The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

From the WSJ:

"Secondary Sources: Greenspan’s Defense, Depression, Looting

A roundup of economic news from around the Web.

• Greenspan Defense: On the Journal’s opinion pages, former Federal Reserve Chairman Alan Greenspan says the central bank wasn’t responsible for the housing bubble. “There are at least two broad and competing explanations of the origins of this crisis. The first is that the “easy money” policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess. The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.”
• What Is Depression?: Calculated Risk looks at what would need to happen for this recession to become a depression. “Some people argue the duration of the economic slump defines a depression - and the current recession is already 15 months old. That is longer than the recessions of ‘90/’91 and ‘01. The ‘73-’75 recession lasted 16 months peak to trough, and the early ’80s recession (a double dip) was classified as a 6 month recession followed by a 16 month recession (22 months total). Those earlier periods weren’t “depressions”, so if duration is the key measure, the current recession still has a ways to go… Even though the current recession is already one of the worst since 1947, it is only about 1/3 of the way to a depression (assuming a terrible Q1). To reach a depression, the economy would have to decline at about a 6.6% annual rate each quarter for the next year… I still think a depression is very unlikely. More likely the economy will bottom later this year or at least the rate of economic decline will slow sharply. I also still believe that the eventual recovery will be very sluggish, and it will take some time to return to normal growth.”
• Looting: David Leonhardt of the New York Times looks at a 1993 paper titled “Looting” by George Akerlof and Paul Romer, and he sees parallels to the current crisis. ““Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem. Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame. But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem. Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess. He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.”

Compiled by Phil Izzo"

Me:
11:26 am March 11, 2009

• • • Don the libertarian Democrat wrote:

    “The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.”

    You’ve got it. This is the main cause of the crisis, even though it’s practically impossible to get people to see this. Maybe this post will help.

In layman’s terms, he was asking for a clearer legal path to nationalization.

From the NY Times:

"Banks Counted on Looting America’s Coffers

By DAVID LEONHARDT

Sixteen years ago, two economists published a research paper with a delightfully simple title: “Looting.”

The economists were George Akerlof, who would later win a Nobel Prize, and Paul Romer, the renowned expert on economic growth. In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”

On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.

Now, it would have been nice if the Fed had shown some of this regulatory zeal before the worst financial crisis since the Great Depression. But that day has passed. So people are rightly starting to think about building a new, less vulnerable financial system.

And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.

Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess.

He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.

•

The term that’s used to describe this general problem, of course, is moral hazard. When people are protected from the consequences of risky behavior, they behave in a pretty risky fashion. Bankers can make long-shot investments, knowing that they will keep the profits if they succeed, while the taxpayers will cover the losses.

This form of moral hazard — when profits are privatized and losses are socialized — certainly played a role in creating the current mess. But when I spoke with Mr. Romer on Tuesday, he was careful to make a distinction between classic moral hazard and looting. It’s an important distinction.

With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.

Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.

What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

I understand this chain of events sounds a bit like a conspiracy. And in some cases, it surely was. Some A.I.G. employees, to take one example, had to have understood what their credit derivative division in London was doing. But more innocent optimism probably played a role, too. The human mind has a tremendous ability to rationalize, and the possibility of making millions of dollars invites some hard-core rationalization.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Unfortunately, we can’t very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can’t function without credit, which means the financial system needs to be bailed out.

But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.

Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.

Mr. Bernanke actually took a step in this direction on Tuesday. He said the government “needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm.” In layman’s terms, he was asking for a clearer legal path to nationalization.

At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

Mr. Akerlof and Mr. Romer finished writing their paper in the early 1990s, when the economy was still suffering a hangover from the excesses of the 1980s. But Mr. Akerlof told Mr. Romer — a skeptical Mr. Romer, as he acknowledged with a laugh on Tuesday — that the next candidate for looting already seemed to be taking shape.

It was an obscure little market called credit derivatives."

Me:

"With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise."

"Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Thank you for this post. I believe that looting was the main cause of this crisis. At least now, some people will finally see its importance.

I'd like to add this quote:

WHY BANKS FAILED THE STRESS TEST
Andrew G Haldane*
Executive Director for Financial Stability
Bank of England
13 February 2009

http://www.bankofengland.co.uk...

"No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and
show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that
event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.
All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did
banks not understand that the official sector would not underwrite banks mismanaging their risks? Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big
one came, his bonus went and the government duly rode to the rescue. The timeconsistency problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities"

Don the libertarian Democrat

— Don, Tacoma, WA

It's simpler and safer to start entirely new banks.

From the WSJ:

"Let's Start Brand New Banks

A clean slate would keep TARP money away from bad banks.

By PAUL ROMER

Everyone agrees that the United States urgently needs a few good banks. Turning bad banks into good banks is a difficult and risky way to get them. It's simpler and safer to start entirely new banks.

In this context, "good" means a bank with assets and liabilities that are easy to value using market prices. At a good bank, officers, regulators and investors can be confident about the value of the bank's capital.

The Opinion Journal Widget

Download Opinion Journal's widget and link to the most important editorials and op-eds of the day from your blog or Web page.

The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage. Right out of the gate, the newly created banks could do what the Fed has already been doing -- buying pools of loans originated by existing banks that meet high underwriting standards.

If the TARP funds go to existing banks, much of them will end up stuck in financial institutions that are still bad after the transfer. We know from the previous round of TARP that giving more capital to bad banks generates very little net new lending.

Proposals for turning existing banks into good banks -- recapitalizing them, nationalizing them, transferring the toxic assets off their balance sheets, or insuring the toxic assets -- require prices for all these hard-to-value assets or, worse still, prices for derivative contracts on the toxic assets. (Calling the derivatives "insurance" doesn't make them any easier to price.) Without reliable market prices for the hard-to-value assets, any proposal for turning bad banks into good banks could lead to huge transfers of wealth between taxpayers and bank shareholders.

If the government lets new banks provide the new lending that the economy needs, it could return to clearly stated and familiar policies for bank regulation. The government could announce that it will not invest any new capital in a troubled bank that it hasn't yet taken over. Nor will it offer troubled banks any transfers or implicit subsidies. It can stick to a policy of assigning accurate values to assets as new information comes in. It can follow the usual FDIC procedures for protecting depositors and taxpayers and for deciding when to take over a distressed bank, and managing careful workouts that avoid the turmoil that a Lehman-style bankruptcy proceeding can cause.

With a return to a clearly articulated and familiar pattern of bank regulation, investors from the private sector could invest in the banking sector without fear that they will be competing with zombie banks that receive ongoing subsidies and transfers from taxpayers. Provided that the government accelerates the approval process, investors from the private sector can quickly create the new banks that the government backs. Over time, they can also buy the government's shares in these banks. Investors from the private sector can also invest in existing banks that truly are good banks.

The government should move first and signal unambiguously that new banks with at least $350 billion worth of capital will enter the market quickly. Over time, the private sector will deliver on this commitment. The government's role is merely to act as a temporary bridge.

There are, to be sure, risks of political interference from government involvement in banking, but all of the current proposals for increasing lending require more government involvement. The challenge is to find one that increases lending and does the least harm.

If the government starts as a shareholder in new, healthy banks that eventually end up entirely in the hands of the private sector, the political risks start small and diminish. If instead the government combines open-ended and opaque financial support for troubled banks with promises of tight supervision and punishment for bad behavior, the risks are large and grow over time.

The brewing backlash against the existing players from the financial sector is almost certain to burn hotter as the recession wears on, and new election campaigns get underway. If the new administration ties its fate to the existing players, it could lose its room to maneuver on countercyclical policy and be put under political pressure to intervene in bank decisions in ever more intrusive ways.

Because they can and will borrow, new banks will be much more effective in leveraging TARP funds. They will undertake more total lending, bring more trading to financial markets, and do more to limit the depth of the recession. As a result, investing the TARP funds in new banks will do more to help the troubled but potentially viable existing banks than giving funds directly to them.

Banks that are not viable, the ones with liabilities that substantially exceed their assets, will lobby vociferously against a return to historical patterns of bank regulation. They will say anything to postpone a looming FDIC takeover. The administration should not listen to threats and pleas from these doomed banks. It does not have to rely on them to get new lending going quickly and on a large scale. New entrants could give us a few good banks. That, plus an FDIC that can do its job, is all we need.

Mr. Romer is a senior fellow at the Stanford Institute for Economic Policy Research."

Me:
Posted: Fri Feb 06, 2009 9:38 am Post subject: Re: Let's Start Brand New Banks I'm puzzled about what's supposed to happen to the wounded banks who would be left out in the cold. Presumably, if they go ahead and fail, the FDIC will step in. How is that different than nationalizing? Is it simply a better procedure in your opinion? If the government nationalizes these banks, presumably they would create just the sort of banks that you advocate. Again, what's the difference?

In a recessionary economy, tax cuts do not necessarily encourage consumers to spend and businesses to hire.

From Salon:

"How to lie about tax cuts

Here's what appears to be the House Republican strategy going forward: lie, misrepresent, and obfuscate. And when you get called on it, just ignore reality and repeat yourself.

A Wednesday afternoon case in point: The Republican leadership is now declaring that their economic recovery plan, which consists primarily of tax cuts, will result in the creation of 6.2 million jobs in two years. As the authority for their claim, they cite none other than Christina Romer, President Obama's Chair of the Council of Economic Advisers.

From a press conference:

...We have an analysis by the president's senior economic adviser who also shows that tax cuts actually provide more immediate relief and more jobs than spending, so you get more -- a bigger bang for the buck.

Well, using the methods and economic models developed by the president's top adviser -- and when those are applied to our Republican plan, it shows the Republican plan could create as many as 6.2 million jobs over the next two years.

Now, let's just be clear about where these estimates come from, the nation's top economic adviser, the president's nominee to chair the Council of Economic Advisors, Dr. Christina Romer, and her peer-reviewed research.

Now, it is true that in their classic paper, "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks," Christina Romer and her husband David Romer found that certain types of tax cuts in certain types of economic situations provided considerable "bang for the buck."

But as has already been endlessly hashed out in the econoblogosphere, their findings primarily applied to tax cuts that were enacted during periods when the economy was healthy. In other words, when the economy's normal job creation engine is plugging along nicely and companies are turning profits and unemployment is relatively low, a tax cut can provide an added stimulus.

But the Romers did not find the same was true when the economy was in recession. Explicitly: "Policymakers' efforts to adjust taxes to offset anticipated changes in private economic activity have been largely unsuccessful."

There is an intuitively obvious explanation for this, which will be familiar to anyone who has been reading How the World Works this week. In a recessionary economy, tax cuts do not necessarily encourage consumers to spend and businesses to hire. When confidence in the economy is low, people are inclined to pay off their bills and boost their savings. Tax cuts might provide a little more cushion for consumers and businesses to wait out the storm, but they are unlikely to incite a wave of euphoric shopping.

Pointing out, again that the House Republicans are misrepresenting the academic research on tax cuts is unlikely to make House Minority Leader John Boehner or Minority Whip Eric Cantor change their tune. But it might help to explain why after two consecutive walloping defeats for Congressional Republicans, the two men have little power to make their obfuscations change policy.

― Andrew Leonard"

And Don:

GOP On Stimulus

I do agree with the administrations attempt to target tax cuts for investment. As well, I liked the idea of a sales tax cut or payroll tax cut that would be phased out in the future. This could give some incentive to spending now. How much either of these proposals would help is hard to gauge, but so is infrastructure spending.

The GOP position is not serious. They are simply looking for a reason to vote no, without appearing to be political. After all, the administration's position is a compromise. Holding out for everything that you say that you want is not serious government.

-- Don the libertarian Democrat

it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending

When I first read about this, I believed that Stiglitz really disagreed with me. Let's take a peek on the FT:

"Do not squander America’s stimulus on tax cuts

By Joseph Stiglitz

Published: January 15 2009 19:48 | Last updated: January 15 2009 19:48

As news of the US economy worsens, worries about whether a stimulus could restart the economy are growing. Making matters more complicated is the fact that our 2009 fiscal deficit will exceed 8 per cent of gross domestic product( TRUE, WHICH IS ONE MORE REASON THE BUSH YEARS HAVE BEEN A NIGHTMARE ), even before the stimulus.

What is clear is that tax cuts will not help much. When Barack Obama, president-elect, last week proposed to use nearly 40 per cent of the stimulus for tax cuts, he was rightly told this would be less effective than, say, spending on infrastructure( HERE, I DON'T AGREE ). It has been surprising, then, to see President George W. Bush’s former economic advisers, including Greg Mankiw, argue that tax cuts are the way forward.

Mr Mankiw cites a recent study by Christina Romer and David Romer, economists at the University of California, Berkeley, who found that each dollar of tax cuts raises GDP by about $3 (€2.30). Such studies, based on past data, may have little to say about the situation the world now faces( CHUCK THEM ). Americans confronted with debt, shrinking retirement accounts, houses worth less than mortgages and a tough credit environment will save more of their money than in the past( TRUE. FOR A WHILE. ). That was the experience with the February 2008 tax cut, where less than half of it has been spent. It matters who gets the break – if it is lower income Americans, the fraction spent will, on average, be greater( TRUE ) than for wealthier Americans.

Tax breaks for business may prove to be a sink-hole as bad as the troubled assets relief programme. Particularly worrisome are rumours that companies will be allowed to set off their losses against profits made in the past five years to get tax rebates( I AGREE ) – a big gift to those who mismanaged risk, including banks such as Citibank. Some suggest that, having exhausted the more transparent bail-out strategy, banks are seeking less transparent help through the tax code. We learnt the lesson from Tarp: we need to link handouts to changes in behaviour( I AGREE ). We should have insisted banks commit to more lending. Now we should insist any tax breaks for business are linked to investment( HE AND I AGREE ).

Similar caution needs to be exercised in evaluating each element of the stimulus package. The Obama team has issued a report projecting its potential for job creation. In estimating the impact of offering relief to the states, it assumed, based on experience, that 30 per cent of the relief would be used to stall tax increases that would otherwise have occurred. (States are facing a shortfall of perhaps $150bn a year.) But with property values plummeting, there is pressure to cut property taxes. And, in any case, state taxes are more regressive than federal taxes – more of the burden of taxation is borne by those with lower incomes. This means that if tax cuts come partly at the expense of state relief, and states are forced to raise taxes, the net effect on the economy is likely to be negative.

There is a more fundamental point that the Bush team missed. Tax cuts have increased our national debt. They encouraged( ONLY THAT ) America to live beyond its means, increasing our liabilities without commensurate increases in assets( WEREN'T HOUSES ASSETS ). Further tax cuts would do the same. Good accounting looks at assets and liabilities. Spending on infrastructure, education and technology create assets; they increase future productivity( IF THEY ARE WELL SPENT. OTHERWISE, THEY CAN DO GREAT HARM. IT'S NOT A PRIORI A GREAT INVESTMENT. ).

Some of the spending in the stimulus serves multiple ends. Increased unemployment benefits ( NOT A STIMULUS )have the largest multiplier effects – cash-strapped families spend every cent given – and meet vital social needs. It is imperative to provide health insurance to the unemployed( NOT A STIMULUS ): without that, a single serious incident can push a family into bankruptcy. Helping the unemployed meet house payments reduces foreclosures, addressing one of the underlying causes of the crisis. There are thus triple benefits.( BUT NOT A STIMULUS. THIS IS SOCIAL SAFETY NET SPENDING. )

We are in uncharted territory in this crisis. But household tax cuts, except for possibly the poorest, should have no place in the stimulus. Nor should business tax breaks, except when closely linked with additional investment( I AGREE ). The one tax cut that should be included is a temporary incremental investment tax credit; it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending( I AGREE ). Increased investments in infrastructure, education and technology, relief to states, and help to the unemployed need pride of place.

This is a stimulus that some Republicans will find less attractive than previous give-aways. But Americans voted for change they could believe in. I trust that that is what we will get.

The writer was awarded the Nobel Prize in economics in 2001. His latest book is The Three Trillion Dollar War, co-authored with Linda Bilmes (2008)"

My only disagreement is about one tax cut, but it's big. I would like a sales tax cut or payroll tax cut which will be phased out in the future, giving people an incentive to spend now instead of waiting. Some people will save money by not spending, but that's fine as well.

"This leads me to wonder how we should view the Bush Administration's stewardship of the economy."

Menzie Chinn on econbrowser scores the Bush Economic Disaster. As you know, I believe that the causes of this crisis are:
1) Effects on Investors of the Implicit and Explicit Government Guarantees to intervene in a financial crisis. This allowed much of the excessive risk. I also include here the lack of clarity as to what the government will or won't do.
2) Fraud, Negligence, Fiduciary Mismanagement, and Collusion. I include here lack of enforcement by the government.
3) The perceived incompetence of the Bush Administration. In my view, when this crisis hit, expectations were that the Bush Administration would make things far worse.
Now, let me add:
4) The budget deficit and debt run up in the last eight years. Truly speaking, this should be 3, but, in this crisis, I think that 4 added with other Bush disasters to push the total Bush Disaster Effect higher.

Here's the post:

"Stuff Happens": the Bush Administration's Economic Stewardship

As we near the end of the year, and the end of eight years of Bush economic policy, I think it's useful( BUT NOT PLEASANT ) to look back. The White House has recently tangled with the NYT regarding what got us into the current economic crisis [0] (see also [1]). This comes on the heels of the Paulson argument that he would not have done anything different( SO ASININE ), had he known the full extent of the looming crisis. This leads me to wonder( I DON'T ) how we should view the Bush Administration's stewardship of the economy.

Figure 1: IMF, Global Financial Stability Report (Oct. 2008), Box 1.3.

Candidate Explanations

In particular, when one examines the mixture of policies and events that have led us to the brink of possibly the deepest and most persistent downturn since the Great Depression, one can see several suspects listed.

• Fannie and Freddie( A BIT )
  
• Community Reinvestment Act( A BIT )
  
• CDO's and CDS's( NO. THE MISUSE OF THESE WAS FRAUD, ETC. )
  
• Global saving glut( NO )
  
• Monetary policy( A BIT )
  
• Deregulation( A BIT )
  
• Criminal activity and regulatory disarmament( 2nd MAJOR CAUSE )
  
• Tax cuts and fiscal profligacy( 4 MAJOR CAUSE )
  
• Tax policy( A BIT )
  

Red Herrings

I've already dealt with the first two "betes noire" -- favorite villains in the fevered commentary of certain noneconomists -- in this post, so we can dispense with these as key drivers (Jim attributes some blame, here, although I don't think he attributes central blame here either). I don't think CDO's and CDS's in and of themselves caused the crisis( I AGREE ), although they certainly obscured the primary problem of overleveraging (CDO's) and lack of transparency (CDS's). And the saving glut -- well, the saving glut was a worldwide phenomenon, but I think it safe to say the countries that did and didn't borrow from the Chinese have suffered in the current crisis( I AGREE ) (here is my critique from 2005; CFR report [pdf]).

Synergy

So what I want to think about is the toxic mixture of the last five items, which interacted in a synergistic manner to place us in the situation we are now in.

First, monetary policy. While there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not -- according to a Taylor rule framework -- overly lax.( I AGREE )

Second, deregulation. On this front, I think it's important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS's does not( A FAIR POINT). I outline some empirical research on what factors were important in this crisis in this post.

Third, regulatory disarmament/nonenforcement and "criminal activity". I would have discounted this item in the absence of clear evidence, but now that we know about how the OTS "helped out" IndyMac [2] [3], I think we can be reasonably confident that we'll hear a lot more about how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.( 2nd MAJOR CAUSE )

Fourth, fiscal profligacy via tax cuts. I think it's important to focus on profligacy (because it pushed the economy more into a boom exactly at a time when not needed) and on tax cuts (because it made people feel like they had more discretionary income than reasonable), thereby pushing the asset boom. ( 4th MAJOR CAUSE )

Fifth, tax policy. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (I've been thinking about this in part because mortgage deductibility on a second home never made sense to me, let alone on a first home). Capital Games and Gains has pointed out this provision, citing a NYT article. But even this last article doesn't locate primary blame here; rather it's cited as a contributing factor. I suspect that on its own, this provision wouldn't had a big impact, but in combination, it might have. My caveat here is that I haven't found much empirical work backing a big role for this factor.( MINOR )

Typically, in my academic work, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But (departing from a model, and with no econometric work to back up the hypothesis interactive effects), I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) we've witnessed, the deflation of which has been associated with the ongoing financial crisis.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [7]; with regulatory oversight absent, and low interest rates, well the stage was set.

Prescient, or Not

I won't claim to have foreseen the full enormity of the crisis we're now undergoing. As I indicated when I posted my first blogpost some three years ago, I thought the sheer irresponsibility of the fiscal policy being pursued( TRUE ), against a backdrop of overconfidence in largely nontraded derivatives, would lead to grief in the form of a "sudden stop" of net capital flows to the US. In this respect, I was wrong -- what we've achieved instead is a sort of "global sudden stop" where the process of deleveraging proceeded in a discrete (and "disorderly") fashion( TRUE. DUE TO THE FEAR AND AVERSION TO RISK AND THE ACCOMPANYING FLIGHT TO SAFETY ). So, unlike some, I was only partially -- not completely -- blindsided. (And, I'm sure Akerlof and Romer were completely aware of what was coming...)

I believe history will look critically on the Bush Administration's economic stewardship, in particular how the policies propelled an unsustainable bubble, and tied our hands in the use of fiscal policy tools. In sum, I think Kevin (Dow 36,000) Hassett's view "Bush's Legacy May End Up Better Than You Think" will not prove true."

You are thinking very clearly. I believe that her Synergy is equivalent to my Bush Disaster Effect. Only she fails to see how the Wars, Katrina, etc., can effect economic behavior. For me, Economics only exists in the context and presuppositions of its time.

"A similar result might obtain if the tax cut included, say, an investment tax credit."

Greg Mankiw on the stimulus:

"A key issue facing the new Obama administration is to what extent the economic stimulus should take the form of spending increases versus tax reduction. One way to think about the issue is the size of the fiscal policy multipliers. The multipliers measure bang for the buck--the amount of short-run GDP expansion one gets from a dollar of spending hikes or tax cuts.

So what are these multipliers? In their new blog, Bob Hall and Susan Woodward look at spending increases from World War II and the Korean War and conclude that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. Similarly, the results in Valerie Ramey's research suggest a government spending multiplier of about 1.4. (Valerie does not present her results in multiplier form, but she emails me this translation: "The right column of figure 5A of my paper shows that for a log change of government spending of 1, log GDP rises by 0.28, implying an elasticity of 0.28. To back out the implied multiplier, we can use the fact that government spending averages around 20% of GDP. This implies a multiplier of 1.4.")"

Well there is a difference between 1 and 1.4. I'm wondering how they can be different, since they relied on the same research.

"By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars. The puzzle is that, taken together, these findings are inconsistent with the conventional Keynesian model. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers."

This is interesting. Couldn't people just save the tax cut? Also, I though that the tax cut earlier this year didn't do much for the economy?

"How can these empirical results be reconciled? One hypothesis is that that compared with spending increases, tax cuts produce a bigger boost in investment demand. This might work through changing relative prices in a direction favorable to capital investment--a mechanism absent in the textbook Keynesian model.

Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes (as suggested by Bils and Klenow). This tax cut would reduce the cost of labor and, if labor and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit."

I am for, and have said so a number of times, incentivizing more investment income to try and overcome this fear and aversion to risk through targeted tax breaks. I would accept either attempt, but frankly prefer the investment tax credit as more focused on the immediate necessity. It might also be easier to assess, which is something I find essential with any tax proposal.

"This hypothesized channel seems broadly consistent with the empirical findings of Blanchard and Perotti, Mountford and Uhlig, Alesina and Ardagna, and Alesina, Ardagna, Perotti, and Schiantarelli. The results of all these authors suggest you need to go beyond the standard Keynesian model to understand the short-run effects of fiscal policy."

I still insist on social safety net spending. Some infrastructure spending also seems advisable to me, but only on projects clearly warranted on their own. The tax breaks mentioned above, especially the investment tax credit, actually try and attack the main problem from my point of view, namely, the fear and aversion to risk.

"My advice to Team Obama: Do not be intellectually bound by the textbook Keynesian model. Be prepared to recognize that the world is vastly more complicated than the one we describe in ec 10. In particular, empirical studies that do not impose the restrictions of Keynesian theory suggest that you might get more bang for the buck with tax cuts than spending hikes."

I believe that targeted tax cuts would work better to alleviate our main problem.