So that set of regulatory problems is what we are looking to solve in the proposals I’ll put forward tomorrow.

TO BE NOTED: From the WSJ:

"A transcript of The Journal’s interview with President Obama, which touches on financial-regulatory reform, the power of free markets, health care and Bernanke’s future at the Fed.

* * *
THE PRESIDENT: All right, fire away.

Question: Thank you for doing this, very much. You know, in our world, the world of The Wall Street Journal, a big event this week — financial regulatory reform. Let me get you to talk a little bit about the philosophical backdrop. Obviously a lot of things went wrong in the markets in the last year. Where do you think they failed?

THE PRESIDENT: Well, I think that there are some immediate and obvious culprits. We had a regulatory system that was outdated that did not encompass the non-bank sector. We had a securitization market that had separated borrowers and lenders and investors in ways that allowed everybody to take risks, with nobody feeling accountable or feeling their money was at stake. We had I think banks who were incented to boost their profits with some of these same risky financial instruments, and you didn’t have the kind of systemic oversight that would anticipate the enormous failures that could arise if any link in the chain broke. So that set of regulatory problems is what we are looking to solve in the proposals I’ll put forward tomorrow.

You then have, though, just to finish up, I think you’ve got a broader structural problem in our economy in which our last two recoveries had been based on bubbles, and a massively overleveraged consumer, a massively overleveraged corporate sector, and a financial system that didn’t have much restraint.

And so the question for us is how do we create the foundation for a more sustainable model of economic growth, one that doesn’t impinge on the dynamism of the free market, the innovative products that are critical and the entrepreneurship that creates jobs, but also recognizes that the levels of debt and a model that’s premised on an endless supply of foreign dollars is not one that is going to be sustainable over the long term.

And then just to wrap it up then, that’s why, in addition to financial regulation, we think that health care reform, creating a clean energy economy, ramping up our education system, our investment in science and technology and infrastructure — why all those things are so important, because if we get the fundamentals right, then the market will work its magic, but we won’t have sort of house-of-cards economy that crashed over the last year.

Question: One of the things that you’re going to do this week that hasn’t gotten as much attention is try to directly regulate the consumer part of the financial system. Now, one could argue that consumers benefited a lot from financial innovation over the last generation, that a lot of people are in houses, a lot of people moved ahead in the economy in the environment that existed, and that maybe consumers ought to look out for themselves. You are going to go in a direction of trying to regulate the way consumers are treated in the financial marketplace. What are you thinking there? Is there a danger of going too far? Why do consumers need that kind of help?

THE PRESIDENT: Well, I think there would be a danger in going too far if, for example, we were restricting the ability of consumers to borrow, or setting very stringent caps on interest rates or — there are a whole range of steps that are out there that in fact some people advocate for. That’s not what we were recommending.

What we are saying is, number one, that we should have some common-sense protections around transparency, around full disclosure. Whether we’re talking about the mortgage market, credit cards, annuities — on a whole host of these financial instruments, in fact, people didn’t know what they were getting themselves into. And making sure that they are properly informed is I think the most market-friendly of regulatory approaches that still empowers consumers to make choices but ensures that they know what choices they’re making.

We also think that it’s important to have some consolidation of the regulatory agency responsible for consumer protection. And so, as I think has already has been shared with you, we’re putting together a consumer financial protection agency that will pull — that will ensure that one agency is responsible for protecting consumers, as opposed to having a lot of divided attention between consumers, investors against the soundness of financial institutions, et cetera.

We think that if we — if you look at what we’ve already done on credit cards, what we’ve already done in terms of mortgage lending reform, if you look at the proposals that we have for ensuring that consumers know the kinds of financial instruments and investments that they’re making, that that ultimately will strengthen our financial markets, because one of the strengths of the U.S. financial markets has always been that, at least relative to other parts of the world, this has been the place where consumers and investors had the most confidence, that they had the most information, that they were the least likely to fall prey to Ponzi schemes and various other frauds. And the more that we can shore up that confidence, the more likely investors are going to continue to put money into our markets and consumers are going to be able to borrow from our markets.

Question: Are you saying that reality changed over the last generation?

THE PRESIDENT: Well, I think that the world has gotten more complicated. If suddenly you can, as a 20-year-old college student, sign for up for five different credit cards, if you find yourself able on a $30,000-a-year income to buy a $400,000 house with no money down, then you are much more vulnerable to the inducements that are out there than a generation ago.

Now, I know that some people would argue, well, people have to suffer the consequences when they make these bad decisions. The problem is, is that when you start seeing the entire housing market collapse because of foreclosures, or banks and other financial institutions requiring extraordinary support from taxpayers because they’ve greatly overextended themselves, this is not just a problem for one individual consumer; this is a problem for the economy as a whole.

And if we’ve done a better job giving people good information, I think they’ll make good decisions. But right now we don’t have the regulatory mechanisms in place. And the proof is what happened over the last several years.

Question: Does all that say to you that capitalism failed here somehow? The system needs to be changed, that there has to be some kind of a hybrid — capitalism and something else?

THE PRESIDENT: I am a firm believer in the power of the free market to allocate capital and produce goods and services, and ultimately wealth. I think the system is unsurpassed. But I think we’ve understood at least since the 1930s, when we put in place things like deposit insurance, that a sensible regulatory structure can ensure that the benefits of the free market are obtained without the risks of the system falling in on itself. And we just want to update that for a new environment in which you have things like credit default swaps.

Question: On a broader scale — you mentioned health care before. There’s a lot of — one of the things people wonder about most on the part of your approach, and clearly people who read my publication wonder, what is your view about what the government’s role in the economy really ought to be? When you step back from all of this, what’s the unifying theme? What’s government’s role? Does it steer? Does it push? Does it guide? Does it run? What’s the government’s role in the economy in the environment that you’ve just described?

THE PRESIDENT: I think the irony — and you wouldn’t know this from reading your publication’s editorial page — (laughter) — is that I actually would like to see a relatively light touch when it comes to the government. I think what I described in terms of financial regulation is typical, and that is set up so the rules of the road; ensure transparency and openness; guard against huge, systemic risks that will lead us potentially into — lead government potentially having to step in to avoid a depression; and then let entrepreneurs and individual businesses compete and do what they do.

And so it’s puzzling to me sometimes to hear the standard conservative critique of what we’re doing, when essentially every step we’re taking really involves cleaning up the mess that we found when we arrived here at 1600 Pennsylvania Avenue.

Let’s take autos as an example. Other than basic issues like consumer safety — seatbelts, airbags, which save a lot of lives — and consumer protections — lemon laws and making sure that people know what they’re buying — the only real regulatory approach that I’ve been interested in is raising fuel efficiency standards so that we can wean ourselves off dependence on foreign oil. Beyond that, the last thing that I want is to be running a car company, or to be having to make decisions about what the auto market of the future is going to look like.

The reason we stepped in was because when we arrived $10 billion had already been provided to the auto companies with essentially no strings attached. And we then had essentially three choices: We could continue on the path of giving more taxpayer money to the auto companies without asking them to change at all. We could let them go into liquidation in the midst of the worst recession since the Great Depression, which I don’t think anybody would argue would have a salutary effect on the economy. Or we could say we will provide you some short-term help, but take a pretty tough approach in terms of showing us a plan — a restructuring plan that will allow you to stand on your own two feet. And we chose option number three.

Now, if somebody can tell me what other options were available I’d be interested, because I spent a lot of time talking to a lot of experts about that.

And so, on a whole host of — what do we got, five minutes — on a whole host of these issues, we want to do the minimum possible to assure that every stakeholder in the marketplace — consumers, workers, investors, entrepreneurs — have a clear set of rules of the road, they know what they’re getting themselves into, they’re making decisions based on the pursuit of profits, but that we are not setting up so few rules that you have the kind of situation that we saw last year where we really were on the verge of a financial meltdown.

I’ll use one more example because I think this is salient, and that’s the whole issue of executive compensation. I don’t think I’m alone in believing that the incentive structure in many companies has not been to reward high performance; that you had huge compensation packages for people who ran their companies into the ground, and that there was very little oversight from either shareholders or compensation committees on the board.

We also had a situation in which, as a consequence of some of these huge incentive packages, financial firms in particular were taking some exorbitant risks to feed the short-term bottom line that weakened the system as a whole.

Now, the only place where we’ve sort of stepped in in a significant way on this issue has been if you’re getting a whole bunch of taxpayer money, because, I think as the reaction to AIG indicated, the average taxpayer who is maybe pulling down $60,000-$70,000 a year is not going to have a lot of patience for seeing their taxpayer dollars bailing out firms that are then giving out multimillion-dollar bonuses.

Question: As you discovered fairly quickly.

THE PRESIDENT: Absolutely. So on that front, I think extraordinary assistance to these firms to keep them afloat justifies some extraordinary accountability measures in terms of how executive compensation proceeds.

But beyond those specific terms, all we’ve said is just make sure that shareholders know what your compensation packages are, and make sure that your compensation committees are actually independent, as opposed to an incestuous situation in which everybody is getting rewarded.

Now, I think it’s hard to argue that that is somehow the heavy hand of government in the marketplace. It’s just saying that if the operative theory is that shareholders are going to be able to hold management accountable, and that management isn’t operating in a way that is contrary to shareholder interest and is in fact self-interested, that for us to create that — to strengthen that link so that shareholders actually know what’s going on is a pretty reasonable request.

Question: Two quick questions on this, and then I’ll let you go. Ben Bernanke — you’ve obviously seen a lot of him.

THE PRESIDENT: Yes.

Question: Inclined to reappoint him?

THE PRESIDENT: I think that Ben Bernanke has handled his position extraordinarily well under extraordinarily difficult circumstances, but I’m not going to make news on that right now.

Question: Okay. If you had your druthers, in the long run what would the top tax rate for the very richest Americans settle at?

THE PRESIDENT: Well, I think instinctively that the tax rates that existed for the top — for the very wealthiest Americans under Bill Clinton struck the right balance. I think that we’re always talking marginal tax rates, and I do think that what’s happened in terms of our tax code has been that it’s been so fraught with loopholes, we’ve got so many deductions and exemptions and credits and this and that and the other, that in some cases, on paper, things look very high, but as a practical matter they’re pretty low.

I do think that tackling tax reform, both on the individual side and on the corporate side at some point — akin to what was done in 1986, where you clear out some of the underbrush and you make sure that the base is broad, but everybody knows what it is that they’re paying and there aren’t a whole bunch of loopholes; there is serious enforcement and predictability — that kind of reform could end up generating the revenues that we need to run the basics of our government while actually in some cases lowering some rates. But that requires that everybody buy into a simpler, fairer system.

The one thing that I think is very important to understand is that there’s no free lunch, and sometimes politicians have been pretty irresponsible in saying you can have a prescription drug plan, you can have two wars, we can do a whole bunch of things, but we’re going to cut your taxes at the same time. And at some point something has to give."

Bailouts for Bunglers: Paul Krugman on why the government should nationalize.

From Felix Salmon:

"Extra Credit, Monday Morning Edition

Why stimulus spending should go to public art

Bailouts for Bunglers: Paul Krugman on why the government should nationalize.

Hazardous Materials? Jim Surowiecki on overblown moral-hazard concerns.

OpenTable files for IPO, finally: And it might actually make sense, even in this market.

Me:

“We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system,” says Timothy Geithner, the Treasury secretary — as he prepares to put taxpayers on the hook for that system’s immense losses."

Can someone explain to him that we have a Hybrid System, which is our version of a Welfare State. Banks and the Investor Class lobby continually for largess from the government. They couldn't compete in a free market any more than I could compete in a marathon.

The reactions since Lehman can be seen as "Where the hell is the government. Pick us up. We've no Plan B".

Please read this post to understand how much government influences our system:

http://www.petersoninstitute.org/publications/interstitial.cfm?ResearchID=1096

Did Reagan Rule In Vain? A Closer Look at True Expenditure Levels in the United States and Europe

by Jacob Funk Kirkegaard, Peterson Institute for International Economics

By DonthelibertarianDemocrat Posted: Feb 02 2009 10:10am ET

Fair enough. Here's my version of Bagehot:


"Bagehot's Principles":

1) If the Fed exists, it will be the Lender Of Last resort, and that has to be taken in to account in real world Political Economy. It should lend freely in a crisis to solvent banks.

2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.

3) The terms must be onerous.
4) The LOLR should get something valuable in return.

Here are a few others:

5) The taxpayer's interests should come first.

6) Moral Hazard needs to be constantly applied by quickly liquidating problem banks in normal times.

7) Any entity receiving a guarantee will have to be supervised or regulated effectively, and violations should be quickly and severely punished.

8) There is no doubt that any entity receiving a LOLR guarantee will need to be more conservative in its practices in order to limit the liability of the taxpayer.

9) There should be a class of financial concerns that can act more freely, but they should not receive LOLR guarantees. They will be strictly supervised or regulated though, and are subject to laws against fraud, etc."

Read W. Bagehot " Lombard Street" here:

http://bagehot.classicauthors.net/LOMBARDSTREET/LOMBARDSTREET9.html

For my reasoning on Lehman, you'll also need this:

Read Irving Fisher's "The Debt-Deflation Theory Of Great Depressions" here:

http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

In both cases I've added my own opinions. See here as well; Comments appreciated:

http://don-thelibertariandemocrat.blogspot.com/2008/12/thats-just-sort-of-thing-that-troubled.html

Finally:

"Samuel Johnson's Dictum":

One thing about passing fifty years of age is that I now feel old enough to invoke what I call Samuel Johnson's Dictum. It is thus: If I invoke a view based on an author that I read in the past, and that view is not actually held by that author, I'm more than willing to claim the view as originating with me. The beauty of this Dictum is that it is self-referential. It is based upon my reading of Johnson and on Boswell, but I can't remember the actual references that led me to believe that Johnson believed something like this. In any case, I do.

By DonthelibertarianDemocrat Posted: Feb 02 2009 3:07pm ET

"This being so, there is nothing for it but to make the best of our banking system, and to work it in the best way that it is capable of. We can only use palliatives, and the point is to get the best palliative we can. I have endeavoured to show why it seems to me that the palliatives which I have suggested are the best that are at our disposal."

I didn't say that I hadn't read it recently. What I'm trying to do is exactly what he did. I gave you what I took from him, including a few essays, in my principles 1 - 4. I then added some of my own. I distilled, from a book about a different era and a different country, some lessons for banking in the US today. What's wrong with that? I began by saying The Fed. I don't have any problem with your differing with me. That text is on my blog. I look at it all the time.If you look at the section of the Government of the B of E, you will draw your own lessons on how it applies to us. In the same way, I look at Fisher's paper. I take a much more behavioral approach than he did. So what? It's still the inspiration for my own theories. I also referred you to a debate between Selgin and Grant, giving differing views of Bagehot's worth today. If they can interpret him, why can't I? You will also see my version of Graham's investing rules. It's not him exactly, but it's close.

In the end, I'm not even sure what you're objecting to. The point about Lehman had to do with the capriciousness of applying moral hazard. Are you saying that Bagehot had no views on this? If you don't believe me, read Selgin. He's an expert on Bagehot.
As to why I believe that Lehman should be saved, it has to do with Fisher's theory. Once a Calling Run begins, it is hellish to stop. In our circumstances, in which we didn't follow Bagehot's Principles, we didn't have much choice. If you differ, fine.

By DonthelibertarianDemocrat Response to ccm Feb 02 2009 8:27pm ET

I didn't say that he would have supported Lehman. I said that he warned that, in order for moral hazard to work, it had to be explicit and consistently applied. Do you remember Bear Stearns? What happened there? The arbitrary application of moral hazard won't work. That's the point. The point is about moral hazard and the consistency of applying it. I said that, having set a precedent, applying moral hazard, on a whim, would scare the markets, since there was no way to discern who would receive help and who wouldn't. Uncertainty terrifies markets. That's what we're experiencing now. Gross uncertainty. That's my Bagehot rule 2.

"I agree about Lehman, but not about moral hazard. It's very important. However, it must be swift, explicitly expected, principled, and onerous. We've had none of these.( THIS LAST PART IS WHAT I'M ARGUING BAGEHOT BELIEVED )So I'm agreeing with Bagehot in principle.

Why do I violate Bagehot? As I said, I agree about moral hazard, but I'm making an exception. I think that is what Bagehot argued in LS. He didn't like some of what he recommended, but he felt that he had to practically. That's exactly what I'm doing with Lehman.

Why? That's very complicated. I probably have a hundred posts on it on my blog. So as not to bore you, I'm just giving you the essence of my opinion. On the Sunday before Lehman fell, there was a special trading session. At that session, many believed that, if Lehman fell, Merrill would as well. This could start a Calling Run. It is similar to a banking run, but not the same. What I'm describing is Fisher's Debt-Deflation. All I can tell you is that, in order to stop a Calling Run, I believe that you need an explicit government guarantee, because only the government has the resources to stop it. Going forward, I do believe that actually following Bagehot's Principle's could stop this. But the moral hazard must be applied from the start. My view.

By DonthelibertarianDemocrat Posted: Feb 02 2009 9:36pm ET

"swings in confidence are not always logical. The business cycle is in good part driven by animal spirits. "

From the WSJ:

"Animal Spirits Depend on Trust

The proposed stimulus isn't big enough to restore confidence.

By ROBERT J. SHILLER

President Obama is urging Congress to pass an $825 billion stimulus package as soon as possible. But even that may not be enough to stabilize the economy, since it fails to take into account the downward spiral of animal spirits that is underway and may continue to worsen. ( I TEND TO AGREE )

David Gothard

The term "animal spirits," popularized by John Maynard Keynes in his 1936 book "The General Theory of Employment, Interest and Money," is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings( INCLUDING HOW WE SEE THE GOVERNMENT ), and our sense of the extent of corruption and bad faith( RAMPANT ). When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people.( THE FEAR AND AVERSION TO RISK )

Fiscal policy adjustments are what almost all the pundits and the economic policy advisers have in mind when they say now is the time to pursue Keynesian policies. Especially now, when conventional monetary policy is ineffective( I DON'T AGREE. WE COULD PRINT MONEY. ), since short-term interest rates on safe assets are close to zero( ZIRP ), Keynesian theory would argue that the government should have a fiscal target. If spending would otherwise be less than full employment GDP, the government should put more money into people's pockets.( THAT'S THE PLAN )

But lost in the economics textbooks, and all but lost in the thousands of pages of the technical economics literature, is this other message of Keynes regarding why the economy fluctuates as much as it does. Animal spirits offer an explanation for why we get into recessions in the first place -- for why the economy fluctuates as it does. It also gives some hints regarding what we need to do now to get out of the current crisis.

A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. In talking about animal spirits, Keynes sought to convey the message that swings in confidence are not always logical( RATIONAL ). The business cycle is in good part driven by animal spirits( YES ). There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously. They believe instinctively that they will be successful, and they suspend their suspicions. As long as large groups of people remain trusting, people's somewhat rash, impulsive decision-making is not discovered. ( TRUE )

Unfortunately, we have just passed through a period in which confidence was blind. It was not based on rational evidence( PRUDENCE ). The trust( I CALL IT WISHFUL THINKING ) in our mortgage and housing markets that drove real-estate prices to unsustainable heights is one of the most dramatic examples of unbridled animal spirits we have ever seen.

Furthermore, while animal spirits have been high over a very long period of time, a whole new system for the granting of credit had been generated. Some 30 or 40 years ago there was much less intermediation in financial markets. But then along came financial innovation and a new financial system, not just in mortgages and housing but throughout the credit system, with complicated strategies of securitization and use of derivatives. The more complex the transaction the more trust is needed to sustain the transaction. ( THE MORE PRUDENCE )

Then too, over the past several decades a vast "shadow" banking sector developed that engaged in the purchase and sale of such securities. To a great extent these traders borrowed short term at low interest rates against collateral of asset-backed securities, of which residential mortgage-backed securities would be just one example. What enabled them to do that? It was the animal spirits( WISHFUL THINKING BASED UPON GOVERNMENT GUARANTEES ). Those who loaned short to the shadow banking sector were confident. They thought they would be repaid. (They also thought they could insure against loss by the purchase of derivatives). They were trusting. But as soon as these lenders lost their confidence they were no longer trusting. It was like a classic bank run( YES. A CALLING RUN. ), but this time not on the formal banking sector but on those who borrowed short, and loaned long -- on the shadow banking sector. Lenders to the shadow banking sector wanted to be the first not to renew their loans.( TRUE )

The trust in the innovative lending practices was excessive; now that trust is replaced by deep mistrust. The wreckage of formerly towering financial institutions is all around us. Evidence of our overconfidence repeatedly appears in media stories, and thus we are constantly reminded that we were foolish to have been so trusting( IMPRUDENT ).

The danger at this point is that if the actions we take are not aggressive enough to have a substantial, visible impact on the economy, then confidence will continue to plummet( TRUE ). The Obama administration estimated its initial $775 billion stimulus package would shave about 1.8% off the unemployment rate from what it would otherwise be. Even so, by the time any package takes full effect the unemployment rate may be substantially higher than it is today.

So what must we do to revive our animal spirits and economic growth? We must be certain that programs to solve the current financial and economic crisis are large enough, and targeted broadly enough, to impact public confidence. Not only do we need a fiscal stimulus significantly greater than the proposal that is currently on the table, government action is also needed to take the place of the credit markets that seemingly worked so well when animal spirits were high. The Treasury and the Federal Reserve not only need a fiscal target, they also need a credit target. This should not be a dollar number( GOOD ), but rather a target for how the credit markets should behave. The goal should be that those who would normally receive credit in times of full employment can once again find it easy to do so, at rates with realistic risk premiums. ( OK )

There are three ways to restore these credit markets. The Treasury and the Federal Reserve have been inventive in applying all three methods. The first is the extension of rediscounting. The Fed has invented many different special loan facilities. They have even invented ingenious ways to combine Treasury money to make very large-scale loans while still within the legal requirement that the Fed can only lend against safe collateral when using TARP funds for the Term Asset-Backed Securities Loan Facility, which will support consumer, student and small-business loans. But so far the total amount of such rediscounting has been small relative to the size of the credit markets. They need to be much larger.( YIKES )

Second, so far more than $250 billion of government money has been used to recapitalize banks. But just making the banks solvent is not enough. The banks, whose managers are suffering from the same flagging animal spirits( I'VE CALLED THEM SHELL-SHOCKED ) as the rest of the economy, will not expand their credit much just because they are more solvent. The banks will only expand if they see profitable opportunities to grant loans and if their fear of failure is diminished. It will take much more than keeping the banks solvent to make them take on the disappeared credit flows. ( WE DON'T HAVE TIME )

And, finally, especially in considerably expanding the powers to support the lending of Fannie Mae and Freddie Mac, government-sponsored enterprises have replaced a significant portion of the mortgage markets. But the government should do much more here as well. For example, failed banks might be kept alive longer as bridge banks under government supervision with the purpose of making credit freely available.( A HYBRID. BAD IDEA. )

The interventions so far have been in the right direction. Federal Reserve Chairman Ben Bernanke has been especially inventive and aggressive. But the theory of animal spirits and the loss of confidence tell us that a great deal more still needs to be done. Now is not a time for the timid. To meet our needed fiscal-policy target, the Obama administration's fiscal stimulus should be much greater. And to meet our credit target, the expansion of special loan facilities, recapitalization of banks, and use of government institutions to grant credit where it has dried up must be on a scale great enough to overwhelm further doubts about the economy.( TOO MUCH )

In due course our animal spirits will once again turn positive, but we would rather that happen this year or the next rather than five or 10 years from now. There is only one way to speed this process: greatly expand governmental support of credit markets and pass a much larger fiscal stimulus plan than is now proposed.( I DON'T SEE IT THIS WAY. ALTHOUGH I AGREE ON THE APPROACH, I DISAGREE ON THE PARTICULARS. WE CANNOT AFFORD A HUGE STIMULUS OF GOVERNMENT SPENDING. WE NEED TO NATIONALIZE THE BANKS, AND HAVE A SMALL STIMULUS THAT WILL DO SOME GOOD, BUT NOT A LOT. WE COULD ALSO USE MONETARY POLICY. STILL, IT'S PLEASANT TO READ AN ECONOMIST THAT I FEEL SIMPATICO WITH. )

Mr. Shiller is professor of economics at Yale University and chief economist at MacroMarkets LLC. His new book, with George Akerlof, "Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism," will be published by Princeton next month."

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis.

Simon Johnson on the Baseline Scenario:

"The Economic Crisis and the Crisis in Economics

with one comment

The Economic Crisis

The global financial crisis of fall 2008 was unexpected( THE SEVERITY WAS UNEXPECTED. ). A few people had been predicting that serious problems were looming, and even fewer had placed bets accordingly, but even they were astounded by what happened in mid-September( I THINK THAT THEY WERE ASTOUNDED BY THE GOVERNMENT LETTING LEHMAN FAIL ).

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis. (See http://BaselineScenario.com for more on what came before, how events unfolded during fall 2008, and where matters now stand).

• 1. On the weekend of September 13-14, 2008, the U.S. government declined to bailout Lehman. The firm subsequently failed, i.e., did not open for business on Monday, September 15. Creditors suffered major losses, and these had a particularly negative effect on the markets given that through the end of the previous week the Federal Reserve had been encouraging people to continue to do business with Lehman.( A CALLING RUN BEGAN. )
  
• 2. On Tuesday, September 16, the government agreed to provide an emergency loan to the major insurance company, AIG. This loan was structured so as to become the company’s most senior debt and, in this fashion, implied losses for AIG’s previously senior creditors; the value of their investments in this AAA bastion of capitalism dropped 40% overnight.
• 3. By Wednesday, September 17, it was clear that the world’s financial markets - not just the US markets, but particularly US money market funds - were in cardiac arrest. The Secretary of the Treasury immediately approached Congress for an emergency budgetary appropriation of $700bn (about 5% of GDP), to be used to buy up distressed assets and thus relieve pressure on the financial system( IN ORDER TO STOP THE CALLING RUN. ). A rancorous political debate ensued, culminating in the passing of the so-called Troubled Asset Relief Program (TARP), but the financial and economic situation continued to deteriorate both in the US and around the world.

Thus began a financial and economic crisis of the first order, on a magnitude not seen at least since the 1930s and - arguably - with the potential to become bigger than anything seen in the 200 years of modern capitalism. We do not yet know if the economic consequences are “merely” a severe recession or if there will be a prolonged global slump or worse.

The Crisis in Economics

Does this economic crisis constitute or imply a crisis for economics? There are obviously two answers to this question: no, and yes.

Let me discuss the “no crisis” view first. There are actually several variants on this view. The first is that the post-Keynesian consensus comes through the crisis just fine. In fact, the current emphasis on fiscal stimulus in the US (and the debate about fiscal stimulus elsewhere) supports the position that we are back to Keynesian fundamentals. There is a decline in private spending underway, and governments around the world are seeking to replace that with public spending (or, if you prefer, the private sector suddenly wants to save more, so the public sector better rush to save less.)

A more nuanced version of this view adds some financial accelerators, or perhaps we should now call them decelerators. We obviously had a series of bank runs in mid-September, but not just by small depositors and not just on banks. We also had a situation where falling values for collateral triggered more asset sales (either for accounting reasons or due to market pressure of various kinds), and this led to further lowering of collateral. ( A CALLING RUN )

More broadly, there was also some kind bad expectations trap, in which everyone expected everyone else to default ( AND THAT THE GOVERNMENT WOULDN'T INTERVENE ) and that kind of fear of counterparty risk is obviously self-fulfilling.

In other words, this view is that we can retrofit our favorite mainstream models to accommodate what happened, at least at a fairly high level of abstraction. There is no crisis for macroeconomic thinking, let alone for economics.

An alternative interpretation is that mainstream macroeconomics is in big trouble. You can think about this in terms of whether standard thinking provides plausible answers to four current policy issues. (Daron Acemoglu of MIT has an important essay in preparation, arguing that there are deeper problems for economics, including for the most fundamental microeconomics - such as how we think about firms and reputations - in the light of the crisis.)

First, let’s begin with whether macroeconomics can answer definitively or even informatively the most important question of the day. Are we in danger of falling into another Great Depression, with a prolonged, worldwide fall in output and employment?

The mainstream answer to this question is: no, because we’ve learned a lot about economics since the Great Depression and because we also learned a great deal about policy both during and after the 1930s.

I’m not so convinced( I AGREE. WE CAN. ). For example we know that a key policy mistake in the early 1930s was to allow banks to fail. This will not happen again, at least not for “systemic institutions” - as the G7 made clear in October. But bank failure was a problem because it contributed to a big contraction in credit - this has been well established in the work of Ben Bernanke and others. Unfortunately, we know relatively little about how to stop today’s process of falling credit around the world, known as “global deleveraging.”( A CALLING RUN )

Second, consider the current consensus on saving the day in the US and around the world through a large US fiscal stimulus - probably $800bn over several years, which would constitute the largest peacetime boost ever for the US economy. Is this really the right approach?( NOT REALLY, BUT IT WILL HAVE TO DO. )

We know that allowing the price level to decline was an essential error of the early 1930s, as this increased the real debt burden for everyone with fixed nominal obligations. We think we know how central banks can prevent this kind of deflation, and Mr. Bernanke’s now famous November 2002 speech laid out a clear road map for appropriate policies - even to the extent of “quantitative easing,” i.e., extending more credit without sterilization through selling Treasuries, thus increasing the monetary base. ( THIS SHOULD BE DONE. )

Still, I am struck by the fact that while the opinion leaders among US-based macroeconomists eventually called for some version of “credible irresponsibility” (to counter deflation or even produce inflation) in Japan during the 1990s, we have still not reached the point where such terms have joined the acceptable lexicon for most of the mainstream on the US economy today. (Some leading economists, I find, are willing to talk in these terms in private, but not yet in public.)

I would stress that nothing in the Fed policy or the Obama Plan has yet turned the corner on this issue. In fact, inflation expectations have not risen significantly since it became clear Mr. Obama would win the election and introduce a major fiscal stimulus.

Think about that in terms of monthly payments on your (or my) house. Let’s say the interest rate on your mortgage is 6%, which is roughly the average for the U.S. When inflation runs around 2% (as is typical), the real, inflation-adjusted rate you pay is lower - actually only 4%. But the price level is now expected by the financial market to be flat on average for each of the next 5 years. So in this case the real interest rate will be 6%. In other words, the advent of deflation implies a massive unexpected transfer of income from borrowers to lenders. With the face value of outstanding mortgages over $10trn, this will likely depress spending by more than can be compensated for by any reasonable fiscal stimulus. ( IF IT HAPPENS, A GOOD POINT. )

The appeal of recreating positive inflation expectations is that it would put downward pressure on the dollar and thus push our major trading partners to cut interest rates and engage in their own forms of monetary expansion - or face appreciation of their currencies and a fall in exports( TRUE. BUT THIS HAS RISKS FOR THE SAVER COUNTRIES. ). The result will be higher global inflation, to be sure, but this is the only realistic way to persuade European Union members to take the measures necessary to stimulate their stronger economies or even save their own weaker economies from default.

President Obama can ask our allies to provide stimulus until he is blue in the face, but the fact of the matter is that the very size of our own fiscal expansion gives the Germans and others the incentive to free ride - they are hoping to recover on the back of exports to our infrastructure projects( TRUE ). It is only more expansionary monetary policy in the US that will force their hands in the right direction, for us and for them.( IT WOULD SEEM SO. )

Third, what is the deeper cause of this crisis? A supersized financial system - the obesity of banks and shadow banks - helped create the vulnerabilities that made the September crisis possible. This financial system captured its regulators( COLLUSION ) and took on far more risk than it could manage( TRUE ) (or even understand( I DON'T AGREE )). And this is a statement not just about US banks, but also about most parts of the global financial system.

The answer lies with the political economy( GOOD ) of the US financial system, including the power politics of large financial firms( ABSOLUTELY ). These grew large relative to the institutions that support and constrain them. In effect, we created an emerging market-type of structure. There is nothing in the mainstream textbooks or working papers about this - the general working assumption has been that institutions in the US were significantly better than in emerging markets. The time has obviously come to question in what sense this is really true.

The US banks have received generous bailouts, at least after the Lehman-AIG events, with no change in management( VERY BAD ). Have they become stronger or weaker? After the crisis we will have probably no more than 6 major banks in the US, with little threat from new entrants and small hope of controlling their actions indefinitely through effective regulation( I AGREE ).

The problems are even more pressing if it is the case that these banks need to be recapitalized fully. They oppose this policy, for obvious reasons. The fiscal stimulus may well prove ineffective in the face of this political opposition, which is still well represented at the heart of the new administration’s economic strategy. Again, however, I find leading economists to be surprisingly quiet on this key issue.

The fourth question is: what are the implications for the eurozone? Again, there is a huge divergence of opinions among economists on this point. Personally, I’m struck by the growing pressure on some of the weaker sovereigns that belong to the euro currency union. Greece faces the most immediate problems, as demonstrated both by widening credit default swap spreads and - over the past few weeks - increasing spreads of Greek bonds over German government bonds. The cost of servicing Greek government debt is thus rising at the same time as Greece has to roll over debt worth around 20 percent of GDP in the coming year.

Greece has a debt-to-GDP ratio over 90 percent, and the perceived risk of default is significant. In our baseline view, Greece receives a fairly generous bailout from other eurozone countries (and probably from the EU). This, however, does not come early enough to prevent problems from spreading to Ireland and other smaller countries (which then also need to implement fiscal austerity or to receive support). Italy is also likely to come under pressure, due to its high debt levels, and here there will be no way other than austerity. With or without a bailout, Greece and other weaker euro sovereigns will need to implement fiscal austerity.

The net result - in my opinion - is less fiscal stimulus than would otherwise be possible, and in fact there is a move to austerity among stronger euro sovereigns as a signal. Governments will therefore struggle to dissave enough to offset the increase in private sector savings. But the global mainstream economics approach still seems to be emphasis on fiscal policy coordination.

In any case, monetary policy in Europe will be slow to respond. The European Central Bank decision-making process seeks consensus and some key members are still more worried about inflation down the road than deflation today. Eventually the ECB will catch up, but not before there has been considerable further slowing in the eurozone. ( I AGREE )

Probably existing macroeconomic thinking can accommodate this kind of analysis. It’s a blend of financial market analysis with political economy. But I don’t know any models, let alone much empirical work, that bears directly on - or comes close to testing - any dimensions of this issue. Economics is in thin air.

My guess is that, among other things, we need to change dramatically our ways of thinking about fiscal policy. This needs to prepare for irregular but large crises, which implies being more countercyclical - and that implies less growth in boom times. Monetary policy will not stop bubbles and regulators will always fall behind; responsibility for making sure we can handle major financial crises rests with fiscal policy. ( I NEED TO SEE ALL OF THE PROPOSALS. )

Rethinking the Structure of the Global Economy

If economics is in so much trouble, what does this imply for thinking about economic policy - both in terms of sensible crisis management and more medium-term attempts to rebuild a reasonable global system?

In order to create the conditions for long-term economic health, we need to identify the real structural problem that created the current situation and likely means the global economy has entered a new phase of instability. It wasn’t a particular set of payments imbalances (read: US-China)( I AGREE ), as these can and will change (which does not excuse policymakers who refused to address this issue). It wasn’t the failure of a particular set of domestic regulators( SOME OF IT IS COLLUSION. SO I DISAGREE. ), as regulatory challenges and responses change over time (which doesn’t excuse the specific regulators).

Let me suggest a way to think about these economic issues, although I know this will not sit well with many macroeconomists (although it may go down better with those who focus on longer run growth issues). The underlying problem was that, after the 1980s, the “Great Moderation” of volatility in industrialized countries created the conditions under which finance became larger relative to GDP and credit could grow rapidly in any boom. In addition, globalization allowed banks to become big relative to the countries in which they are based (with Iceland as an extreme example). Financial development, while often beneficial, brings risks as well. (None of these points would have sat well with mainstream finance or economics two years ago, but perhaps the consensus around some of these points has shifted recently.)

The global economic growth of the last several years was in reality a global, debt-financed boom, with self-fulfilling characteristics - i.e., it could have gone on for many years or it could have collapsed earlier. The US housing bubble was inflated by global capital flows, but bubbles can occur in a closed economy (as shown by experiments, http://baselinescenario.com/2008/12/07/financial-crisis-bubbles-causes-psychology/]). The European financial bubble, including massive lending to Eastern Europe and Latin America, occurred with zero net capital flows (the eurozone had a current account roughly in balance). China’s export-driven manufacturing sector had a bubble of its own, in its case with net capital outflow (a current account surplus).

But these regional bubbles were amplified and connected by a global financial system that allowed capital to flow easily around the world. We are not saying that global capital flows are a bad thing; ordinarily, by delivering capital to the places where it is most useful, they promote economic growth, in particular in the developing world. But the global system also allows bubbles to feed on money raised from anywhere in the world, exacerbating global systemic risks. When billions of dollars are flowing from the richest countries in the world to Iceland, a country of 320,000 people, chasing high rates of interest, the risks of a downturn are magnified, for the people of Iceland in particular.

The prevalence of debt in the global boom was also a major contributing factor to today’s recession (although major disruptions could also arise from the busting of pure equity-financed booms). Debt introduces discontinuities on the downside: instead of simply becoming losing money, companies with high debt levels go bankrupt in hard times. Lehman, AIG, and now GM all created systemic risks to the US and global economies because one default can trigger a series of defaults among other companies - and simply the fear( I AGREE HERE ) of those dominos falling can have systemic effects( A CALLING RUN ). Similarly, emerging market defaults can have systemic effects by spreading fear and causing investors to pull out of unrelated by similarly situated countries (and causing speculators to bet against their currencies and stock markets).

Ideally, global economic growth requires a rebalancing away from the financial sector and toward non-financial industries such as manufacturing, retail, and health care (for an expansion of this argument, see our opinion piece on this topic, available through [http://baselinescenario.com/2008/11/11/obama-economic-strateg/]. Especially in advanced economies such as the US and the UK, the financial sector has accounted for an unsustainable share of corporate profits and profit growth. However, the financial sector, despite the experiences of the last year, is still powerful enough to resist significant structural reform( TRUE ). While this will not prevent a return to economic growth, it will maintain all of the risks that led to the current situation - in particular, the risk of synchronized booms and busts around the world.

Understanding how to prevent stability from creating future vulnerability will require us to rethink a great deal about economics and how economies operate. Political economy is probably the place to begin( YES ), but a lot more needs to be done on fundamentals. Whether or not our economies manage to avoid a major global depression, economics is in crisis."

I like his approach, but simply reach different conclusions. In order to stop Calling Runs, as in this crisis, government guarantees are necessary, in the same way that FDIC insurance helps stop banking runs. The main adversary is fear, which can only be quelled by a LOLR with the power and funds to guarantee that an orderly unwinding is possible, and that a Calling Run will only lead to worse losses for the parties involved. In my estimation, the lack of guarantees was what caused the crisis, with the result that we had a flighty to safety. In other words, a flight to guaranteed investments. Even Implicitly Guaranteed Investments, like Agency Bonds, have turned out to be too risky. In order to lessen the probability that such a Calling Run occurs again, a version of Bagehot's Principles should be instituted.

The subrime and other bad loans are, in my book, Fraud, Negligence, Fiduciary Mismanagement, and Collusion. They violate the rules of Banking 101. The same holds true for CDOs, CDSs, and other investments meant to lessen the capital requirements of investments. It was not the instruments or equations, but the flaunting of Investing 101 rules, that caused the problems. The culprits are individuals, not incentives, the system, or whatever Mechanistic Explanation that is offered. The credit ratings agencies fall under the same rubric. These were not honest mistakes.

Underlying the decisions made by these investors and bankers, was a belief that the government would intervene in a serious financial crisis in a timely and effective way. There was no Plan B. In other words, no plans were ever made for a large blow up, not because they were held to be impossible, the S & L Crisis and LTCM and Tech Bubble showed that view was false, but because the government showed that it would intervene and, as well, investigation and prosecution of graft would be minimal and ineffective.

Finally, we do not have a free market system. We have a Hybid called a Welfare State. Anyone who examines the beliefs and presuppositions of the investor class in this country will immediately see that this investor uses and assumes the implicit backing of the government. Under no circumstances could they be considered free market fanatics, unless by that is meant the use of BS to explain their beliefs.

The only real threat to this Hybrid comes from major social disruption and dislocation, which many assume is not possible. This view is false. Massive Unemployment together with perceived, correctly by the way, cronyism in the government could well lead to a massive falling off in the belief in our system. The alternative would likely be some form of totalitarianism. In any case, we should endeavor to never find out.

"Friedrich Hayek is going to be out; Friedrich Engels in. Larry Kudlow out; Larry Mishel in."

John Judis sees a resurgence of Marx:

"The Crisis Of '08 Reading List

The best books to help you make sense of Marx, Keynes, the Great Depression, and how we got where we are now.

John B. Judis, The New Republic Published: Wednesday, December 24, 2008

Every few years, someone urges me to do a Christmas book list, and while protesting my ignorance and incompetence, I gladly comply. This year's subject is the current global recession, which threatens to become a global depression. This is a layman's list, because I am strictly a layman on the subject of economics. You don't have to know anything about string theory to read any of the books I recommend.

I learned most (or what little I know) of economics from reading on my own or from study groups we used to hold in the fading days of the new left. I read all three volumes of Capital in a study group organized by the late Harry Chang, a Korean immigrant to the Bay Area who was a computer programmer by day (in the keypunch era) and a Marxist scholar by night. I read Keynes under sporadic supervision of economist Jim O'Connor, the author of The Fiscal Crisis of the State( A GOOD BOOK ), and a fellow member of the collective that published Socialist Revolution (which in 1978 became Socialist Review). And I got my introduction to economic history from historian Marty Sklar, who was also a member of that collective.

A decade ago, I might have been embarrassed to admit that I was raised on Marx and Marxism, but I am convinced that the left is coming back( NONSENSE ). Friedrich Hayek is going to be out( SILLY ); Friedrich Engels in( NO WAY ). Larry Kudlow out( THANK GOD ); Larry Mishel in( I DON'T KNOW HIM ). And why is that? Because a severe global recession like this puts in relief the transient, fragile, and corruptible nature of capitalism( SILLY ), and the looming contradiction between what Marx called the forces and relations of production evidenced in unemployed engineers and boarded up factories and growing poverty amidst a potential for abundance. As capitalism itself--or at the least the vaunted miracle of the free market--becomes problematic, the left is poised for an intellectual comeback( GOOD LUCK ). So here are four topics and some books to read about them, plus a few articles, from someone who learned economics by reading and rereading Paul Baran and Paul Sweezy's Monopoly Capital( INTERESTING BOOK ).

1. The current crisis. I was warning my colleagues of an encroaching disaster a year ago, because I was reading the columns and articles of Paul Krugman, Nouriel Roubini, Larry Summers, and Dean Baker. They were on top of this when Hank Paulson and Ben Bernanke were still telling everyone not to worry. Of the current books I've read (and I haven't read many), I'm very high on Financial Times columnist Martin Wolf's Fixing Global Finance, George Cooper's The Origin of Financial Crises, Jamie Galbraith's The Predator State, and Dean Baker's Plunder and Blunder. Wolf is terrific on the international currency mess--and the Financial Times is the paper to read--Cooper is first-rate on the irrationality of money and finance, Galbraith has a good explanation of how we got to where we are, and how to get out of it, and Baker is the expert on the housing bubble. I also liked Krugman's The Return of Depression Economics when it appeared almost ten years ago (Short take: If it could happen to Japan, it could happen to us). There is a new edition that incorporates some material about 2008, but I haven't read it. ( THESE SOUND GOOD )

2. John Maynard Keynes. Keynes is back in vogue, and rightly so( I AGREE ). One economist--I can't remember who it was--recently warned against reading The General Theory of Employment, Interest, and Money( I AGREE ) because it was written strictly for economists. I don't agree at all. It's a very hard book, especially some of the middle sections, but worth reading and rereading. If you don't have energy for the whole thing, read the first three chapters, some of the middle chapters (7, 10, 16, and 18 are my suggestions) and the last three. I suggest, however, a guide. The best I've found is Dudley Dillard's The Economics of John Maynard Keynes, which, to my amazement, is still in print after sixty years. I also like Hyman Minsky and Paul Davidson's guidebooks to Keynes. But you've got to read Robert Skidelsky's three-volume biography of Keynes, Hopes Betrayed, The Economist as Savior, and Fighting for Freedom (also now available in an abridged one-volume edition). Believe me, this is one of the great biographies( I READ VOLUME ONE. IT IS GOOD ). The way he brings together Keynes, the gay aesthete of Bloomsbury, and Keynes, the economist and man of worldly affairs, is something to behold. Skidelsky's second volume is also the best introduction to Keynes's economics, because you learn that exactly those ideas you found mystifying or most difficult in Keynes were hotly debated between him and his colleagues.

3. The Great Depression. There have been a lot of books on this subject, but most of what I read I read decades ago, so I'm sure I'm going to overlook worthy choices. Still, there are two older books that continue to stand up. George Soule was an editor of The New Republic during the 1930s. He was also an economist and in 1947 published a study of the American economy from 1917 to 1929 entitled Prosperity Decade. Soule shows that well before 1929, there were rumblings of trouble in the American economy--not only in the stock market bubble, but in overcapacity in key industries like auto, and in the rise of technological unemployment( SOUNDS INTERESTING ). You'll see the surprising resemblance to our own decade, including an anticipatory recession in 1926 like the one in 2001. On the international crisis of the 1930s, I like Charles P. Kindleberger's The World in Depression( GOOD BOOK ), which I reread two months ago when I was writing about the current international imbroglio. I want also to mention an essay by Sklar in The United States as a Developing Country. In chapter five, "Some Political and Cultural Consequences of the Disaccumulation of Capital," Sklar puts forward the idea that during the 1920s, capitalism shifted from the accumulation to disaccumulation of capital. That's Marxist jargon, but what it means is that goods production began to expand as a function of the reduction rather than increase in labor-time and in the labor force( I DON'T FOLLOW HERE. COULD BE WORTH LOOKING INTO ). That created an enormous opportunity, but also a potential crisis. The depression of the 1930s, Sklar argues, was the first "disaccumulationist" depression. One of his former students, historian Jim Livingston from Rutgers, has put forward a similar analysis of the current recession.

4. Marx and Marxism. Marx, like Keynes, is best read in his own words. There are a lot of brilliant shorter works, but I'd put the first volume( VOL. 2 IS THE MOST IMPORTANT ) of Capital up there with The Origin of Species, The Interpretation of Dreams, and The Philosophical Investigations on my list( IT'S AN EXCELLENT LIST ) of great books of the last two hundred years. It's not a guide to starting your own business and really doesn't have a theory of crises. Some of that is in the other unfinished volumes. What volume one does is establish capitalism as a phase, and perhaps a passing phase, in world history whose very nature has consisted in disguising that fact from worker and capitalist alike. You read Capital to understand the historical underpinnings, not the mechanics of capitalism. Marx's theory of history has obvious deficiencies( IT'S FALSE I'M AFRAID )--he didn't foresee, certainly, the rise of corporate capitalism and of corporate liberalism. His trademark theory of the falling rate of profit, which you can find in volume three, is also unpersuasive( IT'S FALSE). But these failings pale beside his portrayal of capitalism as mode of production based upon labor power as a commodity and on the accumulation of capital( IF YOU UNDERSTAND VOL. 2, YOU CAN UNDERSTAND HOW JEVONS REFUTES IT ). I wish I could recommend guides to Marx's thought( I.BERLIN ). The economic guides often err by trying to justify his works as modern economics. G. A. Cohen's book, Karl Marx's Theory of History, is a little academic, but of all the books I've read in the last twenty or thirty years, it's the best( IT'S A VERY GOOD BOOK. ).

Have a good, if grim, read of these books--if you have some better ideas, include them in the comments below--and let's hope that the next year brings some better economic news than this one.

John B. Judis is a senior editor at The New Republic."

What we have in the US is our version of the Welfare State. It is a government/private sector hybrid. That is not going to change, nor has it been discredited. In fact, these bailouts are a confirmation that the system is alive and well and functioning according to plan. What was not anticipated is the virulence of the crisis or the impotence of government actions to effectively quell this crisis swiftly. The people who populate the investor class are firm believers in this system. The idea that they are free market fanatics is silly. They simply use the rhetoric when it suits them. Otherwise, they say that the government needs to help them because they are essential to the health of the economy and country, and lobby for government favors and protections.

The Obama Administration is firmly rooted in this system. However, one can hardly imagine anything worse than the recent cronyism driven and interest driven administration that we've just experienced. It simply had an especially obnoxious and incompetent version of our hybrid, which allowed massive fraud, massive government guarantees implicitly guaranteeing the massive fraud, and allowed massive incompetence and graft in the name of party and interest groups associated with it. It has less destroyed the system than robbed it.

Once rid of this pestilence, we will slowly meander back through a thicket of problems to a different point of equilibrium in the balance of the hybrid. However, unless we allow social problems to insert themselves into these largely economic problems, we will retain this hybrid system indefinitely. It is a peculiarly resilient cultural artifact, created by a whole host of political compromises that are not easily disentangled without ruinous consequences.

All of the authors Judis cites might have some use for us, and we should certainly read them and learn from them. But most of the people he cites, certainly Marx and Engels, are defined by their Mechanistic Explanations, as opposed to Human Agency Explanations, and, as such, are likely to do more harm than good. To not understand the importance of panic and fear in this crisis, as opposed to "forces" of production, say, is to miss the whole tragedy that got us into this mess, and will only delay our leaving it behind.

It's too bad humans aren't mechanical for some theories, but they aren't.

"“These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.”

Apparently everyone is jumping on the Credit Ratings Agencies. Here's Gretchen Morgenson in the NY Times:

“These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.” — A Moody’s managing director responding anonymously to an internal management survey, September 2007.

Anytime anyone qualifies a very negative statement, it's the very negative statement that's true. In other words, they sold their souls to the devil for revenues.

Latest Activity

"The housing mania was in full swing in 2005 when analysts at Moody’s Investors Service, the nation’s oldest and most prestigious credit-rating agency, were pressured to go back to the drawing board.

Moody’s, which judges the quality of debt that corporations and banks issue to raise money, had just graded a pool of securities underwritten by Countrywide Financial, the nation’s largest mortgage lender. But Countrywide complained that the assessment was too tough.

The next day, Moody’s changed its rating, even though no new and significant information had come to light, according to two people briefed on the change who requested anonymity to preserve their professional relationships."

I wonder why.

"Moody’s had assigned high grades to many securities containing Countrywide mortgages. Those securities and mortgages, issued during the lending spree of recent years, later soured — leaving investors with large losses and homeowners and communities struggling with foreclosures.

That was not the only time Moody’s softened its stance on Countrywide securities. It elevated ratings several times after Countrywide complained, the people briefed on the matter say.

Since the subprime mortgage troubles exploded into a full-blown financial crisis last year, the three top credit-rating agencies — Moody’s, Standard & Poor’s and Fitch Ratings — have faced a firestorm of criticism about whether their rosy ratings of mortgage securities generated billions of dollars in losses to investors who relied on them."

I would guess that they did. It's just a hunch.

"The agencies are supposed to help investors evaluate the risk of what they are buying. But some former employees and many investors say the agencies, which were paid far more to rate complicated mortgage-related securities than to assess more traditional debt, either underestimated the risk of mortgage debt or simply overlooked its danger so they could rake in large profits during the housing boom."

I believe that they overlooked the danger. If they couldn't really estimate the risk, they should have said so or been extremely conservative.

"A Moody’s spokesman, Anthony Mirenda, said the company would not change ratings without substantive reasons. “As a matter of policy, Moody’s is obligated to reconvene a rating committee if there is new information put forth by an issuer that could have a material impact on a security’s creditworthiness,” he said, “and our policies prohibit changes to ratings for anything other than credit considerations.”

He added that “Moody’s knows of no instances in which a reconvened rating committee resulted in improper changes to ratings on Countrywide securities.”

He's using "know" in the sense of apodictic.

"Bank of America, which took over Countrywide earlier this year, said it could not verify details of prior management’s interactions with Moody’s."

"Know". "Verify". Have you noticed how these spokesmen become epistemologists when they're in trouble?

"Members of Congress have grilled the agencies, asking their executives to answer accusations of incompetence and to say whether they assigned glowing ratings to keep clients happy and expand their business."

I'm sure they're terrified by Congress.

"State and federal officials are also making inquiries. Moody’s recently disclosed in its regulatory filings that it had received subpoenas from state attorneys general and other authorities pertaining to its role in the credit crisis.

Moody’s said it was cooperating with the investigations."

They've received the subpoenas and hired a phalanx of attorneys.

“Moody’s credit ratings play an important but limited role in the financial markets — to offer reasoned, independent, forward-looking opinions about relative credit risk, based on rigorous analysis and published methodologies,” Mr. Mirenda said. The company denies that it went easy on ratings to generate income."

Limited to providing the imprimatur for people to invest real money.

"That the credit-rating agencies missed immense problems in the mortgage-related securities they blessed is undeniable. Moody’s declined to say how many classes of the securities it has downgraded. But the number is in the thousands and the original value in the hundreds of billions of dollars."

Downgraded:
A: Thousands
B: Billions Of Dollars

Job well done.

"When Moody’s began lowering the ratings of a wave of debt in July 2007, many investors were incredulous.

“If you can’t figure out the loss ahead of the fact, what’s the use of using your ratings?” asked an executive with Fortis Investments, a money management firm, in a July 2007 e-mail message to Moody’s. “You have legitimized these things, leading people into dangerous risk.”

That's right. They legitimized. Let's write this one down:

“If you can’t figure out the loss ahead of the fact, what’s the use of using your ratings?”

That means, "If you can't tell anything until everyone else can, what's your value?"

"Whether such risks were truly undetectable, or were ignored by Moody’s and the other agencies, is at the core of what regulators, legislators, investigators and investors are trying to determine."

Hey, using just 2005 sources myself, in two hours on the web, I discovered how risky they were. Are you telling me professionals, making thousands of dollars, couldn't have done what I did?

"Moody’s current woes, former executives say, were set in motion a decade or so ago when top management started pushing the company to be more profit-oriented and friendly to issuers of debt. Along the way, the firm, whose objectivity once derived from the fact that its revenue came from investors who bought Moody’s research and analysis, ended up working closely with the companies it rated, and being paid by them."

Conflict of interest.

"And in 2000, when Moody’s issued stock to the public for the first time, executives hungry to churn out quarterly profit growth had another incentive to redirect the firm’s focus from low-margin ratings of relatively simple bonds to highly lucrative assessments of much more complex debt securities.

As it rode the mortgage wave, Moody’s came to enjoy profit margins that were higher than those of the mightiest of Fortune 500 companies, including Exxon and Microsoft.

“Moody’s was like a good watchdog that had regarded the financial markets as its turf and barked and growled when anybody it didn’t know came near it,” said Thomas J. McGuire, a former director of corporate development at the company who left in 1996. “But in the ’90s, that watchdog got muzzled and gelded. It was told to turn into a lapdog.”

That's not a very nice description of their transformation. Apt, but not nice.

"A Lucrative Niche

A key reason for the soaring housing market was a process known as securitization. The machinery, devised by Wall Street, packaged individual mortgages into ever larger and more complex bundles. This allowed banks to sell their loans to investors, thereby reducing the banks’ risk and allowing them to lend more to aspiring homeowners."

Please no more about lowering risk. False. Period.

"Wall Street made handsome profits bundling and selling the loans, and investors stepped up to buy the packaged debt, often because rating agencies like Moody’s had graded it as safe enough for the investors’ portfolios.

The agencies divided the securities into slices known as tranches and analyzed each based on its risk. The securities deemed safest received the rating Moody’s called Aaa."

Here we go. Tranches. That terrifying graph an eight year old could understand.

"Consider a residential mortgage pool put together in summer 2006 by Goldman Sachs. Called GSAMP 2006-S5, it held $338 million of second mortgages to subprime, or riskier, borrowers.

The safest slice of the security held $165 million in loans. When it was issued on Aug. 17, 2006, Moody’s and S.& P. rated it triple-A. Just eight months later, Moody’s alerted investors that it might downgrade the top-rated tranche. Sure enough, it dropped the rating to Baa, the lowest investment-grade level, on Aug. 16, 2007.

Then, on Dec. 4, 2007, Moody’s downgraded the tranche to a “junk” rating. On April 15 of this year, Moody’s downgraded the tranche yet again; today, it no longer trades. The combination of downgrades and defaults hammered the securities."

Well, technically, it was still the "safest" tranche.

"Reversals like this have enraged investors. Internal e-mail messages disclosed by Congress in October, for example, recounted a July 2007 conversation Moody’s had with an irate customer at Pimco, a major money management firm.

“He feels that Moody’s has a powerful control over Wall Street but is frustrated that Moody’s doesn’t stand up to Wall Street,” the e-mail stated. “They are disappointed that in this case Moody’s has ‘toed the line. Someone up there just wasn’t on top of it,’ he said.” For decades after its founding in 1909, Moody’s was an independent and respected arbiter of credit quality. Today, the company’s 1,200 analysts rate debts of 100 nations, 12,000 corporate issuers, 29,000 public issuers like cities and 96,000 complex securities known as “structured finance.” It is a franchise that generated revenue of $1.35 billion and earnings of $370 million in the first three quarters of this year alone."

Oddly, their business thrives. Can you say cartel?

"Edmund Vogelius, a Moody’s vice president, explained the company’s business model in a 1957 article in The Christian Science Monitor.

“We obviously cannot ask payment for rating a bond,” he wrote. “To do so would attach a price to the process, and we could not escape the charge, which would undoubtedly come, that our ratings are for sale.”

In the early 1970s, Moody’s and other rating agencies began charging issuers for opinions. The numbers of securities — and their complexity — had increased and the agencies could no longer finance their operations on revenue from investors who bought Moody’s publications."

Photocopying killed the model, so they sold now to the people they rated. Vogelius was correct.

"In 1975, the Securities and Exchange Commission secured the rating agencies’ positions by allowing banks to base their capital requirements on the ratings of securities they held. The upside of this was that it theoretically created an elegant self-policing mechanism: any firm that ran afoul of the agencies also would run afoul of investors. The heavier hand of direct government regulation could be scaled back.

But for Mr. McGuire, the former director of corporate development at Moody’s, there were also dangers in relying on ratings as a form of regulation because the agencies would be able to sell ratings even if they failed investors.

“Rating agencies are staffed by ordinary people with families to support and bills to meet and mortgages to pay,” he said in a speech to the S.E.C. in 1995. “Government regulators are inadvertently subjecting those people to improper pressure, and share accountability for any scandals which may result.”

A Hybrid Model. By now, you know that they spell lobbying, shopping, favoritism, etc.

"Fortunes Tied to Issuers

As the agencies exerted growing sway, they became the arbiters that issuers loved to hate. Yet instead of viewing that ire as a reflection of their independence, Moody’s executives decided that it signaled a need to become more friendly to issuers of debt, according to Jerome S. Fons, a former managing director for credit quality at Moody’s.

“In my view, the focus of Moody’s shifted from protecting investors to being a marketing-driven organization,” he said in testimony before Congress last month. “Management’s focus increasingly turned to maximizing revenues. Stock options and other incentives raised the possibility of large payoffs.”

An early proponent of the profit push was John Rutherfurd Jr., who joined Moody’s in 1985. In 1998, he became chief executive; a news release that year praised him for helping the company’s bottom line.

According to people who worked with him at Moody’s, Mr. Rutherfurd was very focused on profit. They recall a conversation about 10 years ago in which he said he wanted every Moody’s analyst to produce at least $1 million in revenue each year. This encouraged Moody’s to generate as many ratings per analyst as possible.

In an interview, Mr. Rutherfurd said that he might have discussed such a goal but that he did not recall it specifically.

“Moody’s has to be all the time both a standards business and a service business,” he said. “I wasn’t in Moody’s in the old days, so to speak, but I think I always understood both elements of what we had to do.”

The model has conflict of interest built into it. Period.

"By the time Moody’s became a public company in 2000, structured finance had become its top source of revenue. Employees in this unit rated bundles of assets like credit card receivables, car loans and residential mortgages. Later they rated collateralized debt obligations, or C.D.O.’s, yet another combination of various bundles of debt.

Moody’s could receive between $200,000 and $250,000 to rate a $350 million mortgage pool, for example, while rating a municipal bond of a similar size might have generated just $50,000 in fees, according to people familiar with Moody’s fee structure.

A standard of profitability at many companies is its operating margin, which measures how much of its revenue is left over after it pays most expenses. While operating margins at Moody’s were always enviable — in 2000 they stood at 48 percent — they climbed even higher as revenue from structured finance rose. From 2000 to 2007, company documents show, operating margins averaged 53 percent.

Even thriving companies like Exxon and Microsoft had margins of 17 and 36 percent respectively in 2007. But Moody’s and its counterparts were not founded to be profit machines.

“The mistaken notion that Moody’s was a company like any other, that was very fundamental,” said Sylvain Raynes, a former Moody’s analyst who is co-founder of R&R Consulting, a firm that helps investors gauge debt risks. “It is not just a profit-maximization entity like Exxon or Microsoft. Moody’s has a duty to the American public. People trusted it.”

They were trading on people thinking of the old model, when they had substituted a new model. They traded on their reputation.

"Moody’s soaring fortunes were tied to the housing boom. When the Federal Reserve Board cut interest rates to 1 percent in 2003, Moody’s structured-finance revenue stood at $474 million, more than twice the amount generated just three years earlier.

As low interest rates fed the housing surge, Moody’s structured-finance business continued to rack up impressive gains. In 2005, structured finance generated $715 million, or 41 percent, of Moody’s total revenue.

In both 2005 and 2006, almost all of the unit’s growth came from mortgage-related securities, the company said, rather than other forms of debt like credit card receivables or auto loans. By the first quarter of 2007, structured finance accounted for 53 percent of Moody’s revenue.

The man overseeing Moody’s structured-finance unit in the midst of the mania was Brian M. Clarkson, 52. He had joined Moody’s as an analyst in 1991 and rose through the organization until he became president in 2007. He resigned last May; he declined to comment for this article.

As mortgage securities grew more complex, investors leaned more heavily on the agencies’ ratings. There was little transparency around the composition and characteristics of the loans held in the pools, and the securitization process grew so complicated that it required sophisticated systems to assess the risks embedded in each bundle.

Even though the standards at many lenders declined precipitously during the boom, rating agencies did not take that into account. The agencies maintained that it was not their responsibility to assess the quality of each and every mortgage loan tossed into a pool."

That is just plain negligence, at the very least.

"Anger From Investors

By early 2007, it was becoming more and more obvious that the subprime mortgage boom was ending. Yet Moody’s did not start downgrading mortgage-related securities until that summer. In July and August, the firm cut the ratings on almost 1,000 securities valued at almost $25 billion.

“These loans are defaulting at a rate materially higher than original expectations,” Moody’s said. Investors sharply criticized Moody’s over the tardiness of the response, internal documents made public in Congressional hearings show.

Two e-mail messages in July 2007 recount conversations Moody’s had with executives at Vanguard, BlackRock and Fortis, three huge money management firms. While Fortis offered some of the harshest assessments, none of the firms were pleased.

The Vanguard executive, the messages show, was frustrated that Moody’s was willing to “allow issuers to get away with murder.” As a result, the Moody’s messages say, Vanguard “finds itself ‘less and less relying on the opinions of rating agencies.’ ” BlackRock, meanwhile, said that Moody’s “relied too much on manufactured data that is weak” when rating residential mortgage securities.

Two months later, Moody’s executives held a meeting for their managing directors to talk about the crisis. The tone of the meeting, according to a transcript released by Congress, was defiant.

Moody’s had become a “punching bag,” said one of its executives, an easy target for investors eager to deflect responsibility for escalating mortgage losses.

“One of the questions everybody asks is, ‘Why does everybody hate us so much?’ ” Mr. Clarkson said during the meeting. “The theory that I’ve come up with lately is the fact that it’s perfect. It’s perfect to be able to blame us for everything.”

During the meeting, Moody’s executives predicted that the current crisis of confidence would pass, just as investor outrage over the company’s failure to detect trouble at Enron and Worldcom had several years earlier.

Other employees at the meeting were not so sure. When asked by top management if the meeting addressed the topics of greatest concern, one managing director whose anonymous comments were part of the documents given to Congress said there had been “really no discussion of why the structured group refused to change their ratings in the face of overwhelming evidence they were wrong.”

And two months later, Christopher Mahoney, former vice chairman of Moody’s and the person who led its credit policy committee, wrote in an e-mail message to Raymond W. McDaniel, the firm’s chief executive, that although mistakes had been made in subprime mortgage loss estimates, “more importantly I think sector wide risk management rules should have done more to alert investors of problems.”

When people responsible for so much money are so full of self pity and little self knowledge, you know that it's either fraud, negligence, fiduciary mismanagement, or collusion. This constant performance of, on the one hand, charging enormous fees for your knowledge, and, on the other hand, pleading ignorance when things go sideways, is incredible to watch. It's amazing how many people read from the same tired script and walk away unscathed. All the world is a stage, but the audience is poorly cast.

"less lending for years or public ownership of the banks for the foreseeable future. It's not an easy choice, is it? "

Robert Peston on BBC probably doesn't like my hijacking his point for the Swedish Plan, but he probably doesn't read my blog, so here goes. Here's Peston:

"In saying that there's a case for nationalising the entire British banking system, John McFall - the chairman of Commons Treasury select committee - has shone a light on the paradox of the recent global rescue of the world's biggest banks (listen to his interview on Today).

McFall and many others are exasperated that our banks remain deeply reluctant to lend to businesses and to individuals, even after so much taxpayers' money has been pumped into the banking system.

"What are the banks playing at?" many of you ask.

Well, funnily enough, part of the reason our banks are restricting the supply of credit actually stems from the official description of the bailout as "temporary".

Governments and central banks are saying that they want their (our) money back from banks within about five years.

That may seem a long time. But it's no time at all in the context of all the money that we've pumped into the banks.

The capital element of taxpayer support is only a small part of the problem."

This is a good point, but that's no more than saying that banks are looking out for their own interests. Either you have to tell them what to do with the money, or they'll do what they want with it, as they see what's in their best interests.

"And, again, the imperative of paying this back is a massive drag on banks' ability to lend and is therefore also a ball-and-chain on economic growth.

This, of course, is just one of the deadening weights on banks' ability and desire to lend.

The other severe constraints are:

1) regulators' very belated stipulation that banks and other financial institutions should hold much more capital and cash in their balance sheets relative to the value of their loans - which in a world where capital and cash is scarce and expensive is a massive disincentive to lend;
2) the devastating effect on credit creation of falling asset prices;
3) the relative dependence of British banks on funding from overseas institutions which are progressively calling in their loans;
4) the considerably increased risks of lending to individuals and companies when the economy shrinks.

Against that backdrop, the question is whether it is remotely sensible to put a deadline - implicitly or explicitly - on the repayment of all that taxpayer funding for banks."

One thing's for sure, they're don't think that it's sensible. In which case, they're not likely to do it.

"But if we don't demand our money back, we'd be formalising that there's been a semi-permanent nationalisation of the entire banking system.

And that would massively encroach on the ability of our banks to operate as independent commercial entities.

There would be massive political pressure on them to become quasi-social utilities, providing loans at the behest of ministers and officials rather than on the basis of commercial criteria.

So here's what may turn out to be the choice: less lending for years or public ownership of the banks for the foreseeable future. It's not an easy choice, is it?"

This is why a hybrid Government/Private Bank arrangement is so messy. The two don't often see eye to eye, and often don't have the same interests. This leads to lobbying, fudging, needless delays, etc., the whole list of problems I've talked about from the beginning.

That's why a Swedish Plan would have been preferable. Nationalize, then Privatize. What we have now is neither, and we aren't likely to get out of it soon, as Peston observes.