, but it does not provide a reliable map. But I am in the same position as Taleb. People want to believe in a map, so telling them they have the wrong map is not going to get me very far.

Finally, a reminder that on Tuesday, February 10, I will be speaking here. If they don't record it, I'll try to remember what I said. (I try not to use notes or a text. Instead, I prepare by practicing while I walk. These days, if you're talking to yourself while walking, people just assume you are on the phone, so they don't even look at you funny.)"

Me:

Don the libertarian Democrat writes:

"Taleb, like me, wants to get rid of risk-taking by banks, and leave non-insured institutions free to take whatever risks they want, as long as they are not creating risks for others. His solution is to nationalize banks. (me: why would this mean that they would not take risks? Suppose that Freddie Mac and Fannie Mae had been fully nationalized as of three years ago. Would they have taken more risk or less risk?)"

Although I'd like to nationalize a few banks in this mess, I agree with you. We don't need to run them, especially if we have narrow/limited purpose banks. I didn't like this idea at first, but if it allows the existence of risk-taking non-insured institutions, then I'd be for it.

Macroeconometrics is fundamentally an attempt to turn different time periods (say, the 1970's and the 1990's) into controlled experiments.

From Arnold Kling:

"Menzie Chinn writes,

A key reason for the academic disenchantment with these types of models included the view that the identification schemes used were untenable (e.g., why is income in the consumption function but not in the investment?). Another source is the combined impact of the inflationary 1960's and 1970's, and the Lucas Critique.

Chinn ignores the critique of structural macroeconometric models that most influenced me. In this regard, he is like many young macroeconomists today, including some who have taken shots at my blog posts (I don't feel personally insulted, just bothered by the wrong-headed view of people who think that the only problem you need to solve in macroeconometrics is the Lucas critique). The American Economic Association has a new Journal of Macroeconomics containing no less than three articles that reflect this misguided view. My anger at these articles prompted me to begin an essay called "The Lost History of Macroeconometrics." When I finish, I may submit it to the journal. In any case, I will post it here, because I really think that younger economists have failed to learn some key lessons. Below, I elaborate on my views.

[update: Mark Thoma adds color.]

Macroeconometrics is fundamentally an attempt to turn different time periods (say, the 1970's and the 1990's) into controlled experiments. There are many challenges to overcome. One is that the size of the economy differs across time periods. There is more income and more consumption in 1990 than in 1970, for reasons having nothing to do with fiscal policy or monetary policy.

How can we make data from different time periods truly comparable? One approach would be to adjust data for trend factors that affect the scale of the economy--population growth and trend productivity growth. Unfortunately, these trend adjustments fail, as is demonstrated by the high coefficients of serial correlation that remain in the de-trended data. In layman's terms, no matter how hard you try to adjust for trends, macro data still send out strong signals saying that time periods far apart are not really comparable.

The next thing that you can try is to "difference" the data. That is, instead of focusing on the level of consumption in the fourth quarter of 2003, you take the difference between consumption in the fourth quarter and consumption in the third quarter. In fact, given the high degree of serial correlation, failure to difference the data, or at least semi-difference the data, would be utterly unsound practice.

Once you difference the data, however, you greatly amplify noise in the data relative to signal. At this point, if you know anything about the conceptual problems and implementation issues that the statistical agencies have in constructing the data to begin with, you realize how reckless a project it is to simply turn a computer loose trying to find patterns in this noise, which is what vector autoregressions are all about. Instead, you filter out the noise in differenced or quasi-differenced data using "priors" about economic structure. In other words, you bring a point of view about key macroeconomic relationships to the data, and you force your statistical estimates to conform to those relationships. This is the structural approach.

The structural approach is nothing but a roundabout way of communicating the way you believe the economy works. The estimated equations are not being used to inform the investigator about how the economy works. Instead, the equations are being used by the econometrician to communicate to others the econometrician's beliefs about how the economy ought to work. To a first approximation, using structural estimates is no different from creating a simulation model out of thin air by making up the parameters.

This "making up out of thin air" critique is logically distinct from the Lucas critique. Telling me that a structural model is robust with respect to the Lucas critique only tells me that you made it up out of thin air in a way that satisfies a particular set of beliefs about how the economy ought to work. It does not tell me that you have found reliable relationships in the data. The relationships are in your own head, and you have used the data as a calibration tool.

In my day, the leading macro model, which was the antecedent to the Federal Reserve model, was abbreviated FMP. This stood for Fed-MIT-Penn, but a common joke was that it stood for "Franco Modigliani's Priors," meaning his beliefs about the economy. The FMP model was a showcase for Modigliani's life-cycle consumption function (one of the ideas cited in his Nobel award). However, his collaborator Albert Ando appeared to me to be the main force behind the FMP model. It would better be termed "Albert Ando's priors." For over thirty years, Flint Brayton at the Fed has been custodian of the model, so today it reflects his priors, which in turn have evolved in response to changes in opinions elsewhere in the profession.

Once again, the second critique of macroeconometrics is this. Structural models do not extract information from data. Instead, they are a method for creating and calibrating simulation models that embody the beliefs of the macroeconomist about how the economy works. Unless one shares those beliefs to begin with, there is no reason for any other economist to take seriously the results that are calculated."

Me:

Don the libertarian Democrat writes:

"Macroeconometrics is fundamentally an attempt to turn different time periods (say, the 1970's and the 1990's) into controlled experiments."

Where any human behavior is involved, I don't see it as possible to denude your investigation of the actual social and historical context of the particular time. For instance, in the 30s, many people assumed that capitalism was dying and that fascism or communism were the future. It's hard for me to believe that the methods tried then were not only influenced by these presuppositions, but had an influence upon how they worked out.

"In other words, you bring a point of view about key macroeconomic relationships to the data, and you force your statistical estimates to conform to those relationships. This is the structural approach."

A major problem here would be confirmation bias. Indeed, in many of the discussions of the 30s, people seem to be looking for any verification that they can find of their views,they then pronounce their evidence valid, and ignore or exclude contrary findings or explanations. I know that you've tried to downplay this, but, from the outside, it does look political.

From my point of view, this is how the world actually works. Keynes provides a map or narrative for our current situation, and, centering on that central narrative, people start offering either assent or dissent, even as people try anything that seems plausible in the real world.

I do the same thing in my own views. For instance, I really enjoy the book called "The Calculus Of Consent". I have a link to it on my blog/diary. I find that it largely confirms my own views of political economy. However, I hesitate to quote it much because, if I'm not mistaken, Gordon Tullock is still around, and I've a bad feeling that he wouldn't agree with some of my uses of that book. I fear a McLuhan in Annie Hall moment on some blog I suppose.

All of this debate seems healthy, assuming you can accept criticism. I can't, but I'm not an academic.

I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion.

From Robert Waldmann:

"Background on "fresh water" and "salt water" macroeconomics

by Robert

Will Wilkinson asks what’s with the economics profession.

A bit more on the public relations quandary the economics profession ought to be in, if it isn’t already…

When I see DeLong more or less indiscriminately trashing everyone at Chicago, or Krugman trashing Barro, etc., what doesn’t arise in my mind is a sense that some of these guys really know what they’re talking about while some of them are idiots. What arises in my mind is the strong suspicion that economic theory, as it is practiced and taught at the world’s leading institutions, is so far from consensus on certain fundamental questions that it is basically useless for adjudicating many profoundly important debates about economic policy. One implication of this is that it is wrong to extend to economists who advise policymakers, or become policymakers themselves, the respect we rightly extend to the practitioners of mature sciences. There is a reason extremely smart economists are out there playing reputation games instead of trying to settle the matter by doing better science. The reason is that, on the questions that are provoking intramural trashtalk, there is no science.

Sadly, there is no one better to listen to.

Now before going on I note that Wilkinson does not address the merits of DeLong's criticisms or Krugman's. He uses a words to suggest that they are writing unprofessionally but he doesn't present a counter argument to their claims. I have quoted his full post. Nothing on the merits.

Instead he asks if disagreements between economists are so fundamental that there is no professional consensus useful to non economists. My brief answer is “yes.” A longer answer after the jump.

Update: Over at Kling's blog commenter Bill Woolsey hits the nail on the head.

Perhaps part of the problem we face in macroeconomics today is that a substantial part of the "macro" wing of free market economists really think that new classical macroeconomics is "true" because simple and formalistically complete models fit their notion of what is scientific.

After the jump you can read my verbose effort to say that.

By the way, Kling's willingness to criticize the arguments others present to support policy positions with which he agrees is really admirable.


It is like Ricardian equivalence. Because the model people (person) rationally saves to pay future taxes, we are supposed to assume this has a connection to reality?





Arnold Kling has already attempted to explain things to Wilkinson. He obtained a “department of huh?” from Brad DeLong and, for what it’s worth, two extremely intemporate comments from me (one was blocked as suspected spam because I provided to many links to support my claims which suggests something about the intellectual seriousness of comment threads at at least one blog).

While I claim that Kling’s take on the stimulus debate is absolutely inconsistent with facts in the public record which I found with a few minutes of googling, I share his general view on the divisions in the profession. He notes that there is more than one fundamental gulf which means that there isn’t a consensus among economists which would enable the few non economists who respect us to take our advice. I will mention three more just because I want to consider more economists than those discussed by Wilkensen and Kling and not because I think Kling left out anything relevant to his post

Kling discusses the policy advice of macroeconomists (and Fama). Not all economists are macroeconomists who think that it is there job to offer policy advice. He notes two divisioins left and right and fresh water and salt water.

Left and right correspond fairly closely to libertarian vs egalitarian in the US political spectrum, that is, closely to Democratic vs Republican positions on economics (except that there are leading economists well to the left of the Democratic party and well to right of all but the left fringe of the Republican party). It is a fact that, except for general support for free international trade, the range of views of economists is similar to the range of views of congressmen but somewhat broader. This is a wide enough ideological range that the methods of verification used by economists are absolutely unable to force economists on left and right to admit that economists on right and left have a point.

In the field of macroeconomics there is a much deeper division between macroeconomics as practiced at universities closer to the great lakes than to an Ocean (Fresh water economics) and that practiced at universities closer to Oceans (Salt water economics). The geography has shifted some as Fresh water economics has been exported. I’d consider Professor Robert Barro at Harvard to be brackish (with, he reports, noticed salty contamination in the first 6 months after he moved from U. Rochester) and the economics department at the University of Pompeu Fabra (in Barcelona) seems to be distilled. It is a little difficult to explain the disagreement to non economists. Frankly, I think this is because non-economists have difficulty believing that any sane person would take ffresh water economics seriously.

Roughly Fresh water economists consider general equilibrium models with complete markets and symmetric information to be decent approximations to reality. Unless they are specifically studying bounded rationality they assume rational expectations, that everyone knows and has always known every conceivable conditional probability. I’ve only met one economists who claims to believe that people actually do have rational expectations (and I suspect he was joking). However, the fresh water view is that it usually must be assumed that people have rational expectations.

Over near the Great Lakes there is considerable investigation of models in which the market outcome is Pareto efficient, that is, it is asserted that recessions are optimal and that, if they could be prevented, it would be a mistake to prevent them.

Salt water macroeconomics is basically everything else with huge differences between people who attempt to conduct useful empirical research without using formal economic theory and people who note the fundamental theoretical importance of incomplete markets and of asymmetric information and of imperfect competition (as in everything you think you know about general equilibrium theory is known to be false if markets are incomplete or there is asymmetric information or there is imperfect competition – Market outcomes are generically constrained Pareto inefficient which means that everyone can be made better off by regulations imposed by regulators who don’t know anything not known to market participants who also just restrict economic activity and don’t introduce innovations like, say, unemployment insurance).

Leading fresh water macroeconomists include Robert Lucas, Ed Prescott Thomas Sargent, Lars Hansen, John Cochrane, Larry Jones, Robert Barro (mostly), and Kevin Murphy (usually). Leading salt water economists include Paul Samuelson, Edmund Malinvaud, Jacques Dreze, Joseph Stiglitz, Robert Solow, Paul Krugman, Andrei Shliefer, Olivier Blanchard, George Akerlof, Robert Hall, Ben Bernankle, N. Gregory Mankiw, Christina Romer, David Romer and, and Lawrence Summers. Brad DeLong is also a salt water economist and he is very very smart, but last I knew, he was a little too far out there to be really a member of the economists club. I can’t classify Paul Romer.

Notably all of the above have made important contributions to fields other than macroeconomics.

In the US there is a strong correlation between Fresh and Salt and Right and Left. The correlation is not perfect: I understand that Hansen and Sargent are politically left of center. Hall is far right politically, Mankiw is right of center. and I must admit that I have no clue about Bernanke (who I have never actually, you know, seen in the flesh).

An important discrimminant is opinions of John Maynard Keynes. Fresh water macroeconomists generally seem to think that he was not a competent economist. Salt water macroeconomists claim (often implausibly) to be in some way his intellectual followers. Barro for example clearly doesn’t remember what is written in “The General Theory of Employment Interest and Money.” Mankiw, in contrast, advised the students in his macro class (including me) to read it again and again searching for insights.

Interestingly, the fresh water macroeconomists are certain that salt water macro is discredited along the lines of the Ptolomaic model or the Phlogiston hypothesis. For a while they called their models “Modern Business Cycle Theory” stating that all incompatible models were obsolete. In the current debate many have considered it sufficient to say that arguments for the stimulus are nonsense (e.g. Cochrane). The surprisingly low quality of contributions to the debate from the vicinity of Great Lakes has a lot to do with the fact that Fresh Water macroeconomists haven’t thought about fiscal stimulus in decades and sincerely believe that it is an obviously invalid proposal so obvious arguments against it might be valid.

Even more interesting, Fresh water macroeconomists do not claim that their models have not been refuted by the data. Rather they note that all models are, by definition, false. They do test hypotheses from time to time, but don’t explain what the point is. As far as I can understand, they claim that a model *can* be both false and useful and, therefore, their models *are* useful.

I understand that in the 70s and, maybe, the early 80s there was a heated debate between Fresh Water and Salt water macroecnomists. Now, it seems to me that there is a truce of sorts where each school of thought ignores the other – that macroeconomists have specialized not in the questions that they ask but in the answers.

I think that this is a very bad situation. Anyone can see that, when top macroeconomists are asked for policy advice, some support each of the different proposals which are under consideration.

Frankly, this truce seems to me to be unilateral. Many salt water economists claim (in public) to respect the contribution of fresh water economists. I know of no fresh water economist who has expressed anything but contempt for the contributions of salt water economists to the stimulus debate and I haven’t heard one word of praise of a Salt Water economist from a Fresh water macroeconomist other than Arrow, Samuelson or Solow. I added the phrase “in public” because I clearly remember one of the salt water economists on my list refer to the fresh water economists as “the crazies”.

update: The truce is over. There have been continual cease fire offensives violations, but the shrill blitzkreig is here.

As far as I can tell, fresh water economists have some respect for some thinkers other than fresh water economists. I think they have rather a favorable view of mathematicians and Physicists. I think it would be useful of mathematicians and physicists to look into fresh water macro and express an opinion. On the other hand, in principle they have great respect for general equilibrium theory, but they don’t listen to general equilibrium theorists at all. Top general equilibrium theorists are all at least left of center politically, the closest David Cass could come to naming an exception is Ed Prescott who, he said, uses general equilibrium theory and studies examples (snort).

Finally I have a view of how people can devote so much effort to working out the implications of assumptions which almost no ordinary people would find other than nonsensical if they understood them. Fresh water economics uses difficult mathematical tools. Students in fresh water graduate programs have to learn a huge amount of math very fast. It is not possible to do so if one doesn't set aside all doubt as to the validity of the approach. Once the huge investment has been made it is psychologically difficult to decide that it was wasted. Hence the school gets new disciples by forcing students to follow extremely difficult courses. Last I hear very few graduate students at U Minnesota came from the USA. Undergrads over there know what the program is like. If my information is not out of date, innocents from abroad are the new blood of fresh water economics."

Me:

Don the libertarian Democrat says:

Today, 2:40:56 PM

“I believe that there is a difference between Economics and Political Economy. Many FW theorists don't seem to agree with this, while SW ones do. My personal favorite is Alan Blinder. Political Economy necessitates that one cannot rely on math or models. They are of limited use. Some of the FW models are of some use, but they do not decribe laws of nature. At best, they are correlative reasoning dressed up with equations. They describe possible movements among different stats or facts. In our situation, there are good arguments for both trying government spending and tax cuts. While a large stimulus would be nice, we are somewhat constrained by debt. I would probably also use more QE. Wilkinson seems to believe that certainty or agreement is necessary for Economics to be useful. He is wrong. It is useful to Political Economy, which, while not leading to certainty, does lend itself to better and worse arguments.Finally, about science. There is often a lot more disagreement on theories than people believe.

"On the contrary, among the biggest supporters of both have been the world’s investors, at least insofar as their collective judgment "

Another good James Surowiecki post:

"Libertarians Against the Market

Tyler Cowen, in his ongoing effort to ensure that the government spends as little as possible in its attempt to stimulate the economy, cites approvingly a post by Arnold Kling arguing against a big fiscal-stimulus package, because the risks vastly outweigh the potential rewards (actually, Kling doesn’t really think there are any potential rewards from a stimulus plan). Kling enumerates those “risks” in a list. This is not a very useful list, because it contains absolutely no evidence for any of his assertions—he simply assumes the existence of his risks to be a fact—and no assertion about how likely any of these “risks” are, which makes it a little hard to do a cost-benefit analysis. Kling says that “on close examination,” the case for stimulus is weak, but, in this post, at least, he offers no such “close examination,” merely a laundry list of familiar (and unproven) criticisms of government spending.

The most curious thing about Kling’s post, though, is the way he closes—namely by complaining that even though he and his side “have logic on their side,” they will be “mocked and vilified in the media” for their opposition to a big stimulus package, and that that package will be pushed through as a result of “elite groupthink”—the same groupthink, in fact, that pushed through the Paulson rescue plan. The implicit assertion here is that the support for a stimulus package, as for the rescue plan, is driven by this élite group of interventionist economists and politicians, who are overriding what would otehrwise be commonsense economic policy.

What’s odd about this is that the support for the stimulus package, as well as support for the Paulson plan, hasn’t just come from liberal economists or Democratic politicians. On the contrary, among the biggest supporters of both have been the world’s investors( TRUE ), at least insofar as their collective judgment is reflected in market prices. As I showed yesterday, investors overwhelmingly supported the Paulson plan: it was only when it was killed, that stock prices really started their downward spiral( I AGREE ). And it was only after Obama unveiled his economic team and made clear how big his stimulus plans were that the market began its sharp recovery( I AGREE ) (the S. & P. 500 is now up twenty-five per cent since Nov. 20th). And as The Economist’s mystery blogger noted yesterday, anyone’s who’s paying attention to the stock market knows what would happen if Obama announced today that he was abandoning his plans for a major stimulus package:

Markets would plummet, with significant knock-on effects, based on the actual news that government spending would not nearly close the American output gap, but also given the signal that America was no longer committed to serious stimulus.( TRUE )

The point is that it isn’t just some group of pointy-headed Keynesians saying that a big stimulus package will be good for the economy: the collective wisdom of the market is saying the same thing( TRUE ). And it seems peculiar for a supposed believer in the efficiency and intelligence of markets—which, as a libertarian economist, I assume Kling is—to simply disregard what the market is saying in this case. In effect, libertarian economists are saying that they have a better sense of what’s good for the economy than the aggregated wisdom of investors does. And that makes them sound peculiarly like the Platonic economic planners that they typically decry( TRUE ).

There is no doubt that our Investor Class wants a government bailout large enough to stop both the Calling Run and the Proactivity Run. TARP and other various government actions have tried to stop the first, while the stimulus is an attempt to stop the second. Only explicit government guarantees and actions are believed to be sufficient enough to stop these runs. Leaving the two Runs to run their course could lead to extreme losses of wealth and jobs, large enough to effect social stability. This outcome must be avoided at all costs.

The Investor Class had no Plan B. They believed, quite correctly, that the government would have to intervene in a financial crisis. Investing has been done for at least the last twenty years with this understanding, as well as the understanding that government has an important role in funding and helping the Investor Class. They do not believe in limited or no government, and would have no idea to do business in such an environment. As Wittgenstein said, "If a lion could talk, we could not understand him". I say, "If the free market showed up, the Investor Class would not know how to do business in it". They are the ones with the money, not theoreticians.

In the future, we will need a LOLR and SOLR to undergird our financial system. The explicit conditions of these guarantees will be meant to prevent Calling and Proactivity Runs. This can work. In other words, the intent is to keep the government from having to actually spend money, by allowing time for financial knots to unwind at minimal cost and disruption. Only the government can do this. In order to keep moral hazard from being a consequence, a strict application of Bagehot's Laws and a strict regime of supervision, not regulation, which focuses on aims and methods, as opposed to relying on particular laws, can keep moral hazard from becoming a problem. For one thing, by the end of the process, the Investor Class members which need a bailout will essentially be bust. It will not be a pleasant experience for them, as opposed to TARP.

The current political culture is a result of compromises over time. It cannot be easily changed, and should not be quickly changed. But, over, time, the system can be made fairer and freer for most people. Starting out with the changes listed above would be an excellent down payment.

Stiglitz says that banks may be postponing writing down loans because they are waiting to see what sort of bailout they might get from the government

Arnold Kling has this:

"Mark Thoma gives us Joseph Stiglitz and Martin Feldstein being interviewed by Charlie Rose. I listened to it last night, and I found it so chilling that it adversely affected my sleep. Two issues stand out.

1. Both of them are keen on re-working mortgages. Neither of them mentions non-owner-occupied housing or any of the other issues that make re-working mortgages extremely difficult. At one point, Stiglitz says that banks may be postponing writing down loans because they are waiting to see what sort of bailout they might get from the government( THIS HAS BEEN MY POINT ). But he doesn't draw the obvious conclusion that government interference is the problem, not the solution.( NO. THE INDECISION HAS BEEN THE PROBLEM. A CLEAR ANSWER WOULD SETTLE THE QUESTION ONE WAY OR THE OTHER. )

2. Both of them are keen on trying a big stimulus. Stiglitz says that everything done so far has been a failure, but again he doesn't draw the obvious conclusion. Instead, he says we have to try something bigger and different.( MY OPINION IS THAT IT SHOULD SOUND AND BE SOLD AS BIG, BUT NOT ACTUALLY BE THAT BIG. IN OTHER WORDS, DO IT IN STAGES. FOR EXAMPLE, OVER TWO YEARS, AND TAKE A LOOK AT HOW IT'S PROGRESSING BEFORE COMMITTING THE SECOND HALF. REMEMBER, WE ARE STILL IN A CALLING RUN FOLLOWED BY A PROACTIVITY RUN. ONLY GOVERNMENTS HAVE THE RESOURCES TO STOP THESE EVENTS. THE PEOPLE MUST BELIEVE THAT GOVERNMENT WILL COVER THE LOSSES IF IT HAS TO. OUR JOB THEN IS TO SEE THAT IT DOESN'T. ECONOMISTS DON'T SEEM TO KNOW A LOT ABOUT HUMAN BEINGS. )

I was reminded of the Battle of the Somme, one of the worst policy blunders of all time. Having experienced nothing but failure using offensive tactics up to that point, the Allies decided that what they needed to try was....a really big offensive( OF COURSE, PEOPLE ARE SAYING THAT IF A LITTLE DEREGULATION HAS LED TO THIS CRISIS, THEN ONLY AN IDIOT WOULD ADVOCATE MORE DEREGULATION. THIS IS ONE OF THOSE DOUBLE-EDGED SWORD TYPE OF ARGUMENTS. PEOPLE NEVER TIRE OF USING THEM, EVEN THOUGH THEY USUALLY CUT BACK. ). Just as Feldstein and Stiglitz pay no attention to the on-the-ground the housing market, the British generals ignored the impact of machine guns on men advancing over open fields.

My guess is that in 1916, anyone who doubted his own ability to direct an enormous offensive involving hundreds of thousands of soldiers would never have made it to general. Similarly, today, anyone who doubts the ability of a handful of technocrats to sensibly allocate $800 billion would never make it into government or the mainstream media. ( MAYBE. BUT THERE ARE GOOD ARGUMENTS ON BOTH SIDES. )

How many people will have meaningful input in determining the overall allocation of the billion stimulus? 10? 20? It won't be more than 1000. These people--let's say that in the end 500 technocrats will play a meaningful role in writing the bill--will have unimaginable power( THEY ALREADY DO.). Remember that what they are doing is taking our money and deciding for us how to spend it( NO. IN OUR GOVERNMENT, THEY ARE OUR ELECTED REPRESENTATIVES. IF YOU DON'T LIKE WHAT THEY'RE DOING, THEN RUN AGAINST THEM. ). Presumably, that is because they are wiser at spending our money than we are at spending it ourselves( NO. WE HAVE GOVERNMENT FOR MANY REASONS, INCLUDING IRENIC ONES, AS VON MISES ARGUED. FRANKLY, IT'S NOT ABOUT WISER, BUT WHO'S IS IT TO SQUANDER. THE WISER ARGUMENT IS DUBIOUS.) .

The arithmetic is mind-boggling. If 500 people have meaningful input, and the stimulus is almost $800 billion, then on average each person is responsible for taking more than $1.5 billion of our money and trying to spend it more wisely( FORGET WISER. YOU'RE NOT THAT SMART EITHER. IT'S ABOUT WHOSE MONEY IT IS TO USE. ) than we would spend it ourselves. I can imagine a wise technocrat taking $100,000 or perhaps even $1 million from American households and spending it more wisely than they would. But $1.5 billion? I do not believe that any human being knows so much that he or she can quickly and wisely( THAT'S NOT THE ARGUMENT. GOVERNMENT ISN'T BASED ON WISDOM. THE MONEY THE GOVERNMENT SPENDS IS FOR GOODS AND SERVICES WE WANT THEM TO PROVIDE. PERIOD. ) allocate $1.5 billion.

Once again, I am very happy that we are not fighting World War I. The Paulson/Obama offensives may be squandering resources, sowing confusion in households and businesses, and creating large financial imbalances. But they are not sending young men charging into machine guns."( THAT'S WHY IT'S ALSO BETTER THAN 1968. I'M ANGRY ABOUT HOW MANY OF OUR SOLDIERS HAVE BEEN LOST IN THESE TWO WARS, BUT VIETNAM WAS MUCH MORE COSTLY TO US IN TERMS OF LIVES. )

Kling must not believe that we're in a Calling and Proactivity Run, which is worse than any other current scenario, including large deficits, precisely because it is not possible to tell where they will stop, and how much wealth will be destroyed, and how many unemployed there will be at the end of them. I choose the relative certainty of inflation and a large budget deficit, as opposed to waiting for a Calling Run and a Proactivity Run to end. That's a road that can lead to serious social dislocations and disruptions. However, only Martin Wolf seems to agree with me.

"I see a multiplicative effect of misallocation and misperception of risk. "

Arnold Kling:

"He writes,

Tyler Cowen focuses on the misallocation of risk due to government induced moral hazard. My own view is that misallocation of risk did play a role, but I think risk misallocation due to market failures, i.e. the failure of regulation, was more important in generating the crisis than moral hazard brought about by implicit or explicit government guarantees. I also think the misperception of risk was important, perhaps even more important than the misallocation of risk (though these are sometimes hard to separate)

I tend to agree with Mark, at least as far as the mortgage/housing crisis is concerned. I see a multiplicative effect of misallocation and misperception of risk( WRONG ). The primary misallocation was due to institutional factors, especially bank capital regulations, that raised the demand for AAA and AA securities( THE RATINGS WERE FRAUD AND CONFLICT OF INTEREST ). The primary misperception was the view taken by rating agencies, and probably by the key sellers of credit default swaps, that house prices could never fall nationwide( NO ONE REALLY BELIEVED THAT. COME ON. ). These misperceptions allowed the creation of artificially highly-rated securities to meet the artificially high demand.( NO WAY )

A deep, Minsky-esque question is whether misperception of risk is inherently cyclical. It could be that, at certain points in history, an epidemic of bad judgment concerning risk is pretty much inevitable. When the epidemic occurs, it carries with it government regulators as well as private investors."

Let's go over the two view:
1) Misallocation Of Risk: This relies on a counterfactual argument claiming that regulators could have stopped this crisis from occuring. I have already said that this business of investing in investments with lower capital standards would simply have moved offshore, as much of it did. As for mortgages, it is conceivable that regulators or regulations could have stopped some of the more egregious ones, but that leads to the conclusion that this explanation is really a tautology. Now that we see what has gone wrong, if we had prevented those things from occurring, then this crisis wouldn't have happened. That has almost no explanatory power whatsoever. It is really an argument for more government based on the above mentioned tautology. There's no real reason to believe that regulators or regulations could have prevented this crisis in the real world we were dealing with.

On the other hand, Collusion and Fraud by regulators is an important cause of this crisis, as is Conflict Of Interest and Collusion and Fraud in the credit rating agencies.

2) Misperception of Risk: This one is amusing. There is nothing complicated in explaining how CDOs and CDSs work, or in explainig their risk. What's complicated is computing the risk of the individual investments. That takes skill and expertise. And yet, using only 2005 or earlier sources, in two hours on the internet, I discovered that:
A: These investments were based on lowering capital requirements, which is inherently risky.
B: The math models were of recent origin and of limited power and scope. They were inherently risky.
C: These investments were prone to calling runs.
This explanation beggars human belief. That I could discover these facts, and experts and millionaires could not, is truly a laugh.

Why people believe such explanations mystifies me.

"In a sense, what we have is a a "just so" story, and not a theory"

Arnold Kling has a point about theories:

"Josh Hendrickson writes,

there are many so-called Keynesians who have been out there promoting policies that are quite the opposite. They have been promoting the re-capitalization of banks, forcing banks to lend, automotive bailouts, and a push toward developing "green" jobs. These attempts to micromanage the supply side of the economy are not consistent with Keynesian stimulus or that of modern macroeconomic theory( THAT DOESN'T MATTER. THEORIES ARE SIMPLY MORE OR LESS USEFUL ).

In my mind, there are three dots that need to be connected:

1. theory( KANTIAN: ECONOMICS: MORE OR LESS USEFUL )
2. the explanation for the recent crisis ( HUMAN AGENCY AND NARRATIVE THINKING )
3. policy to get us out of the crisis.( POLITICAL ECONOMY: PRAGMATIC:EXISTENTIAL:TRIAL AND ERROR )

Hendrickson is worried about the disconnect between (1) and (3). I agree. But I also worry that there is a disconnect between (1) and (2) and between (2) and (3).

Neither textbook macro nor modern theory is focused on sudden shifts in the risk premium( FEAR AND AVERSION TO RISK AND THE ACCOMPANYING FLIGHT TO SAFETY ), although I think it is impossible to describe the recent crisis without referring to such a shift. In a sense, what we have is a a "just so" story ( I'VE CALLED IT A NARRATIVE ), and not a theory. That in turn makes the connection between theory and policy rather tenuous( FOR ME, IT ALWAYS IS. IF THE QUANTS HAD UNDERSTOOD THIS, THEY WOULDN'T HAVE HAD SUCH FAITH IN THEIR THEORIES ).