Economics did not become ‘a hard science’; its proponents confused ‘hard science’ with economic models that were bereft of the presence of human being

TO BE NOTED: From Adam Smith's Lost Legacy:

"Ethical Crisis - What Crisis?

MURRAY WHYTE write in Toronto Star (The Star.com HERE)

‘Closed due to the recession’

“U of T's Lind, whose central field of study is economic ethics, points out that this is a relatively new quandary. Until the industrial revolution, ethics and economics were a unified field. Adam Smith, who described the advent of market economics as being guided by "an invisible hand," is often misconstrued as the early progenitor of the Milton Friedman-spawned, market-knows-all Chicago School. "But really, he was making a moral argument, because to him, there was no distinction."
As the 20th century dawned and economics turned away from the philosophical and more toward hard math, the separation grew. "The field of ethics went into crisis just as economics turned to mathematics," Lind says. "Economics became a hard science, whereas ethics became a confusion."

Comment
From where do they get these muddled ideas? Economics as a subject did not exist in the 18th century, certainly not as Adam Smith wrote about what was called ‘police’ (ensuring subsistence for a society).

Political economy was a title coming into vogue when Smith wrote Wealth Of Nations, which lasted a century until the 1870s when mathematical analysis began to appear. That title too declined in the 20th century.

Smith wrote about ‘commercial society’ and market, but did not mention The Metaphor of an ‘invisible hand’ in his analysis of how markets functioned (Books I and II of Wealth Of Nations). He certainly never said ‘the advent of market economics as being guided by "an invisible hand" ’.

It is, however, true that The Metaphor is ‘often misconstrued as the early progenitor of the Milton Friedman-spawned, market-knows-all Chicago School’.

Indeed, the modern myth of The Metaphor was virtually invented by ‘Chicago’ in the environs of 59th street (see Oscar Lange, 1946 and Paul Samuelson, 1948) and has become universally misconstrued as ‘markets always produce socially beneficial outcomes’, despite the presence of monopolistic practices, protectionist policies, tariffs and non-tariff barriers, pollution, and other negative externalities.

Economics didn’t turn ‘to mathematics’; scholars calling themselves economists ‘turned to mathematics’. Economics did not become ‘a hard science’; its proponents confused ‘hard science’ with economic models that were bereft of the presence of human beings.

And ‘ethics’ did not become ‘a confusion’ – the basic ideas of ethics (partly summarized by Adam Smith in his Moral Sentiments) remain valid.

The absence of people in mathematical modeling of the kind dependent on 19th-century calculus eliminates ethics from the equations. People are given objectives that lead to determinate solutions; the ‘solutions’ have little operational value.

I am not sure that ethics is in ‘crisis’; people without ethics are in crisis. The ‘U of T[oronto]’ should be teaching its students to think about the differences in the tone of this article and the reality of the dead-end where economics has come to rest.

posted by Gavin Kennedy at 12:46 PM"

The practical man must follow the branch approach – the science of muddling through.

TO BE NOTED: From the FT:

"History vindicates the science of muddling through

Published: April 14 2009 21:07 | Last updated: April 14 2009 21:07

When I was a student, Penguin published several collections of classic articles on economics and business. They were an indispensable resource. The first book on business strategy I ever read was the title in that series edited by Dr H. Igor Ansoff. Recently I re-opened it and understood how much changes in the way we think about business strategy – and how much remains the same.

Only one article found there is still widely cited. It was written by the American political scientist Charles Lindblom and published in 1959 under the title The Science of Muddling Through. Prof Lindblom contrasted what he called the “root” method of decision-making with the “branch” approach. The root method required comprehensive evaluation of options in the light of defined objectives. The branch method involved building out, step-by-step and by small degrees, from the current situation. Prof Lindblom claimed “the root method is in fact not usable for complex policy questions”. The practical man must follow the branch approach – the science of muddling through.

Ansoff included Prof Lindblom’s article mainly to poke fun at those who acted on this advice. He told students the article was instructive, since “it describes a widely prevalent state of practice in business and government organisations”. We can imagine sniggering MBA students.

They would be chortling when Ansoff turned his attention to France’s Saint-Gobain, the glass and materials group. “Saint-Gobain, for all the modernity of its headquarters building, will remain something of an old lady, likely to move only with the slow deliberate steps of great age.”

America, and Ansoff, were pointing to the road ahead. Prof Lindblom, he explained, “is wrong when he claims the ‘root’ method to be impossible”. Ansoff’s analysis of TRW, the US conglomerate, “shows how one of the world’s most dynamic corporations goes about a methodical exploration of wide vistas of opportunities in the process of formulating its corporate strategy”. The future held no bounds. Senior management “feels that the corporation hasn’t begun to exploit the opportunities they believe that TRW is equipped, for example, to play a three-sided role in technological programmes for the solution to such pressing problems as urban renewal, mass transportation, and pollution”.

But Ansoff’s highest praise was reserved for Litton Industries, another US conglomerate. Litton – “a proverbial success story by any conceivable yardstick” – was the creation of Tex Thornton, the leader of the “whiz kids”. This group of brilliant young men had made an important contribution to US military organisation in the second world war. A letter from Thornton to Henry Ford II led Ford to hire the entire group to help the Ford Motor Company recover from the chaos left by war and its irascible founder. Robert McNamara, the most famous whiz kid, was the company’s president before being recruited by John Kennedy as US defence secretary.

Ansoff died in 2002. History has not been kind to him, or to the whiz kids. Even as Ansoff was putting together his collection in 1968, the future of Litton Industries was being questioned. Like many acquisitive conglomerates, it experienced a rapid ascent and sharp fall. Its reputation and share price rose steadily before a setback to earnings made its stock less attractive. Acquisitions became impossible. The business gradually unwound. Tex Thornton is today forgotten, McNamara was driven from the defence department by public hostility and his private doubts. He went on to preside over a substantial expansion of lending – much of it never repaid – at the World Bank. Today, he reminisces on his experiences – and the virtues of muddling through.

TRW, like Litton, would be forced to slim operations and ambition and return to its modest roots in automobile parts supply. Saint-Gobain, by contrast, is a successful multinational, with 200,000 employees worldwide. Prof Lindblom, still muddling through at 92, celebrates the 50th anniversary of his article. We should celebrate too – and applaud the relevance of his insight.

Post and read comments at www.ft.com/kay

johnkay@johnkay.com"

lso that there is a strong political economy case (which I consider dominant)

From the Economics Of Contempt:

"Wednesday, February 11, 2009

Will Wilkinson's strange theory about Krugman

Will Wilkinson mocks Paul Krugman for not including political factors in his economic thinking:

Perhaps more than any economist of his caliber, Krugman understands that policy is largely determined by the outcome of the public opinion shoutfest. Yet this recognition seems to have no effect on Krugman’s ideas. Rather than bring inside his models disagreement over economic theory and the lack of political incentive to faithfully apply them, which would lead him to radically revise his prescriptions, Krugman leaves his textbook theory untouched and simply tries to win the shoutfest. Krugman’s often unbearable stridency seems to reflect an attempt to overcome the problems of democratic disagreement and incentive compatibility through sheer force of will–as if the deep reality of politics is no match for the rhetorical gifts and gold-plated reputation of Paul Freaking Krugman.

It's strange that Wilkinson espoused this theory just days after Krugman laid out the economic case for including the "Buy American" provision in the stimulus bill, and then rejected the provision for reasons of political economy. Here's how Krugman summarized his views the next day:

First of all: my piece was NOT an endorsement of protectionism — it was an explanation that there is an economic case for it, but also that there is a strong political economy case (which I consider dominant) against acting on that economic case. It was, in short, an attempt to be intellectually honest.

If Wilkinson's theory was right, then Krugman would have tried to "win the shoutfest" on the "Buy American" provision. But he didn't. Instead, Krugman essentially acknowledged that he couldn't win the shoutfest—that is, neither he nor anyone else would be able to stop the cycle of protectionist retaliations. Recognizing this, he concluded that the "political economy case" against the "Buy American" provision was dominant.

It would be hard to come up with a better example of Krugman incorporating politics into his economic thinking. Krugman's treatment of the "Buy American" provision definitely disproves Wilkinson's theory about Krugman sticking to the pure economics and trying to "win the shoutfest." Which makes it all the more amusing that Wilkinson espoused his theory a mere 4 days after Krugman disproved it. "

Me:

Don said...

It's actually wonderful and a step forward having an economist who understands that political economy is more important than economics.

Don the libertarian Democrat

February 11, 2009 3:28 PM

Good comment on a Tyler Cowen post at Marginal Revolution wherein Cowen unearths an ancient Keynes letter providing some support for tax cuts.

From Paul Kedrosky:

"Negative Externalities and Dueling Economists

Good comment on a Tyler Cowen post at Marginal Revolution wherein Cowen unearths an ancient Keynes letter providing some support for tax cuts. More fuel for my take that skepticism-verging-on-nihilism is the right answer when faced by economists splitting along party lines.

….negative externalities accrue when we disparage poor expert consensus in a way that doesn't clearly lead to advocating for better expert consensus.

As for unearthing an old Keynes letter, I understand it may be fighting fire with fire, but really, I think the economics and legal profession should move away the pre-rational human tendency to want to derive policy wisdom from interpreting the texts of ancestors. Let's leave that to religious fundamentalism.

I'm more intrigued by the empirical work of folks like Romer and Barro and others, than the dueling sacred texts of Keynes and Mises."

Me:

It depends upon how you view Economics. To me, it produces some theories and models that are more or less useful in helping us to understand the economy. The really important action exists in Political Economy. Keynes and Mises are of continuing interest because they studied Political Economy. Although I did read a couple of books by Barro that qualify, they were not great, but good. I haven't read books by Romer.

However, it is a bizarre claim that Political Economy can't use the classics. That's like saying that sociologists can't use Durkheim. After all, we still use Newtonian Mechanics. If you think that Economics is more like physics than a human science, I can understand this position, sort of. If not, it's strange.

Since we're not sure what to do, and the economic theories are of limited use, we naturally look to the past for help. Isn't a lot of economics based on comparing different historical examples and trying to derive some useful ideas? Keynes is useful because his theories are widely thought to have been of help in ending the depression. As well, he was a very good writer. He provides us a set of ideas which we can use as a guide in considering current ideas, and, quite frankly, a hopeful narrative of how we might get out of this mess. I consider narrative thinking to be very important for politics and political economy. Others don't, I suppose.

Merely appealing to Keynes is an example of the fallacy called the appeal to authority. I don't think that Cowen is doing this, since he believes, as I do, that a payroll tax cut is a good thing. The Keynes letter also gives some reasons for his views, which you can agree with or not. But, since there are reasons given, it is not simply the argument from authority. It is valid, in my opinion, to want to know what Keynes thought about this issue, because he was a brilliant. That's all.

However, just calling on Barro and Romer is also the argument from authority. I've been reading Romer and Barro. In fact, yesterday, their ideas were both on blogs. Barro called for tax cuts as incentives, without offering anything specific. Romer, if I've got the right Romer, advocated giving the FDIC more power to collapse banks and concerns like Lehman I believe, which, from my perspective, is just nationalization under a different rubric. I'm fine with it, but it qualifies as a government takeover.

So, it's fine to quote whomever you want, assuming that you can explain what they said, and give reasons why you do or don't agree. I don't take that for granted, by the way. I know that it's hard to do for all of us.

if you can’t explain the propensity to hoard, then you can’t explain our current predicament.

From Free Exchange:

"Blanchard roundtable: Where economists fear to tread

Posted by:

The Economist | DELHI

Categories:

Blanchard roundtable

OLIVIER BLANCHARD provides a disturbing account of what Knightian uncertainty means for the economy; let me offer a few untutored thoughts about what it means for economics.

Economists do not, in fact, follow Knight’s work very much. The discipline shys away from his concept of uncertainty (as distinct from risk), because it is, by definition, so hard to model. If economists could model it, then so could firms and investors. The future would be calculable, if not knowable, and there would be less excuse for bewildered inaction.

Paul Samuelson once went so far as to argue that economics must surrender its pretensions to science if it cannot assume the economy is “ergodic”, which is a fancy way of saying that Fortune’s wheel will spin tomorrow much as it did today (and that tomorrow's turn of the wheel is independent of today's). To relax that assumption, Mr Samuelson has argued, is to take the subject “out of the realm of science into the realm of genuine history”.

The scientific pose has great appeal. But this crisis is reminding us again of its intellectual costs. Knightian uncertainty may be fiendishly hard to fathom, but ignoring it, as economists tend to do, makes other phenomena devilishly hard to explain. The thirst for liquidity—the sudden surge in the propensity to hoard—is one example. If risks are calculable, then investors will place their bets and roll the dice. Only if they are incalculable will they try to take their chips off the table altogether, in a desperate scramble for cash (or near-cash). As Keynes put it, “our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.”

We journalists make great sport poking fun at the techniques on which financial markets have relied—the value-at-risk models with their normal distributions—much as Keynes scorned all those “pretty polite techniques, made for a well-panelled board room and a nicely regulated market”. But as economists (or as friends of economics) we have to fess up that the models that led banks astray are, fundamentally, ours—they spring from the same intellectual tradition. My suspicion, perhaps unfair, is that in recent years too much macroeconomic theory itself became “one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.”

As Mr Blanchard’s article makes clear, if you can’t explain the propensity to hoard, then you can’t explain our current predicament. And a macroeconomics that cannot explain this crisis is hardly worthy of the name."

Me:

Don the libertarian Democrat wrote:

Paul Samuelson once went so far as to argue that economics must surrender its pretensions to science if it cannot assume the economy is “ergodic”, which is a fancy way of saying that Fortune’s wheel will spin tomorrow much as it did today (and that tomorrow's turn of the wheel is independent of today's). To relax that assumption, Mr Samuelson has argued, is to take the subject “out of the realm of science into the realm of genuine history”.

Much of economics is Correlative Explanation and Reasoning. It is not cause and effect. Math can be useful in describing relations, as long as those relations continue to hold. Where behavior is concerned, or any teleological action, you will have correlative reasoning and explanation.

The math models used are simply useful in simple ways. What is shocking is that, compared to the old practitioners of political economy, which will always be the really important realm of understanding these issues, current economists don't seem to have a philosophy of action or math that can explain their assumptions. Consequently, many spit out mechanistic explanations, or versions of dubious psychological theories like behaviorism.

The only way to explain Political Economy is through a Human Agency approach or explanation. The only way to explain hoarding is such an approach. I have found Fisher's Debt-Deflation model to be of great help, but that model also needs a more robust human agency explanation to fill it out.

One famous economist recently mocked Shiller's 'trust' as hard to measure. In saying this, he showed that he had no clear idea of what is involved in a human agency explanation, nor a clear idea of what the limitations of measurement are. It is would interesting to hear the assumptions and presuppositions underlying his basic view of human behavior, if he has one.

Incidentally, I find Bagehot to be still valuable for understanding our current crisis.

2/1/2009 4:25 PM GST

"Without training in modern econometrics it is simply impossible to assume something that stupid."

Robert Waldmann with a good post on Angry Bear:

"Barro on Keynes Barro and Grossman

Robert Waldmann

Robert Barro wrote an op-ed in The Wall Street Journal. The substance of the op-ed is to report an estimate of the Fiscal multiplier 0.8 which is less than one. Thus, according to Barro, a stimulus will partially crowd out of investment, consumption or net exports and not just reduced leisure. Paul Krugman took Barro to task for using the huge WWII stimulus in his estimates, since the economy was at full employment during WWII. So have Matthew Yglesias using his Harvard BA in philosophy from Harvard and Kevin Drum using his BA in Communications from The California State University in Long Beach.

I might want to reassess Long Beach State, but I think the reason that Yglesias and Drum immediately make the same argument is Krugman is that Yglesias and Drum don't know about modern econometrics. Barro is using an instrumental variables regression in which wartime military spending is considered to be an exogenous variable which is correlated with government consumption. The implicit assumption is that we can safely assume that the fiscal multiplier today is identical to the fiscal multiplier during World War II, because the economy is basically similar. Without training in modern econometrics it is simply impossible to assume something that stupid. ( A GOOD POINT. I KEEP WONDERING WHAT BARRO'S PHILOSOPHY OF MATH AND THE HUMAN SCIENCES IS. )

There is also a severe gap in economic theory, at least as remembered by Robert Barro. Wouldn't one think that there must be some model( YES ) in which correlations( MATH IS A WAY OF EXPRESSING CORRELATIVE REASONING. HOWEVER, IT IS STILL SIMPLY CORRELATIVE REASONING. THE MATH IS SIMPLY A HEURISTIC TOOL. ) vary depending on the general conditions of the economy -- say like whether at current prices there is excess demand for goods or excess supply of goods.

Of course, no one could expect Barro to know that there is a vaguely Keynesian model, which differs from the neoclassical model only because of rigid nominal wages and prices, in which the economy can be in one of three different regimes, Keynsian (with insufficient aggregate demand), Classical (firms can sell as much as they want but real wages are too high so workers are unemployed) and repressed inflation (excess supply of labor and goods).

I'm mean who's ever heard of the Barro-Grossman model (A General Disequilibrium Model of Income and Employment Barro, Robert J.; Grossman, Herschel I.; American Economic Review, March 1971, v. 61, iss. 1, pp. 82-93 [stable JSTOR link added for those with access])? Certainly not Robert Barro.

The passage quoted by Krugman about what Keynes thought is inconsistent with The General Theory. However, it can be corrected easily. The accurate description of the history of economic thought is "John Maynard Keynes Robert Barro and Herschel Grossman thought that the problem lay with wages and prices ... will mean that wages and prices do not have to fall."

Look I sympathise. Like Barro, when I was young and reckless I did embarrassing things which I have tried to cancel from my memory. I really wish I could do that as well as he has."

The historical context must be considered when addressing the question of why people behaved as they did, even in economic behavior. This is what I call the Existential Context. The context of the 1930s was far different than ours.

Also, there is a difference between economics and political economy. Barro doesn't seem to see a difference. Too bad.

"assemble general principles that seem to be of practical benefit to assumed goals, and apply them to current events and trends."

From Adam Smith's Lost Legacy:

"Adam Smith On State Expenditures and Interventions

A correspondent asks:

“I'm still puzzled as to where Smith draws the line with regard to government intervention. In Book V, Chapter I, he talks about justice, defence and public works but it seems that he has a wider application for the state in market matters. I'd be very interested to hear your viewpoint on this.

To which I replied:

Yes, it is widely believed, even by some top academic economists, especially on Blogland, that Adam Smith favoured small government, often represented by the phrase, the 'night watchman state', which in fact was coined in the late 19th century by a firebrand socialist.

I have posted this list from my book, Adam Smith: a moral philosopher and his political economy' (2008, pp 247-48, Palgrave Macmillan):

"● The Navigation Acts, blessed by Smith under the assertion that ‘defence, however, is of much more importance than opulence’; (WN464)
● Sterling marks on plate and stamps upon linen and woollen cloth (WN138-9)
● Enforcement of contracts by a system of justice; (WN720)
● Wages to be paid in money, not goods;
● Regulations of paper money in banking; (WN437)
● Obligations to build party wars to prevent the spread of fire; (WN324)
● Rights of farmers to send farm produce to the best market (except ‘only in the most urgent necessity’);(WN 539)
● Premiums and other encouragements to advance the linen and woollen industries’; (TMS185)
● ‘Police’, or preservation of the ‘cleanliness of roads, streets, and to prevent the bad effects of corruption and putrifying substances’;
● ensuring the ‘cheapness or plenty [of provisions]’; (LJ6; 331) ( YES )
● patrols by town guards, fire fighters and of other hazardous accidents; (LJ331-2)
● Erecting and maintaining certain public works and public institutions intended to facilitate commerce (roads, bridges, canals and harbours); (WN723)
● Coinage and the Mint; (WN478; 1724)
● Post office; (WN724)
● Regulation of institutions, such as company structures (joint stock companies; co-partneries, regulated companies); (WN731-58)
● Temporary monopolies, including copyright, patents, of fixed duration; (WN754)
● Education of youth (‘village schools’, curriculum design); (WN758-89)
● Education of people of all ages (tythes or land tax) (WN788);
● Encouragement of ‘the frequency and gaiety of publick diversions’; (WN796)
● The prevention of ‘leprosy or any other loathsome and offensive disease’ from spreading among the population; (WN787-88)
● Encouragement of martial exercises; (WN786)
● Registration of mortgages for land, houses, and boats over two tons; (WN861, 863)
● Government restrictions on interest for borrowing (usury laws) to overcome investor ‘stupidity’; (WN356-7)( INTERESTING )
● Laws against banks issuing low-denomination promissory notes; (WN324)
● Natural liberty may be breached if individuals ‘endanger the security of the whole society’; (WN324)
● Limiting ‘free exportation of corn’ only ‘in cases of the most urgent necessity’ (‘dearth’ turning into ‘famine’); (WN539)
● Moderate export taxes on wool exports for government revenue; (WN 879)

Jacob Viner concluded, unsurprisingly, that Adam Smith was not a doctrinaire laissez-faire advocate.

[From Viner, J. 1928. ‘Adam Smith and Laissez-faire’, In ‘Adam Smith, 1776-1928: Lectures to Commemorate the Sesquicentennial of the Publication of Wealth Of Nations, p 53, August M. Kelly, Fairfield, NJ; I provided the references to Wealth Of Nations.]

Second Question:

“How exactly does Smith make a distinction between permissible and unacceptable government intervention? I could justify some of this divergence by considering that much of his criticism of government involvement stems from actual experience rather than theoretical reasoning (which, if used, could rule out regulation all together!). What's your take on it?”

Smith, remember, wrote (Book V) of ‘public works and public institutions’ that ‘facilitated commerce’. It was, and I think, remains, an empirical test( YES ), not a theoretical outcome. Markets do not work because of theory, or ‘rational thought’, or who wrote books about it. ( MY POINT )

He didn’t sit down and think great thoughts about gaps in knowledge from his appreciation of the explanations of others and himself of real world events. That is the way of ‘shamans’, priests and inventors of religious explanations, with everything they cannot explain shunted into the mysteries of ‘invisible beings’ or gods.

The pure theory of markets, such as neoclassical economics and general equilibrium as much that it is meritorious, but it is a theory( YES ) not a description of how markets actually work( YES ).

The players in markets are real human beings( YES ), not variables that operate within narrow confines of deterministic mathematics( MY POINT ). Consider how Smith chided some of the Physiocrats (mentioning Dr Quesnay by name) for their apparent insistence that the ‘political body would thrive only under a precise regimen, the exact regimen of perfect liberty and perfect justice’… ‘if a nation could not prosper without the enjoyment of perfect liberty and perfect justice, there is not in the world a nation which could ever have prospered’. (WN IV.ix.28: p 674)

The message is clear: start with the history, how things arrived at their present day circumstances and arrangements, and observe how they operate, drawing on lessons of how they worked, more or less, well in the past and what that teaches us selectively about what works and what doesn’t( MY METHOD ), assemble general principles that seem to be of practical benefit( MY METHOD ) to assumed goals, and apply them( YES ) to current events and trends.

Of course, everything depends on the selection and the objectives. Machiavelli, the Italian political practitioner drew on history to show how rulers ruled in the past and selected common aspects that could apply to rulers in his present (1500s), where the objective function was to remain ‘safe’ in power.

Smith’s objective function was how an economy, the State, and the people, could spread opulence from commerce to the nation, especially the poor majority( YES. THIS IS WHY I FOCUS ON THE SOCIAL SAFETY NET AND THE MIDDLE CLASS. ), drawing on how nations remained stable( MY BURKEAN FOCUS ) (justice and the distinction of ranks), became prosperous (the desire of people to ‘better themselves’) given as much freedom to do so (Liberty) without it degenerating into monopoly, restrictive protectionism, and opulence for a minority using their political influence over the State( OUR SYSTEM ), while leaving the poor as they had been left throughout all history as serfs, slaves, and penurious labourers.( ALL STILL TRUE )

Smith believed that a commercial society was the best opportunity for continual growth and the spread of opulence, and showed in his critique of mercantile political economy, as it had operated since the 15th century and was operating up to the Fall of Rome in the 5th century, what changes might be made by the legislature to let commerce do its work as speedily as was practicable in the real world and not in some kind of impossible utopia.( YES )

He was not an ideologue( MY POINT ). His understanding of history demonstrated what was possible among real men as they were( MY VIEW ), not ideal ‘guardians’ of public interest who usually made everything worse than it need be.

Hence, his proposals for ‘public works and public institutions’, which were written in is inimitable style, were apparently quite modest (the incorrect ‘take’ on them by laissez-faire ideologues), though they added to a level of state expenditure that was actually quiet ambitious, with separately argued cases for the items listed by Jacob Viner in 1928 above, which together extended the agenda of appropriate expenditure by a classical liberal state (and even one ran by quite illiberal personnel)."

Smith knew the difference between Politics and Political Theory, and Economics and Political Economy. Sadly, many people today do not.

"Nonetheless, I’d say that in terms of strict economics it’s wrong. "

Paul Krugman helps me illustrate the difference between Economics and Political Economy. From the NY Times:

"Do we need the middle class?

Kevin Drum writes that

One way or another, there’s really no way for the economy to grow strongly and consistently unless middle-class consumers spend more, and they can’t spend more unless they make more.

This is a widely held view, and I’m as much in favor of a strong middle class as anyone. Nonetheless, I’d say that in terms of strict economics( I AGREE ) it’s wrong. There’s no obvious reason why consumer demand can’t be sustained by the spending of the upper class — $200 dinners and luxury hotels create jobs, the same way that fast food dinners and Motel 6s do. In fact, the prosperity of New York City in the last decade — largely supported off of super-salaried Wall Street types — is a demonstration that you can have an economy sustained by the big spending of the few rather than the modest spending of large numbers of people."

Of course, you know my opinion that a society without a rising Middle Class and decreasing Lower Class is not sustainable. What Krugman gives is an Economic Explanation ( Theoretical, Kantian ), while what I have just given is an explanation in terms of Political economy ( Practical, Existential )

""I don't know anybody involved who thought he could predict these turning points."

Via Marginal Revolution, Drake Bennett on the Boston Globe discusses the current state of Economics:

"THE DEEPENING ECONOMIC downturn has been hard on a lot of people, but it has been hard in a particular way for economists. For most of us, pain and apprehension have been mixed with a sense of grim amazement at the complexity( CONNECTEDNESS ) of what has unfolded: the dense, invisible lattice connecting house prices ( A BUBBLE ) to insurance companies( POOR DECISIONS ) to job losses( MANY PREEMPTIVE ) to car sales( LIKE HOUSES, FINANCED THROUGH CREDIT WHICH IS NOW HARD TO GET ), the inscrutability of the financial instruments( VASTLY OVERSTATES THE COMPLEXITY ) that helped to spread( HIDE ) the poison, the sense that the ratings agencies and regulatory bodies were overmatched( TRY CONFLICT OF INTEREST ) by events, the wild gyrations( AMIDST THE WILD GYRATION'S OF GOVERNMENT POLICIES ) of the stock market in the past few months( NO MENTION OF FRAUD AND GOVERNMENT GUARANTEES ). It's hard enough to understand what's happening, and it seems absurd to think we could have seen it( WE MIGHT HAVE TRIED PREPARING FOR IT ) coming beforehand. The vast majority of us, after all, are not experts ( THANK GOD ).

	Discuss
	COMMENTS (8)

(Getty Images, Globe Staff photo illustration)

But academic economists are. And with very few exceptions, they did not predict the crisis, either( WERE THEY SUPPOSED TO? ). Some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime. And, now that we're in the middle of it, many frankly admit that they're not sure how to prevent things from getting worse( THAT'S SIMPLY THE TRUTH ).

As a result, there's a sense among some economists that, as they try to figure out how to fix the economy, they are also trying to fix their own profession. The discussion has played out in blog posts and opinion pieces, in congressional testimony and at conferences and in working papers. A field that has increasingly been defined, at least in the public eye, by quirky studies explaining the economics of our everyday lives - most famously in the best-selling book "Freakonomics" - has turned decisively, in the last couple months, to more traditional economic turf. And at economics powerhouses like Harvard, MIT, and the University of Chicago, faculty lunch discussions that once might have centered on theoretical questions and the finer points of Bayesian analysis are now given over to dissecting bailout plans. Long-held ideas - about the stability of the business cycle, the resilience of markets, and the power of monetary policy - are being challenged ( GOOD ).

"Everyone that I know in economics, and particularly in the worlds of academic finance and academic macroeconomics, is going back to the drawing board( AGAIN, TRY A NOTEBOOK )," says David Laibson, a Harvard economist. "There are very, very, very few economists who can be proud( THAT'S SILLY )."

A few are suggesting, as well, that there are deeper problems in the discipline. Economists are asking aloud whether the field has grown too specialized, too abstract - and too divorced, in some sense, from the way real-world economies actually function( TRUE, BUT THAT HAS MORE TO DO WITH NOT RECOGNIZING OR CARING ABOUT THE DIFFERENCE BETWEEN ECONOMICS AND POLITICAL ECONOMY ). They argue that many of the models used to explain and predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance( THERE'S A POINT TO THIS AT THE KANTIAN LEVEL OF EXPLANATION ), of the inevitable erraticism of human behavior( THAT'S WHY WE NEED HUMAN AGENCY EXPLANATIONS, WHICH ARE EXISTENTIAL ). As a result, the analytical tools of the trade offer little help in a crisis, and have little to say about the sort of collapses that led to this one( IF THEY TURNED TO POLITICAL ECONOMY, THEIR HELP WOULD BE QUITE USEFUL ).

"You can't just say, 'I have a model for tremors that works great, I just can't explain earthquakes,'( YOU JUST DID ) " says Kenneth Rogoff, a Harvard economist who has studied financial crises.

Historically, periods of severe economic distress have shaken up economics, and helped drive its evolution. And in the midst of the current crash, there is an urgent search for approaches and models that might better illuminate how to speed the recovery and forecast future meltdowns, and that might help us better understand the unruly flow of money.( UNRULY, ERRATICISM, GYRATIONS,INSCRUTABIlITY,DENSE,LATTICED,TREMORS, SCRUBBED CLEAN, DISSECTING, CATACLYSM, DEEPER PROBLEMS,BUBBLE, COLLAPSE, PREVENT, EARTHQUAKES, ETC. AND THAT'S JUST SO FAR )

The question of how well economists can model crises takes on an even greater importance because of the central role economic experts will play in Barack Obama's administration - not only at the Federal Reserve, the Council of Economic Advisors, and the Treasury, but in the Economic Recovery Advisory Board, a newly formed body created by the president-elect and headed by former Federal Reserve chairman Paul Volcker. Obama has a reputation as someone who places a great deal of stock in expertise and the power of data ( THAT'S GOOD. JUST MAKE SURE TO DIVERSIFY YOUR PORTFOLIO. SAY, BY ADDING THIS BLOGGER AS COURT JESTER FOR FINANCES ). For better or worse, the evolving understanding of economic breakdowns will have ample opportunity to test itself against the real thing( ISN'T THAT WHAT IT'S SUPPOSED TO DO? EVEN WITH MATH YOU SHOULD TRY ).

Along with everything else they have done, the financial meltdown and attendant economic slump have spurred unprecedented political attention and participation on the part of economists ( THEY'RE BETTER THAN MANY OTHERS ).

"In my lifetime as an economist I've never seen economists so engaged by what's going on," says Richard Thaler of the University of Chicago. "At the University of Chicago people always talk economics at lunch, but for the last three months they've all been talking about the crisis and the bailout, and writing op-eds( HAVE YOU TRIED STUDYING AT ALL? )."

This is something of a change. The topics economists study often have little to do with the average person's economic life - as in most any academic field, practical relevance can have little to do with what questions are deemed most interesting and rewarding. This divergence was exacerbated, many economists say, during the span of almost uninterrupted economic growth that began in the late 1980s, a period when many of the more practical questions in economic policy-making came to be seen as having been settled( NOTHING IS WRITTEN ). For years, leading economic figures like Larry Summers and Alan Greenspan argued that the United States had more or less( THE QUALIFYING SOUNDS A NOTE OF SKEPTICISM FOR ALL WHO CARE TO HEAR. I'M RATHER LIKE ODYSSEUS IN THAT REGARD, AND ONLY THAT ) brought the business cycle to heel ( THEY'RE LIKE TRAINERS IN THIS MODEL ).

Partly as a result, many bright young economists turned to questions that were quirkier, or more purely mathematical. To the wider public, the most visible ramification of this was the boom in papers and books about the economics of everyday life - the best-known practitioner was Steven Levitt of the University of Chicago, but economists like Ray Fisman of Columbia, Edward Miguel of UC Berkeley, and Justin Wolfers of the University of Pennsylvania also worked at least partly in this vein. In often ingenious studies, they used economics as a forensic tool to examine family dynamics, speed-dating, parking scofflaws, basketball games, or the life choices of street criminals.

For those who stayed on more traditional economic turf, however, the trend was toward narrower questions, and more abstract ones. Financial economists set out to figure out why it is that stocks earn more than bonds, or to devise better ways of calculating "beta," the correlation between the price of a single asset and the price of the market it was part of. Others took on the surprisingly difficult question of defining what, exactly, money is.

Wolfers, being an economist, describes these intellectually challenging but less policy-relevant questions as a sort of scholarly "luxury good." "During good times we all consume more luxuries," he says, "but during a bad economy, it feels to macroeconomists that what we should be doing is stuff to help today."

Some economists have suggested that this focus may account for why so many failed to see the warning signs of the financial crisis, and to predict the size and scope of its fallout.

Others see a broader problem in that the sort of behavior we've seen in everyone from home buyers to investment bankers in recent months is hard to fit into economists' analytical tools. The models that macroeconomists - those who study national and regional economies in their entirety - rely on do a poor job of describing the messiness of an actual market in flux( THAT'S WHY WE NEED A HUMAN AGENCY EXPLANATION ). Many, for example, only have one variable for an interest rate, even though in times of economic turmoil the gap between various rates often widens so far that it's difficult to say what "the" interest rate actually is. As a result, economists end up oversimplifying such situations when they model them - or simply avoid studying them at all.( THAT'S POLITICAL ECONOMY )

"We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools ( THIS IS TRUE OF ALL HUMAN ENDEAVOR )," says Jeremy Stein, a financial economist at Harvard. "Sometimes that means we focus on silly questions and ignore greater ones( SO DOES MODERN PHILOSOPHY )."

Today there is a move to hone and rethink the models that describe the huge interlocking wheels of the economy, and to find a way to include the human tendencies that can bring them grinding to a halt. Some economists are looking to the methods and findings of psychology, others are applying themselves to the tricky task of modeling bubbles, a relatively neglected topic. Whatever the approach, the study of financial crises is likely to be a predominant question for the newest generation of economists. ( POLITICAL ECONOMY AND HUMAN AGENCY EXPLANATIONS ARE ALL THAT IS NEEDED,AND ALL THAT WE CAN EXPECT )

"I guarantee that over the next couple of years you are going to see lots of papers on banking crises and financial blowups," says Andrew Lo, a financial economist at MIT's Sloan School of Management.

In addition, others predict, there's likely to be a sharp migration among young economists into these fields. "Banking has been an incredibly important field that has not been hot for some time," says Edward Glaeser, a Harvard University economist. "What's happened is that banking is sexy again ( BECAUSE OF A CRISIS. NOW THAT'S PARADOXICAL )."

Already, the crisis is reshaping long-running debates. It has chastened believers in the self-correcting abilities of the free market - Alan Greenspan said as much before Congress in October - and emboldened those who see the need for more active government intervention( TRUE ).

In a sense, it's a debate that has been seesawing back and forth from crisis to crisis over the past century. Classical economics was devastated by the Great Depression, and in the years afterward gave way to the ideas of the British economist John Maynard Keynes: that individually rational economic decisions could add up to collectively disastrous consequences, that the "stickiness" of prices and wages could lead to long-term unemployment and stagnation, and that the government, as a result, has to step in to kick-start the economy.

The stagflation of the 1970s, while mild compared with the Depression, swung the pendulum back. It was Milton Friedman, a sharp critic of Keynesianism and a fervent advocate of unfettered free markets, who solved the seeming paradox of simultaneous inflation and high unemployment by realizing the deadening power of people's expectation of future inflation, and it was Friedman's proposed solution - sharply restricting the money supply - that eventually, albeit painfully, solved the problem.

Today's crisis has brought Keynes back to the center of the discussion, but some economists also see it driving the field into new territory. Up until very recently, the study of market bubbles was marginalized - there was no widely accepted definition of what a bubble was, and some economists, believers in the complete rationality of markets, argued that bubbles didn't even exist( BRILLIANT ). Today, however, there is a growing sense that understanding bubbles is vital to understanding markets - among those making the case is Federal Reserve chairman Ben Bernanke, who, as head of the Princeton economics department, made a point of hiring young economists interested in the topic( GOOD FOR HIM ).

Over the same time period, the field of so-called behavioral economics has risen to prominence, led by, among others, Thaler, Laibson, and Robert Shiller, a Yale economist who warned of both the housing bubble and, in 2000, the dot-com bubble. By borrowing the insights and methods of psychology, behavioral economics focuses on all the ways in which humans fail to act as the rational, self-interested beings that economic models call for - we aren't good at thinking about the future, we're susceptible to peer pressure, we overestimate our abilities and underrate the odds of bad things happening. It's a set of traits that describes perfectly the behavior of many of the people who, in a cascade of self-defeating decisions, helped create the subprime crisis. ( A GOOD APPROACH )

"People used to think that these behavioral effects were small anomalies that turned up in experiments but washed out in the real world," says Tyler Cowen, an economist at George Mason University not himself affiliated with behavioral economics. "But there's a sense( TRYING LOOKING AND IT WILL BE MORE THAN THAT ) in which they get multiplied in the real world."

For now, behavioral economics remains a critique without a real alternative. That may be starting to change: Lo has developed what he calls the "adaptive markets hypothesis," a model that he argues reflects both the rationality of the investor in good times and the blind panic of the bad( MIGHT HELP ).

Nonetheless, for some economists, the lessons of the crisis are likely to be smaller, though no less humbling. These scholars argue that they're facing not a new challenge but a familiar nemesis.

"What we're experiencing now is a good old-fashioned financial panic," says Jeffrey Kling, an economist at the Brookings Institution. "This is perhaps the biggest scale, but on some level it's not that different( A SLIGHT SIMILARITY )."

Robert Lucas, an economist and Nobel laureate at the University of Chicago and a champion of the rationality of markets, doesn't see much fundamental change coming out of the crisis, either. What it has reminded us of, he argues, is simply the impossibility of seeing these events in advance ( TRUE ).

"I don't know anybody involved who thought he could predict these turning points. Do macroeconomists know as much as we thought we did?" he asks. "Of course not( NO ONE DOES )."

By this logic, the problem isn't how economists see the world so much as it is what we expect of economics ( NOT MUCH ).

Laurence Ball, an economist at Johns Hopkins, makes a similar point. "Nobody ever sees anything coming," he says. "Nobody saw stagflation coming, nobody saw the Great Depression coming, nobody saw Pearl Harbor or 9/11 coming. Really big, bad things tend to be surprises( OTHERWISE THEY WOULDN'T HAVE HAPPENED )."

A little chastening isn't bad, but, please, no hand wringing.

"I still fear the psychological effect of a formal declaration of bankruptcy at a time when many--probably most--Americans are anxious"

I've already written that Richard Posner has the view closest to my own on the Big 3 Bailout:

"We blogged on November 18 about whether the government should provide money to the U.S. auto manufacturers to keep them alive. (I was for; Becker was against.) In the short period since then, there have been important developments bearing on the issue, culminating this past Friday in the blocking by Senate Republicans of the Democrats' modest ($15 billion) auto bailout bill, and the announcement by the Bush Administration that it might, after all, agree to use part of the $700 billion financial-sector bailout to keep the U.S. auto manufacturers going until President-elect Obama takes office. So Becker and I have decided to return to the issue.

The issue has a political and an economic dimension. From a political standpoint, the current position--no bailout legislation, but possible allocation of part of the financial-sector bailout money to the domestic auto manufacturers--represents, unusually, a victory for both political parties. The Republican Senators have stood up for principle--that freedom to fail is basic to capitalism, that wages and benefits should be set by free labor markets rather than by powerful unions, which are worker cartels, that government should not manage businesses, and that government expenditures should be minimized--and for the interests of Toyota and the other foreign manufacturers that have plants in the United States; for those plants are mainly in the South, which is the stronghold of the Republican Party. By opposing an auto bailout the Republican Senators have also distanced themselves from the Bush Administration, which is at once unpopular and believed by many Republicans to have betrayed Republican small-government principles. There is a grave risk that, as I argued in my November 18 posting, a collapse of the domestic auto industry could have serious adverse consequences for the U.S. economy as a whole, which would expose the Republican Senators to criticism. But that risk is buffered by the Administration’s apparent willingness to bail out the auto industry without new legislation."

I might take that "Free Labor Markets" line seriously if I could find businesses and businessmen who really believe in such a thing, where it doesn't mean free in this particular instance, but not in the ones that we deem inappropriate. The word "Free" is used mighty loosely. I completely agree with the characterization of what I term the difference between Economics and Political Economy, and how the politics of this is playing out.

"The Democrats (including the incoming administration) have scored points among their constituencies by standing up for union workers, for the “greening” of the automobile industry, for states in which the domestic auto industry is centered that voted Democratic in the November election (Michigan, Ohio, and Indiana), for the principle of active government, and for trying to avert a deepening of the current depression. ( I AGREE )

The bailout bill was a mess, but a harmless one, if I am right that the domestic producers should not be allowed to collapse at a time of profound and, it appears, worsening economic distress. The bill was a mess because of the conditions that it would have imposed on the industry, conditions that earned the justified ire of the Republican Senators because of its failure to lean hard on the collective bargaining agreements negotiated by the United Auto Workers, because of the divided control of the industry that the bill if enacted would have brought about--divided among the manufacturers, a federal "car czar," and intrusive congressional oversight--and because of the considerable element of fantasy in the idea that Congress plus the President can revitalize the domestic auto industry. Nowhere is it written that the United States, let alone the midwest, where the domestic auto manufacturers are centered, has a comparative advantage over other countries, or other regions of the United States, in manufacturing motor vehicles. Evidently it does not, and Congress and the President cannot change that, as Japan learned from the failure of its "industrial policy" administered by Japan’s once-admired Ministry of International Trade and Industry."

I do not believe that this deal will actually pass my stated conditions for a bailout, but we'll see.

"For the problem of the Detroit manufacturers is not just a matter of higher wages, to be solved by renegotiation of their collective bargaining agreements. The wage difference (actually the benefits difference--the hourly wages of the auto workers employed by the domestic manufacturers are only slightly higher than the wages of the workers employed in the U.S. plants of Toyota and other foreign manufacturers) is an important but not the decisive factor in the decline of the domestic auto industry. The difference in the wage and benefits package between employees of the domestic manufacturers and of the foreign ones in the United States has been exaggerated by treating as a part of that package the annual payments to retired workers divided by the number of hours worked annually by current workers. The money owed the retirees is a fixed cost, like any other debt. Eliminating those payments, like reducing the industry's bond debt, would improve the industry's balance sheet by reducing its fixed costs, but would not reduce the cost of making cars, or increase their quality. Merely wiping out existing debt, the main consequence of reorganization in bankruptcy, does not improve the efficiency or competitive position of the reorganized firm, which is why most reorganizations end in liquidation. What would improve the efficiency of the domestic auto manufacturers, besides reducing wages and current workers’ benefits, would be jettisoning union-imposed work rules; that was part of Republican Senator Corker’s ingenious proposal (of course rejected by the union) to condition a bailout on the union’s agreeing to a reduction in the wages and benefits of the Detroit auto makers' workers to the level prevailing in the southern automobile plants of the foreign auto companies. The adoption of his proposal would have been tantamount to putting the United Auto Workers out of business--if unionized workers have the identical wages, benefits, and working conditions as nonunionized ones, why would anyone pay union dues?"

I can think of a number of reasons:

1) Not every business treats its workers the same.

2) There might incentives involved in the places where these southern plants are located, that are not available or possible in other areas of the country.

3) If there's no retirement plan or health plan, workers might want to join together to get such coverage.

4) The negotiations are effected by many government rules besides labor related ones, like tax incentives for health and retirement plans, etc., that need to be bargained out between workers and employers.

5) History. This situation involves similar issues with conflicts between countries and tribes; namely, when do you date the beginning of the process that led you to the current negotiations. Oftentimes, each side has a different irreconcilable starting point than the other side.

However, if I took a close look at the actual negotiations, I might well want more concessions from the workers. But I would need to know all of the specifics.

"I doubt that anyone in Congress or in either the outgoing or the incoming Administration really thinks that a bailout bill will place the domestic industry on the path to salvation. The conditions imposed to achieve the "reform" of the industry are window dressing. All three domestic manufacturers (yes, Ford included) are insolvent, and while they are unlikely to close down and liquidate completely if forced into bankruptcy--Americans will probably buy 10 million motor vehicles in 2009 and they are unlikely all to be made by foreign companies (the foreign share of the U.S. car market, including both imports and cars manufactured in the U.S. plants of foreign companies, is about 50 percent, though they could take up some of the slack created by the collapse of the Detroit manufacturers, since the foreign companies’ sales are down too). Even with an infusion of federal money, there will be many plant closings and layoffs and many bankruptcies and liquidations of auto parts suppliers and auto dealers."

This seems correct.

"But formal declarations of bankruptcy by the domestic manufacturers would, I believe (as I argued in my November 18 posting), have a substantial added negative effect on the economy. Consumers are markedly reducing their purchases of durable goods because their savings are so depleted that they cannot, as in previous economic downturns, reallocate savings to consumption. Instead they are reallocating income from consumption to savings. The result is a downward spiral: consumers spend less, so output drops, resulting in layoffs that result in further reductions in consumption and in turn in output. The spiral will eventually bottom out, but it will bottom out at a lower level if hundreds of thousands of employees of auto manufacturers, auto parts suppliers, and auto dealers are terminated more or less all at once and consumers planning to buy a car in 2009 are scared off by the uncertainties associated with bankruptcy. (Will warranties be honored? Will parts be available? Will the dealership from which one bought a car survive? Will service standards slip? What about the car’s resale value? And should one believe the soothing assurances that bankruptcy is no big deal for the customers of the bankrupt firm, as long as it does not liquidate, when all the other soothing assurances by the government have proved unfounded?) Because motor vehicles are highly durable, it is easy to be prudent and defer replacing one’s existing vehicle until one’s economic situation clarifies."

I agree.

"Granted, with General Motors having publicly acknowledged hiring a leading bankruptcy lawyer to counsel it and announced that it will be shutting much of its North American operations for a period of months, there is increasing public recognition that the Detroit automobile industry is bankrupt in all but name. But I still fear the psychological effect of a formal declaration of bankruptcy at a time when many--probably most--Americans are anxious about their economic situation. Individually, consumer prudence is wise; collectively, it will exacerbate the depression."

This is one of my fears as well. It will increase the fear and aversion to risk and flight into safety, thereby exacerbating this crisis.

"The realistic goal of an auto-industry bailout is not to reform, revitalize, or restructure the domestic industry; it is merely to postpone its bankruptcy for a year or two, until the end of the depression is at least in sight and consumer confidence is restored to the point at which the bankruptcy of the domestic manufacturers can be taken in stride. To attain this goal does not require imposing conditions on the use that the auto manufacturers make of the bailout moneys. The conditions that the bill would have imposed and that any other form of government funding will impose are not an economic but a political necessity because of widespread anger at the incompetence of the industry; a majority of Americans oppose any bailout of the Detroit manufacturers. At the very least, the Obama administration should be allowed to decide the fate of the companies; that argues for a modest government loan that will keep them out of bankruptcy until, say, February."

I agree with this although, again, I have pretty stringent requirements, including on the UAW, which will probably not be met in order to support a bailout. My main reason for supporting this bailout, even though there's a lot of anger at the Car Executives, whom I would need to see replaced before I would accept the bailout, is that the government cannot be seen as bailing out only the financial services sector. However, the sincere attempt being made to help the automakers out in order to keep people employed might have deadened the impact of such a fear.

"What does an auto industry default cascade look like? "

Tracy Alloway on Alphaville with a post about why the Automakers would be bailed out through TARP:

"What does an auto industry default cascade look like? Like this, from Bank of America:

And that’s the reason why the US government may well be considering bailing out the country’s flailing auto industry using Tarp funds, according to the Wall Street Journal. It may even go so far as to request the second tranche of the Tarp to do so, according to the article.

Why the desperation determination to bail out what seems like a dying industry? BoA’s Jeffrey Rosenberg explains:
A GM default with no [government] support could lead to payment defaults by GM to its suppliers. The most concentrated of these, Axle, provides little of its sales outside of GM so a default by GM likely cascades into a default at Axle, but becomes limited there. However, consider the exposure of Lear. Here, a default of GM could significantly restrict the ability of Lear to supply Ford. If a payment default from GM lead to a default of Lear and an inability to supply Ford, that could impair Ford’s ability to provide payments to other suppliers. Next, with Ford as its major supplier, Visteon could face payment difficulties.

…

The systemic risk argument of a set of cascading payment defaults is borne out in the close linkages between suppliers and manufacturers. However, as we have argued before, Debtor-In-Possession (DIP) financing helps to forestall such a systemic risk outcome by allowing companies to continue to operate, and in this case, to continue to make payments to their suppliers, and avoid such an event.

By BoA’s reckoning, it would take about £30bn in DIP financing to save General Motors alone (about 2 times working capital plus a £10bn cushion).

Does that seem like a lot? Yes, but when you see graphs like the above you start to understand why the government is concerned about systemic risk.

Of note however, is how potential DIP financing would work. The Fed Reserve has, under “unusual and exigent conditions,” the ability to lend to corporations on a securitised basis — though the funding requires a bankruptcy so the Fed and Treasury can obtain senior claim on all assets. Back to BoA:
Repayment of the loan would contemplate a restructured GM achieving long term viability such that loan proceeds could be paid off over time, say 5-10 years, refinanced or sold to the private market under demonstrated viability several years out.

A 10-year bet that the US auto industry will recover? A rather big gamble for the government (and taxpayers) then."

The gamble that the Treasury Dept. doesn't want to take is with employment and production falling off a cliff. The actual economic sense of the bailout, without Political Economy thrown in, is minimal, and rests on a great deal of Wishful Thinking. I've given pretty stringent requirements for the bailout, which I doubt will be met, but I understand the fear underlying this bailout.

If you believe as I do, that the government not bailing out Lehman caused a crisis of faith in the government's willingness and ability to get us all out of this mess, then you can understand why this bailout is necessary. If you don't think that this is what the underlying assumption and context really is, then I can easily understand your being against this bailout.

" Now how do you organise a new French Revolution? "

Bronte Capital and John Hempton also get it:

"Credit Agricole SA is a bank which obsesses me – and on which I have lost some loot.

The problem is that it is a bank with very good bits and very bad bits. And the good bits are excellent (and mostly outside Paris) – and the bad bits are atrocious.

Charlie Munger observed that if you mix turds with raisins you still have turds. Charlie was right and it shows in Credit Agricole SA’s stock price.

The bank is controlled by a bunch of regional mutual banks who – for reasons that are not apparent to me – have never got around to closing the bad bits. Those regional mutuals are in turn controlled by five million voting mutual certificate holders – a reasonable proportion of French households.

The super-bad bit is their investment bank. It’s a mathematical finance type investment bank in the French mould. As has been noticed by more than a few people – the market recently has not been too kind to mathematical finance.

I just want to extract the results – quarterly – for just investment banking business. Please click for detail...

These numbers really deserve looking at. The first observation is that revenue can go very strongly negative at an investment bank. That is nothing that Lehman et al have not discovered before – but the trading revenue was negative for several quarters in a row. You might conclude the traders were not much better as traders than say the average French farmer.

The second thing is that the costs line doesn’t seem to move much. Now when I was young and naïve – say 2006 – I thought the investment banks would have a very rough trot – but that the staff would take a fair bit of it in the hip-pocket. The argument being that the very high salaries were at risk – and you could at least assume that when time got rough for an investment bank the staff would be paid salary without bonus. Capital risks were lower than it would appear because at least variable expense would go close to zero.

Now I read lots of stories about how children are getting less allowance due to the credit crisis. Such stories always seem to wind up high in big-media’s “most read” and “most emailed” lists. And that is only because we – dear readers – are doing it to our own kids.

And if it is good enough for our kids it is surely good enough for our investment banker!

Anyway – it is noted that Wall Street bonuses remain stubbornly high – but this is France with all its equality and fraternity. And they can’t control this crap either.

But with numbers like these – if the investment bank were not owned by the rich French parent (Credit Agricole SA) then it would be bust – and the children (sorry investment bankers) would be out on the street.

But bust is better than it would have been in 1792. In those days – faced with a class as egregiously and hypocritically greedy as investment bankers they would have set up the guillotine in the Place de la Concorde and we would be treated to the public spectacle of mass beheadings.

These days of course it is easier. The French farmers and middle class all have a vote – its their mutual share. Executing a vote may be less grizzly than executing investment bankers – but it might be just as effective (though somewhat less theatrical).

Now how do you organise a new French Revolution?"

Hempton's not far wrong. Now you know why I sound like a certain Whig who's trying to prevent himself from having to write a book about Major Social And Economic Changes wrought by this crisis. Only, in this case, I'm getting more help from my own party than the opposition. This need not happen. It's a remote possibility as of now.

A True Burkean would be thinking about the Pragmatic and Effective Policy Decisions that will allow us to keep our system intact, and yet deal with the crisis before us. Paradoxically, we need more government intervention in the short run to prepare the possibility of less government intervention in the future. We also, and I know I'm sounding Quixotic here, need to root out Fraud, Negligence, Fiduciary Mismanagement, and Collusion, and deal with it strictly and publicly, in order to forestall a collapse in the belief among many voters that this system is worth preserving, and that this presevation will not come at their expense.

Do I agree with everything Burke says? No. I see him as a Whig with a distaste for Radical Change, which often strays very far from its stated goals. So say I. Political Economy and Politics dictate that we deal with this crisis in a way that both appears and is benefitial to all parts of the citizenry. I'm fine with looking towards Keynes for help, but a quick but focused glance towards Burke is seldom, if ever, amiss.

"This is the angry soil in which populist backlashes can take root."

Robert Reich gets the Political Economy of these bailouts right:

"The government is doing a lousy job helping distressed homeowners. And according to John Dugan, the Comptroller of the Currency, the little that's been done has had surprisingly little effect. Nearly 36 percent of homeowners holding mortgages whose terms were adjusted to give them more leeway defaulted on payments within three months, and almost 53 percent were behind on payments by six months.

What's going on? It's hard to know for sure, because the homeowners who have qualified for help so far were supposed to have been fairly good credit risks to begin with. My guess is the worsening economy is making it harder for just about all homeowners to pay their mortgages, and those who were teetering on the edge months ago -- although perhaps good credit risks before that time -- are now way under water. Two of the biggest culprits: Layoffs and fewer working hours. With far less money coming in, more and more people have to choose between paying their mortgages and trying to keep up with larger and larger credit card debt. They're trying to manage both while paying the medical bills and the food bills and energy bills, and they can't make it.

It wouldn't surprise me if many of these Americans were starting to look at the size of the bailouts of Wall Street and the bailout of the Big Three -- at the executives, well-paid professional employees, upscale creditors and shareholders, and even well-paid blue-collar workers, who are the major beneficiaries of this federal largesse -- and conclude that a fundamental principle of fairness is being violated.

These Americans aren't revolutionaries. To the contrary, they're deeply conservative. They've worked hard, but their hard work hasn't paid off. Some have tried to save, only to see their savings disappear. They're worried about the future and about their kids' futures. They never expected anything like this.

This is the angry soil in which populist backlashes can take root."

I think that this is the bottom line. A bailout of just the financial sector would be a political disaster, given how arbitrary and seemingly ineffective the actions taken so far have been for the general economy. That's why Felix Salmon was wrong about those figures of borrowers defaulting again. People expected that lenders would do more to help people than in normal times. As well, that's why the best argument for the Fannie/Freddie infusion is political. The Fed needs to be seen helping people in real life, as they see it.

I don't like big, fast, and clumsy political changes, and Populism leads to them.We need to harden the soil against such movements.

"Some companies are too powerful to fail": That's Our System

John Kay in the FT has interesting post this morning that echoes some of the points that I was using in talking about Yves Smith's post on the US fear of Nationalization:

"Great banks are “too big to fail”. The predictable consequence of governments accepting this argument is a queue of other companies “too big to fail” lining up at the front door of treasuries. Insurers were next. This week, the car manufacturers secured their subsidy."

It is predictable, but also, in some sense, necessary, because politically, it would be very hard for a bailout of just financial services to be accepted by the citizenry of the US.

"The failure of any business has ripple effects on suppliers, employees, distributors and customers. If the business is General Motors such effects are larger. But since GM is many times larger than most companies, the subsidy needed to keep going is correspondingly larger. There is no reason to think that the ripple effects are larger, relative to the size of GM, than the consequences of the failure of a smaller business relative to its size."

That's not the point, but he understands that.

"So the return on the taxpayers’ dollar is not likely to be larger if their largesse goes to a big company. Indeed, since the large company has readier access to a range of alternative funding options, a need for government support is more likely the result of deep-seated competitive weakness than temporary shortage of funds which can so easily cripple a smaller business."

Not exactly. The government is the implicit guarantor for these businesses at all times, and legislation has been passed favoring these businesses over time. It certainly can mean that they are competitively weak, but the system operates for the benefit of the weak and strong large businesses alike. It's a kind of insurance policy.

"That is true of the carmakers, whose problems are of much longer standing than the current downturn. In automobiles as in many industries, economies of scale are technological, the diseconomies of scale human. Human factors in business are generally more influential than technological ones in determining the long run fate of a company."

The automakers have been a major part of this system.

"The memory of a meeting in one of Britain’s largest companies – now no longer so large – is engraved in my memory. We discussed how best to persuade the regulatory authorities of the cost advantages arising from the company’s size. But the room was crowded with people who had nothing substantive to contribute. They were there to defend and advance their political position in the corporate hierarchy. The meeting itself demonstrated that the arguments we were presenting were false. Politics overrode productivity."

But Politics is important. So is Political Economy, which includes this kind of messy exchange between politics and productivity.

"As has been true in Detroit. Arrogant, complacent and only belatedly sensitive to competitive pressures and changing customer needs, the big three have been in relative decline for half a century."

True. That's why they've been lobbying congress throughout this period.

"But there really are economies of scale in political lobbying. The cost of presenting your case is independent of the size of the benefit you seek. The larger the business, the more likely that legislators will see constituency interest or political advantage in being helpful. Big companies have government affairs departments but for small groups the cost of access is prohibitive. Only large companies have access to the sharpest shooters."

That's the system.

"Too big to fail, but big enough to exert political influence. The malign consequences are evident in many areas of public policy. Large media and software companies write intellectual property rules, while the interests of users go unrepresented. Big pharmaceutical and defence companies employ thousands of lobbyists. Consumer interests come a distant second to producer interests in the formulation of trade policy. In the past two decades the financial services industry has become the most powerful and effective lobby of all. The cash contributed to political campaigns has now been repaid many times over from the public purse."

That's because lobbying is an investment.

"But few things corrode business efficiency and effective markets more insidiously than the discovery that it is more profitable to win the favour of politicians than to win the approval of customers. In Italy, and in some other European states, an inefficient large-business sector is parasitic on the vibrant small- and medium-sized enterprises, which are the mainstay of the economy."

That's true.

"The problems are worse in Russia and in many potentially emerging economies. In these countries, the nexus between the political and business elite undermines both democracy and business efficiency."

That's not good to hear.

"The populist trustbusters who framed anti-monopoly legislation more than a century ago feared that the cost and technical advantages of large companies would be more than offset by damage to economic efficiency and pluralist institutions from the political power they might acquire. These early trustbusters were right."

I agree. But the work to be done to dismantle this current system is going to be long and arduous because, again, that is and has been our system, and it seems very resilient and impervious to challenge and change at the moment. We need to plan and prepare for the the long run, and seek small victories that will allow us to get some important things done under the radar, so to speak, and before the system realizes that, this time, it really has a challenge from people who want a smaller and more effective and efficient and representative government. But anyone who says that they're surprised by the government response in this crisis needs to get out a bit more into the real world of Politics and Political Economy.

"The most extreme (and probably effective) solution would be a full guarantee of all sorts of bank debt. "

Bronte Capital gives us some interesting insights into Citi and other matters. You need to follow his whole post, so I'm just going to do what every sensible person does and quote the sections that buttress my own arguments:

"Now the problem is that no matter how many times Pandit says that Citigroup is well capitalised nobody will believe him. In answer to the Brad DeLong question – the company told lies about its mortgage book – which compounded the lies about the dodgy CDO product they sold. The lies about the mortgage book totalled $20 billion on say $43 billion of optimistically valued assets – and those lies reduced the value of Citigroup by $200 billion because they removed the trust in Citigroup.

It is one of those ironic things that when financial institutions lied in 2006 the market seemed to believe them. When they tell the truth now, nobody will listen. "

I find this an important point. Right now, we're in an inverse universe from just a year or so ago, where exuberance has become panic, overly positive credit ratings have become overly conservative, etc. Citi, I contend, didn't really need to be bailed out, but, given the current mood, it became inevitable. After all, as I've said, it was implicitly guaranteed.

"The most extreme (and probably effective) solution would be a full guarantee of all sorts of bank debt. The problem of course is that is hugely risky for the taxpayer. My view – and I think the only way in which such a guarantee is viable – would be that if the taxpayer takes the risk they should also get the upside. That is full nationalisation. The advantage of full nationalisation is that since the system is actually solvent (but illiquid) the government will make a profit out of it. That is fine. Take the risk – make a profit – it’s the capitalist way. Incidentally the Sheila Bair approach of confiscation from the equity holders and subordinate debt holders works fine in this scenario. Indeed the sub-debt holders should wear it – but they will still be willing to lend again because they will be lending again to the government. In a full nationalisation I see no reason for Sheila Bair to resign. (Her tenure in that position would not threaten the financial system.)

I suspect that wholesale nationalisation is the cheapest (and most sure) way to end the financial crisis. But it would be difficult to find a Deputy Secretary of the Treasury for Citigroup (and Bank of America, JPM etc). Still as I think the system is eventually solvent if the government nationalised pretty well the whole system as it failed then the government would make a shocking profit. It would not be the first time – Norway made such a profit.

But I am not sure that the American politic is ready for a wholesale nationalisation of the financial system. Indeed they are determined it seems not to control financial institutions. If you are not convinced of that see the Deal Professor’s wonderful piece on who controls AIG."

This was my position. Paradoxically, but I think that it's becoming obviously more clear, this would have been cheaper, safer, and would have led to the government being removed from this ownership sooner. Why not a free market plan? Because the people with the money don't believe in it, and would have melted into thin air at the thought of not having a government intervention. With all do respect to Casey Mulligan and Gary Becker, your theories are purely Economic in this case, not based on Political Economy and Politics.

"Robert Rubin racks his brain about how he would have done things differently. Well one thing he would have done differently is get Citigroup to remove the culture of obfuscation – the culture that allowed it to be perceived as if it were lying even when it was telling the truth. The problem is that even Robert Rubin doesn’t have enough uncashed integrity to save Citigroup. Even Robert Rubin. In a world where Berkshire credit default swaps are going skyward because people do not believe that Warren Buffett has no collateral requirement Robert Rubin’s reputation ain’t going to count for much. "

This is the final point I want to make. This is Political Economy, where even known wizards cannot overcome fear and aversion to risk, and point people towards the fundamentals. People don't behave like models in the real world in normal times, although it's close enough to make the models useful. In times like these, you're better off listening to philosophers and other odd ducks who specialize in the nature of Human Agency.

“To be consistent with the last few government interventions, I don’t think Citigroup’s going to be allowed to fail,”

Here's a post on Bloomberg about Citigroup. I'm going to focus on a few points:

“Citi is in the category of ‘too big to fail,’” said Michael Holland, chairman and founder of Holland & Co. in New York, which oversees $4 billion. “There is a commitment from this administration and the next to do what it takes to save Citi.”

“To be consistent with the last few government interventions, I don’t think Citigroup’s going to be allowed to fail,” said William Fitzpatrick, an analyst at Optique Capital Management Inc. in Milwaukee, which oversees about $1 billion and doesn’t own Citigroup shares. “This company’s too intertwined with the rest of the financial system to allow any further deterioration.”

Notice two points:
1) Too big to fail.
2) Government intervention follows from earlier actions because of consistency expectations. This is a part of Political Economy that is hard to describe, because it flows from the particular circumstances of the event. That's the point I was trying to make about the automakers bailout.

“The market may be implying some sort of regulatory intervention,” Jason Goldberg, a former Lehman analyst who now works at Barclays Capital in New York, wrote in a note to clients yesterday. “In situations where the government has stepped in, the equity holders have not fared well.”

In other words, the downward movement of the price of the stock is because investors believe that their interests will be compromised by government intervention. Oddly, one can imagine government intervention helping the whole market, but hurting the stock of the company being helped out.

"If bankers do not start lending of their own accord, governments will force them to."

I was not happy with TARP, once transformed from buying toxic assets, being sold as a credit stimulus plan, and then turning out not to be one. But I never believed that so many people in so many countries would be going through the same thing and feeling the same way. Once having received the money, the banks should be expected to lend. Willem Buiter wants to penalize banks if they don't, and the FT isn't too happy about this problem either:

"Bankers must start lending – or else

Published: November 21 2008 20:00 | Last updated: November 21 2008 20:00

“Neither a borrower nor a lender be” was not intended as advice for bankers. Someone should tell them. The purpose of the recent round of recapitalisations was to strengthen banks so that they could continue lending during a global downturn. But banks are not doing so. They must. They are vital utilities – a modern economy cannot function without credit. If bankers do not start lending of their own accord, governments will force them to.

Banks around the world have been recapitalised. Governments bought shares in them, increasing the banks’ risk-capital buffers. The banks were injected with enough capital not only to make up for the losses they were expected to make in the downturn, but also to allow them to expand their lending without the capital cushion becoming too small relative to the banks’ assets. Newly fortified, banks were supposed to become trustworthy borrowers and confident lenders."

This is my point about TARP being a credit stimulus plan. Only we're talking about Britain, as well. It's like a virus.

"Expecting further losses, however, they have clammed up. They are wary of extending their balance sheets further. This is, in part, because they are still traumatised after a near-death experience. Many banks have also seen their top management decapitated. Finally, investors and banks have become so risk-averse that even government guarantees on lending are not convincing. Despite being underwritten by the US government, perceptions of the risk on Citigroup’s debts have remained stubbornly high".

As Peston showed, this hoarding strategy, cleaning up your books, waiting for sentiment to turn, makes sense from the point of view of the banks. However, they were given the money to lend it. So, as Peston says, there's a conflict. But I predicted this from the first. The banks will lobby and do what they feel they need to in a hybrid plan. That's a major reason that they don't work and cost so much. There's an inherent tension between the banks and the interests of the taxpayers. That's why I favored the Swedish Plan. It wasn't because I wanted the government running banks. But, please, Political Economy is having the knowledge and sense to understand how the real world is functioning. This tension was built in to TARP, and the other hybrids in other countries. I've just showed you Britain, so I'll try and document others.

"Governments can do more to support lending. They can reassure markets that capital ratios are supposed to fall in the downturn and that they stand behind the banks. Finance ministries around the world can recapitalise further. Central banks can expand their lender of last resort functions.

If evidence emerges that banks are not lending because they are hoarding cash to pay off the expensive preference shares taken by governments, the rescue can be restructured. One option would be to give governments more control of the banks; another would be to reduce the short-term costs of the capital.

But even if governments ensure that lenders are solvent and liquid, it could still be rational for each bank not to lend. Banks want safety in numbers when it comes to lending. But a lack of credit would force sound companies under because of a working capital squeeze. Faced with this prospect, governments will have no choice but to step in.

Politicians may attempt to lend directly, taking on credit risk to stimulate certain categories of lending and insurance. But banks, which have always been dependent on the largesse of taxpayers, could be forced to adopt central targets for new lending. This would overcome the problem of no institution wishing to be the first-mover. And banks would have little choice but to obey; if they are unco-operative, they could end up in public ownership."

So, governments can:

1) Explain to creditors that a bank's capital falls during a downturn ( Good luck )

2) Reassure that they stand behind the banks ( Good luck, if this just means jawboning )

3) Give capital to the banks if they need more. Hopefully this means after have loaned a bunch.

4) Make borrowing from Fed cheaper ( Aren't they doing that? )

5) Threaten them with being taken over ( I'm sure they're scared )

I say just take them over and be done with it. Then take them private ASAP.