A Plan for the Mortgage Mess

In the Times, Alan Blinder looks at the Frank-Dodd plan for dealing with the mortgage mess. He identifies some issues that still need to be resolved, but, overall:

[T]he Frank-Dodd proposal, which, while not a panacea, offers a smart approach to a knotty set of problems — an approach that should breathe some life into the housing market, the mortgage market and the related securities markets. Their design is not flawless. But do you know of any perfect solutions? It deserves our support.

See also the economic example worked out by Brad deLong.

Obama-nomics

Barack Obama spoke on the economy in New York on Thursday. He placed the call for increased supervision of the financial sector in historical context:

[T]he American experiment has worked in large part because we guided the market's invisible hand with a higher principle. A free market was never meant to be a free license to take whatever you can get, however you can get it. That's why we've put in place rules of the road: to make competition fair and open, and honest. We've done this not to stifle but rather to advance prosperity and liberty. As I said at Nasdaq last September, the core of our economic success is the fundamental truth that each American does better when all Americans do better; that the well-being of American business, its capital markets and its American people are aligned. I think that all of us here today would acknowledge that we've lost some of that sense of shared prosperity. Now, this loss has not happened by accident. It's because of decisions made in board rooms, on trading floors and in Washington. Under Republican and Democratic administrations, we've failed to guard against practices that all too often rewarded financial manipulation instead of productivity and sound business practice. We let the special interests put their thumbs on the economic scales. The result has been a distorted market that creates bubbles instead of steady, sustainable growth; a market that favors Wall Street over Main Street, but ends up hurting both. Nor is this trend new. The concentrations of economic power and the failures of our political system to protect the American economy and American consumers from its worst excesses have been a staple of our past: most famously in the 1920s, when such excesses ultimately plunged the country into the Great Depression. That is when government stepped in to create a series of regulatory structures, from FDIC to the Glass-Steagall Act, to serve as a corrective, to protect the American people and American business.

Ironically, it was in reaction to the high taxes and some of the outmoded structures of the New Deal that both individuals and institutions in the '80s and '90s began pushing for changes to this regulatory structure. But instead of sensible reform that rewarded success and freed the creative forces of the market, too often we've excused and even embraced an ethic of greed, corner cutting, insider dealing, things that have always threatened the long-term stability of our economic system. Too often we've lost that common stake in each other's prosperity. Now, let me be clear. The American economy does not stand still and neither should the rules that govern it. The evolution of industries often warrants regulatory reform to foster competition, lower prices or replace outdated oversight structures. Old institutions cannot adequately oversee new practices. Old rules may not fit the roads where our economy is leading. So there were good arguments for changing the rules of the road in the 1990s. Our economy was undergoing a fundamental shift, carried along by the swift currents of technological change and globalization. For the sake of our common prosperity, we needed to adapt to keep markets competitive and fair. Unfortunately, instead of establishing a 21st century regulatory framework, we simply dismantled the old one, aided by a legal but corrupt bargain in which campaign money all too often shaped policy and watered down oversight. In doing so we encouraged a winner take all, anything goes environment that helped foster devastating dislocations in our economy.

Of course, some of that "legal but corrupt bargain" was struck while a certain Clinton was in office...

Robert Kuttner and Jared Bernstein were both enthusiastic about the speech, and vexed that Paul Krugman was not (consistent with his general attitude towards Obama).

On housing, Obama (and Clinton) have been supportive of the proposals by Rep. Barney Frank and Sen. Chris Dodd. They would allow people with "under water" mortgages (i.e. who owe more than their houses are worth) to re-finance into mortgages guaranteed by the Federal Housing Administration. The value of the new loans would be limited to 85% of the previous loans, so the current lenders would take a hit, but they would escape the risk of taking a much larger loss from a foreclosure. The Bush administration seems to be moving in the same direction. But McCain is not; he says “it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers.”

Laissez-Faire is Dead, Again

The Fed's recent aid to the financial sector - expanding "discount window" lending to investment banks and arranging (and providing a dowry for) the marriage of Bear Stearns and JP Morgan - has led to growing recognition of the limits of "free market" dogma and the need for regulation of the financial sector. Financial Times columnist Martin Wolf says:

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Josef Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

The Wall Street Journal's David Wessel writes:

[S]omething big just happened. It happened without an explicit vote by Congress. And, though the Treasury hasn't cut any checks for housing or Wall Street rescues, billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess.

Although the acceptance that unregulated markets and laissez-faire do not automatically lead to the best of all possible worlds may represent a swing of the ideological pendulum, this isn't exactly new. In recent years some have tended to forget, or ignore, what has been long understood: financial markets are characterized by market failures (e.g., asymmetric information) and prone to crises. Therefore, some government intervention is merited.

What we are seeing today is a re-cognition, indeed. Brad deLong explains using the example of British Prime Minister Robert Peel, who understood this in the first half of the 19th century. For a more philosophical view, Mark Thoma usefully points us to "The End of Laissez-Faire," a 1926 essay by John Maynard Keynes tracing the history of laissez-faire dogma, and the role of economists in perpetuating it. Keynes explains that laissez-faire is often misperceived as an implication of economics: "the guarded and undogmatic attitude of the best economists has not prevailed against the general opinion that an individualistic laissez-faire is both what they ought to teach and what in fact they do teach."

Looking for a Job?

The current economic environment may be discouraging to college seniors (and others) looking for a job, but here is some good news: the Federal Deposit Insurance Corporation is hiring. They expect to be busy with more bank failures.

A Run on the Shadow Banking System

Paul Krugman sees parallels between the current problems in the financial sector and banking crises of the depression. In his latest column, he writes:

But sometimes — often based on nothing more than a rumor — banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false.

Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction. And there can be wider economic effects: as the surviving banks try to raise cash by calling in loans, there can be a vicious circle in which bank runs cause a credit crunch, which leads to more business failures, which leads to more financial troubles at banks, and so on.

That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.

In recent years, the financial sector has increasingly found ways to evade those safeguards (generally with Washington's acquiescence) and a large portion of activity occurs outside of the commercial banking sector:

Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

In fact, however, we were partying like it was 1929 — and now it’s 1930.

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

The Fed has responded by broadening its lender of last resort function to allow investment banks as well as commercial banks to borrow and to accept a wider range of securities (including mortgage backed securities) as collateral. The investment banks ("primary dealers") will be able to borrow from the new Primary Dealer Credit Facility (PDCF) - in essence, the Fed is opening the discount window to them. This comes in addition to the loans made available through the Term Securities Lending Facility (TSLF), announced the week before.

Although there are parallels with the banking crises of the 1930's, in the Times, Charles Duhigg explains that a repeat of the depression is unlikely. Partly this is because the structure of the economy has changed - in particular, government plays a much larger role in the economy now, acting as an "automatic stabilizer." Furthermore, economists (and policymakers) have learned some lessons, as evidenced the Fed's quick response (in his professor days, Ben Bernanke was a prominent scholar of the depression). [A minor factual error in the story: the highest unemployment rate of the postwar period was 10.8%, at the end of 1982].

Meanwhile, Congress is looking at updating regulation of the financial sector.

A Note From Adam Smith

Salon columnist Glenn Greenwald found the following nugget in Adam Smith's Wealth of Nations. Smith wrote:

In great empires the people who live in the capital, and in the provinces remote from the scene of action, feel, many of them, scarce any inconveniency from the war; but enjoy, at their ease, the amusement of reading in the newspapers the exploits of their own fleets and armies. To them this amusement compensates the small difference between the taxes which they pay on account of the war, and those which they had been accustomed to pay in time of peace. They are commonly dissatisfied with the return of peace, which puts an end to their amusement, and to a thousand visionary hopes of conquest and national glory from a longer continuance of the war.

Remind you of anyone? (Hat tip: Brad de Long)

Is the Midwest Boring?

Yes, and we like it that way:

House Prices (1995 = 100)

That is from Office of Federal Housing Enterprise Oversight's House Price Index. Apparently little pink houses are less prone to bubbles.

McCain-omics

Jared Bernstein examines the McCain economic agenda. (As Bernstein notes, McCain seems more comfortable talking about foreign policy than economic policy, but maybe he shouldn't be so sure of himself).

War Costs

The Iraq war is five years old today. Considering the incalculable human costs of the enterprise, there is something almost unseemly about discussing the economic costs, but those are far from trivial.

The Financial Times reports on several different estimates of the war's costs. Economics Nobel laureate Joseph Stiglitz has co-authored a book on the subject, "The Three Trillion Dollar War." He chatted with washingtonpost.com readers today (see also this op-ed with his co-author Linda Blimes).

One interesting point that came up in his discussion was the notion of "opportunity cost" -

San Francisco, Calif.: A trillion here, a trillion there, pretty soon we'll be talking about real money.

Could you address the opportunity costs of the war? For example, health care reform is a major issue in the presidential election, and three million dollars could've gone a long way towards funding it. Social Security is another example.

Joseph E. Stiglitz: That is the right way of asking the question. As a rich country, we can, in some sense, "afford" the war. But spending money on the war means that we are not spending money on other things that we could have spent the money on.

One of the real costs of the war is that our security is actually less than it otherwise would have been (ironic, since enhancing security was one of the reasons for going to war). Our armed forces have been depleted--we have been wearing out equipment and using up munitions faster than we have been replacing them; the armed forces face difficult problems in recruitment--by any objective measures,including those used by the armed forces, quality has deteriorated significantly.

Economically, we are gain weaker. Millions of americans have no health insurance--including many poor children. if they do not get the care they need, they may become scarred for life; but the President vetoed the children's health insurance bill--evidently we couldn't afford it. But we were talking about just a few days fighting in Iraq.

The list of what we could have done with just a month or even a few days fighting in Iraq is long. These are called the opportunity costs of the war. In our book, we give many examples of these opportunity costs.

Opportunity cost is a good concept for thinking the decisions of utility-maximizing agents - when a choice is made, the opportunity cost is the next best alternative which is forgone. However, that may not be a good way of understanding the outcomes of our political process. The Tax Policy Center's Howard Gleckman tried to be realistic about where the money would have gone:

Here is a little thought experiment. Had there been no occupation, we would have had a balanced budget by fiscal 2007. The deficit was $162 billion, almost exactly equal to the direct cost of the war that year. Factor in other foregone costs, such as the expense of caring for wounded vets and the like, and we probably would have had a modest surplus.

And what would we have done with it? This is just speculation, of course, but if Stiglitz can do it so can I. The White House would have said, "We have balanced the budget, so let's extend the 2001 and 2003 tax cuts." Congressional Democrats would have said, "We have a balanced budget, let's extend the SCHIP child health program." And, in the end, they may very well have done a little of both. But long-term entitlement fixes? I don't think so.

Since taxes were not raised to finance the war, the financial burden ultimately takes the form of higher government debt. That will mean taxes in the future will be higher than otherwise in order to pay the interest (currently more than 8 cents of every federal spending dollar goes to interest), and having those costs locked into the budget may hinder a future administration in addressing other issues. Moreover, the government's borrowing contributes to our current account deficit and a significant portion of the future interest payments will be made to foreign creditors. This last point means that some of our future output will generate income for foreigners rather than Americans (i.e. GNP will be less relative to GDP).

Update (3/19): The Times also looks at estimating war costs.

Professor Jones and the Committee of Doom?

Inside Higher Ed reports:

...Blowtorch Entertainment will next month begin filming on “Tenure,” which is about a college professor coming up for tenure (Luke Wilson) and facing off against a female rival who recently arrived at (fictional) Grey College. (The part of the institution will be played by Bryn Mawr College, where the movie will be shot.) David Koechner will play the professorial sidekick to the Wilson character, and the production company is planning kickoff events next year to promote the film in college towns.

Brendan McDonald, the producer, said that he viewed academe as “one of the interesting worlds to explore” and said that he viewed the project as “lampooning the tenure process.”

Hmmm... the tenure process certainly could use some lampooning. Its hard to see that doing well at the box office, but I'll go see it. Then again, maybe I should wait and rent it after I get tenure. OK, back to work...

Steven Colbert: Lose Hope to Gain Confidence

The number of people working fell last month, but the unemployment rate declined (see earlier post). Steven Colbert explains:

The Economics of the Iraq Insurgency

Many countries abundant in natural resources have been development failures. This apparent paradox is sometimes called the "resource curse." In part it is attributable to the opportunities for corruption created by abundant resources and the incentives that exist for diverting effort away from productive activity into fighting - often literally - over the rents associated with resources like oil and diamonds.

The the persistence of the insurgency in Iraq may be another manifestation of the resource curse. The NY Times reports that oil money is fueling the violence:

The sea of oil under Iraq is supposed to rebuild the nation, then make it prosper. But at least one-third, and possibly much more, of the fuel from Iraq’s largest refinery here is diverted to the black market, according to American military officials. Tankers are hijacked, drivers are bribed, papers are forged and meters are manipulated — and some of the earnings go to insurgents who are still killing more than 100 Iraqis a week.

“It’s the money pit of the insurgency,” said Capt. Joe Da Silva, who commands several platoons stationed at the refinery.

Five years after the war in Iraq began, the insurgency remains a lethal force. The steady flow of cash is one reason, even as the American troop buildup and the recruitment of former insurgents to American-backed militias have helped push the number of attacks down to 2005 levels.

In fact, money, far more than jihadist ideology, is a crucial motivation for a majority of Sunni insurgents, according to American officers in some Sunni provinces and other military officials in Iraq who have reviewed detainee surveys and other intelligence on the insurgency....

“It has a great deal more to do with the economy than with ideology,” said one senior American military official, who said that studies of detainees in American custody found that about three-quarters were not committed to the jihadist ideology. “The vast majority have nothing to do with the caliphate and the central ideology of Al Qaeda.”

For more on the resource curse, see this column by Tyler Cowen in the Times last year.

Wall Street, There's a Place You Can Go

I said, Wall Street, when you're short on your dough...

Earlier this week, the Fed announced a new $200 billion program called the Term Securities Lending Facility (TSLF). This will allow investment banks to borrow US Treasury securities by putting up certain assets including some mortgage-backed securities as collateral. The NY Times reported:

The Federal Reserve, in effect, is trying to ease an acute credit squeeze by agreeing to hold large volumes of mortgage-backed bonds that Wall Street firms are struggling to sell and providing them with either cash or Treasury securities that they can immediately convert to cash.

Fed officials are increasingly convinced that the United States is sliding into a recession, and they worry that the deepening credit squeeze will aggravate the problem by making it even harder for consumers and businesses to borrow money for houses, new equipment or new factories.

The Fed’s hope is to relieve some of the pressure on institutions to sell at fire-sale prices, easing the strains on economic activity and making the credit markets feel more comfortable in buying mortgage bonds again.

The Washington Post's Steven Pearlstein puts the Fed's action in context:

[T]he real problem began in late February, as several of Wall Street's biggest investment banks prepared to close their books for the quarter and realized they were looking not only at big declines in profit from issuance of new stocks and bonds and fees from mergers and acquisitions, but also another round of write-offs in the value of their holdings. In response, the banks began to hunker down, instructing their trading desks to raise margin requirements for hedge funds and other customers, requiring them, in effect, to post more collateral on their heavy borrowings.

Thus began a chain reaction in which hedge funds began selling what they could -- largely mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae -- to raise the cash to meet their new margin calls. That wave of forced selling drove down the price of those bonds, which prompted more margin calls and more forced selling. By the end of last week, the interest rate spread on those securities -- the difference between their yield and that of risk-free U.S. Treasury bonds -- had jumped four, five, even 10 times the normal rate.

(Here is an explanation of "margin call").

A central bank is sometimes called upon to act as a "lender of last resort" to banks in crisis. In an age where loans are widely "securitized" - that is, instead of sitting as an asset on a bank's balance sheet, loans are sold on a market (often in a bundle like a mortgage-backed security which entitles the holders to the payments from the underlying mortgage loans) - Willem Buiter has argued that the central bank needs to be a "market maker of last resort." A market maker acts as both a buyer and a seller (not unlike a used car lot), and thereby ensures "liquidity" - that assets can readily be sold. Buiter sees the TSLF as a sign that the Fed is stepping up to this task (albeit in a somewhat indirect fashion):

The old Lender of Last Resort (LoLR) model of providing funding liquidity to solvent but illiquid banks, at a penalty rate and against collateral that would be good in normal times but may have become impaired in disorderly market conditions, may be appropriate in a relationships-based financial system or traditional banking system. It is not capable of dealing with market illiquidity - the kind of liquidity problem likely to arise in a transactions-based model of financial capitalism, that is, a system in which a large share of intermediation occurs through the capital markets rather than through conventional ‘originate and hold’ banks.

In a transactions-based financial system, the Market Maker of Last Resort function complements or even substitutes for the Lender of Last Resort function as the instrument of choice for pursuing financial stability. Rather than disguising the fact that the Fed has woken up to the fact that the world has changed and that central banks have to accept an expanded range of eligible collateral from an expanded range of counterparties when key financial market seize up, the Fed should advertise the fact. They are doing the right thing.

No bank does it all by itself.
I said, Wall Street, put your pride on the shelf,
And just go there, to the T.S.L.F.
I'm sure they can help you today.

Update: Paul Krugman believes it probably won't work.

RFK on GNP

The American Prospect's Kate Sheppard reports on a hearing held by Senator Byron Dorgan on the deficiency of Gross Domestic Product as a proxy for economic well-being. As she notes, the point was eloquently by Robert Kennedy in this 1968 speech. Each semester, as I read a passage from it to my principles students, I am reminded I that I'm no Robert Kennedy. Next time I might play this instead:
Hat tip: Ezra Klein. NB: Kennedy refers to Gross National Product (GNP); nowadays GDP is the more commonly cited aggregate measure, but the two are closely related.

Update (9/13): The Glaser Progress Foundation informs me that video has moved to a new web location.

They Have Us Outnumbered

Inside Higher Ed informs us:

Full Time Professional Positions in Higher Education
Fall 2004
Administrators: 49.4%
Faculty: 50.6%

Fall 2006
Administrators: 51.4%
Faculty: 48.6%

Next time your tuition increases, don't blame us professors...

To Strive And Not To Enjoy

In his NY Times column, Bob Frank looks at the link (or lack thereof) between income and happiness. After discussing some of the flaws in how GDP and price indexes are measured, he says:

But there is a much bigger problem, one that challenges the very foundation of the presumed link between per-capita G.D.P. and economic welfare. That’s the assumption, traditional in economic models, that absolute income levels are the primary determinant of individual well-being.

This assumption is contradicted by consistent survey findings that when everyone’s income grows at about the same rate, average levels of happiness remain the same. Yet at any given moment, the pattern is that wealthy people are happier, on average, than poor people. Together, these findings suggest that relative income is a much better predictor of well-being than absolute income.

That we are so concerned with our relative status - that our happiness seems to depend more on how much (or little) we feel we are getting ahead than on how well off we are - suggests we have still not shaken loose of the attitudes that Keynes describes in his 1930 essay "Economic Possibilities For Our Grandchildren." He believed that a set of values that encouraged accumulation of wealth for its own sake was an important ingredient in promoting the increase of capital required for economic growth. However, continued growth would ultimately liberate future generations from the "economic problem" of scarcity and allow humanity to live "wisely, agreeably and well" by a nobler set of principles. But, Keynes warned, the transition would be difficult:

The strenuous purposeful money‑makers may carry all of us along with them into the lap of economic abundance. But it will be those peoples, who can keep alive, and cultivate into a fuller perfection, the art of life itself and do not sell themselves for the means of life, who will be able to enjoy the abundance when it comes.

Yet there is no country and no people, I think, who can look forward to the age of leisure and of abundance without a dread. For we have been trained too long to strive and not to enjoy...

Has India Traded Its Passion For Glory?

So many times, it happens too fast...
The Economist believes India needs to reform its public sector:

In many ways India counts as one of liberalisation's greatest success stories. For years, it pottered along, weighed down by the regulations that made up the licence raj, producing only a feeble “Hindu” rate of growth. But over the past 15 years it has been transformed into a far more powerful beast. Its companies have become worldbeaters. Without India's strength, the world economy would have had far less to boast about.

Sadly, this achievement is more fragile than it looks. Many things restrain India's economy, from a government that depends on Communist support to the caste system, power cuts and rigid labour laws. But an enduring constraint is even more awkward: a state that makes a big claim on a poor country's resources but then uses them badly...

[Prime Minister] Singh made administrative reform a priority when he took office in 2004, and he duly set up a commission to look into it. But even the finance minister admits that most of its deliberations have been academic. The civil service is expected shortly to be awarded a huge pay rise, which will be swiftly embraced, along with tougher performance standards, which will be studiously ignored...

That is, Singh must not lose his grip on the dreams of the past; he must fight just to keep them alive.

Unemployment: As We Were Just Saying

David Leonhardt's column on how the unemployment rate can be deceptive (see earlier post) was timely indeed. The latest numbers from the Bureau of Labor Statistics have the number of people employed decreasing by 255,000 in February, but the unemployment rate also fell, from 4.9% to 4.8%. This was made possible by a decrease in labor force participation; the labor force declined by 450,000 and the participation rate fell from 66.13% to 65.88%.

Those numbers are from the household survey; the decline of 63,000 jobs reported by the establishment survey got the headlines (which is strange, I would expect the headline writers to prefer the more dramatic figure).

Either way, not a good sign. Paul Krugman pre-empts the NBER and calls it a recession.

Hillary Doesn't Mean it Either

A mini-scandal over the apparent assurances given by economic advisor Austan Goolsbee to the Canadians that Barack Obama's anti-NAFTA rhetoric shouldn't be taken too seriously may have contributed to his defeat in our primary on Tuesday. Since I brought it up in a recent post, I should, in fairness, note that it appears the Clinton camp was doing the same thing, according to The Globe And Mail:

The leak of a confidential diplomatic discussion that rocked the U.S. presidential campaign began with an offhand remark to journalists from the Prime Minister's chief of staff, Ian Brodie....

Mr. Brodie, during the media lockup for the Feb. 26 budget, stopped to chat with several journalists, and was surrounded by a group from CTV.

The conversation turned to the pledges to renegotiate the North American free-trade agreement made by the two Democratic contenders, Mr. Obama and New York Senator Hillary Clinton.

Mr. Brodie, apparently seeking to play down the potential impact on Canada, told the reporters the threat was not serious, and that someone from Ms. Clinton's campaign had even contacted Canadian diplomats to tell them not to worry because the NAFTA threats were mostly political posturing.

The Canadian Press cited an unnamed source last night as saying that several people overheard the remark.

The news agency quoted that source as saying that Mr. Brodie said that someone from Ms. Clinton's campaign called and was "telling the embassy to take it with a grain of salt."

Hat tip: Jason Zengerle.

The leak has become a bit of a scandal for the Canadian government, with calls for the Mounties to investigate. I know from experience that the Canadians take confidentiality seriously - before I went to graduate school, I wrote about Latin American syndicated loans for a trade publication, and when the Latin deals were drying up in '98 and '99 in the wake of the Asian crisis, we made an attempt to extend my beat to Canada. It was a futile effort - the Toronto bankers, unlike their New York counterparts, were unwilling to violate their confidentiality rules to gossip about their deals.

Of course, this hasn't been very enlightening about where the next President actually will stand on trade issues. A hopeful sign are the intelligent comments that Goolsbee made at a forum in January, as reported in this story on the Chronicle of Higher Ed's campaign blog.

Update (3/7): Or maybe not... more confusion on who said what to whom.

The Last War, or the One Before?

Re-fighting past battles isn't only for generals. Economists are finding different historical precedents for our current economic woes, which lead to very different policy implications.

Collapsing asset prices and credit market turmoil recall the depression (and its recent Japanese echo):

• Morgan Stanley's Steven Roach draws a comparison to Japan's post-bubble slump of the 1990's.
• Robert Reich finds a worryingly relevant passage in the memoirs of depression-era Fed chairman Marriner Eccles.
  

Record oil prices and simultaneous inflation and unemployment bring back memories of 1970's stagflation:

• Fed watcher Tim Duy says we are "Inching Closer to the Reality of Stagflation"
• Allan Meltzer thinks the Fed is repeating the mistakes of the 1970's (and Econospeak's Econoclast has a critical response)
  

The Bernanke Fed's tune sounds more like "Happy Days Are Here Again" than "I Will Survive" - it has been willing to respond aggressively with rate cuts to stimulate the economy and aid the financial sector, even at the risk of inflation.

In the Things That Make You Go Hmmm... Dept.: The lyrics to "Happy Days Are Here Again" were written by J. Yellen, and the President of the San Francisco Fed is also J. Yellen.

Unemployment and the Unemployment Rate

Of all economic statistics, the unemployment rate is probably the one that gets the most headlines, so it is important to understand what it doesn't tell us. Doing so can help us understand why so many people seem unhappy with the state of the economy, even as the unemployment rate (4.9%) is low by historical standards.

In his Economic Scene column, David Leonhardt points us to the increase in the number of people who are not employed, but not looking for work (and therefore not counted as unemployed):

Consider this: the average unemployment rate in this decade, just above 5 percent, has been lower than in any decade since the 1960s. Yet the percentage of prime-age men (those 25 to 54 years old) who are not working has been higher than in any decade since World War II. In January, almost 13 percent of prime-age men did not hold a job, up from 11 percent in 1998, 11 percent in 1988, 9 percent in 1978 and just 6 percent in 1968.

Even prime-age women, who flooded into the work force in the 1970s and 1980s, aren’t working at quite the same rate they were when this decade began. About 27 percent of them don’t hold a job today, up from 25 percent in early 2000.

There are only two possible explanations for this bizarre combination of a falling employment rate and a falling unemployment rate. The first is that there has been a big increase in the number of people not working purely by their own choice. You can think of them as the self-unemployed. They include retirees, as well as stay-at-home parents, people caring for aging parents and others doing unpaid work.

If growth in this group were the reason for the confusing statistics, we wouldn’t need to worry. It would be perfectly fair to say that unemployment was historically low.

The second possible explanation — a jump in the number of people who aren’t working, who aren’t actively looking but who would, in fact, like to find a good job — is less comforting. It also appears to be the more accurate explanation.

Various studies have shown that the new nonemployed are not mainly dot-com millionaires or stay-at-home dads. (Men who have dropped out of the labor force actually do less housework on average than working women, according to Harley Frazis and Jay Stewart of the Bureau of Labor Statistics.)

Instead, these nonemployed workers tend to be those who have been left behind by the economic changes of the last generation. Their jobs have been replaced by technology or have gone overseas, and they can no longer find work that pays as well. West Virginia, a mining state, is a great example. It may have a record-low unemployment rate, but it has also had an enormous rise in the number of out-of-work men.

That is, we have seen an increase in the number of "discouraged workers" who no longer are actively looking for work. The unemployment rate is the percentage of the labor force who are unemployed; to be counted in the labor force, one must be working or looking for work. So when an unemployed person gives up looking and drops out of the labor force, the unemployment rate actually falls. An increase in discouraged workers would be reflected in a falling labor force participation rate (% of people over 16 who are in the labor force).

Although by the NBER's reckoning, the last recession ended in November 2001, the labor force participation rate (red line) has not recovered. It also takes an unemployed person longer to find a new job now - the median duration of unemployment spells (blue line) remains above its pre-recession level. On Sunday, the Times' Peter Goodman looked at the weakness of the labor market. The anecdotes in his article are a reminder that the pain that appears modest in aggregate economic statistics is really quite severe for some.

For more on labor force participation, see the links at the end of Mark Thoma's post on Leonhardt's column.

Democrats Should Listen to Robert Reich on Trade

In last week's Democratic debate, Tim Russert, in his customary fashion, pressed Barack Obama and Hillary Clinton on their criticisms of the 1993 North American Free Trade Agreement (NAFTA):

MR. RUSSERT: ..[I]n the debate that Al Gore had with Ross Perot, Al Gore said the following: "If you don't like NAFTA and what it's done, we can get out of it in six months. The president can say to Canada and Mexico, we are out. This has not been a good agreement." Will you as president say we are out of NAFTA in six months?

SEN. CLINTON: I have said that I will renegotiate NAFTA, so obviously, you'd have to say to Canada and Mexico that that's exactly what we're going to do. But you know, in fairness --

MR. RUSSERT: Just because -- maybe Clinton --

SEN. CLINTON: Yes, I am serious.

MR. RUSSERT: You will get out. You will notify Mexico and Canada, NAFTA is gone in six months.

SEN. CLINTON: No, I will say we will opt out of NAFTA unless we renegotiate it, and we renegotiate on terms that are favorable to all of America.

But let's be fair here, Tim. There are lots of parts of New York that have benefitted, just like there are lots of parts of Texas that have benefitted. The problem is in places like upstate New York, places like Youngstown, Toledo, and others throughout Ohio that have not benefitted. And if you look at what I have been saying, it has been consistent....

...But let's talk about what we're going to do. It is not enough just to criticize NAFTA, which I have, and for some years now. I have put forward a very specific plan about what I would do, and it does include telling Canada and Mexico that we will opt out unless we renegotiate the core labor and environmental standards -- not side agreements, but core agreements; that we will enhance the enforcement mechanism; and that we will have a very clear view of how we're going to review NAFTA going forward to make sure it works, and we're going to take out the ability of foreign companies to sue us because of what we do to protect our workers....

MR. RUSSERT: But let me button this up. Absent the change that you're suggesting, you are willing to opt out of NAFTA in six months?

SEN. CLINTON: I'm confident that as president, when I say we will opt out unless we renegotiate, we will be able to renegotiate.

MR. RUSSERT: Senator Obama, you did in 2004 talk to farmers and suggest that NAFTA had been helpful. The Associated Press today ran a story about NAFTA, saying that you have been consistently ambivalent towards the issue. Simple question: Will you, as president, say to Canada and Mexico, "This has not worked for us; we are out"?

SEN. OBAMA: I will make sure that we renegotiate, in the same way that Senator Clinton talked about. And I think actually Senator Clinton's answer on this one is right. I think we should use the hammer of a potential opt-out as leverage to ensure that we actually get labor and environmental standards that are enforced. And that is not what has been happening so far...

The Canadians are not amused. The Canadian Broadcasting Corporation reported:

Prime Minister Stephen Harper issued a friendly warning to Democratic presidential hopefuls south of the border on Thursday, saying it would be a "mistake" for the United States to reopen the North American Free Trade Agreement...

"If any American government ever chose to make the mistake of opening that, we would have something we would want to talk about as well," the prime minister said with a smile, in response to a question from NDP Leader Jack Layton.

He didn't elaborate, but earlier this week, Trade Minister David Emerson and Finance Minister Jim Flaherty said U.S. officials should not forget the benefits of the agreement and hinted Canada could respond to a NAFTA pull-out by renegotiating U.S. access to Canada's oil.

There have been reports that Obama economic advisor Austan Goolsbee has been quietly reassuring the Canadians that he doesn't really mean it... (see also Andrew Leonard's take).

If the Democrats wanted to say something intelligent about trade, they might listen to former labor secretary Robert Reich, who writes:

...It’s a shame the Democratic candidates for president feel they have to make trade – specifically NAFTA – the enemy of blue-collar workers and the putative cause of their difficulties. NAFTA is not to blame. Consider the numbers. When NAFTA took effect, Ohio had 990,000 manufacturing jobs. Two years later, in 1996, it had 1,300,000 manufacturing jobs. The number stayed above a million for the rest of the 1990s. Today, though, there are about 775,000 manufacturing jobs in Ohio. What happened? The economy expanded briskly through the 1990s. Then it crashed in late 2000, and the manufacturing jobs lost in that last recession never came back. They didn’t come back for two reasons: In some cases, employers automated the jobs out of existence, using robots and computers. In other cases, employers shipped the jobs abroad, mostly to China – not to Mexico.

NAFTA has become a symbol for the mounting insecurities felt by blue-collar Americans. While the overall benefits from free trade far exceed the costs, and the winners from trade (including all of us consumers who get cheaper goods and services because of it) far exceed the losers, there’s a big problem: The costs fall disproportionately on the losers -- mostly blue-collar workers who get dumped because their jobs can be done more cheaply by someone abroad who’ll do it for a fraction of the American wage. The losers usually get new jobs eventually but the new jobs are typically in the local service economy and they pay far less than the ones lost.

Even though the winners from free trade could theoretically compensate the losers and still come out ahead, they don’t. America doesn’t have a system for helping job losers find new jobs that pay about the same as the ones they’ve lost – regardless of whether the loss was because of trade or automation. There’s no national retraining system. Unemployment insurance reaches fewer than 40 percent of people who lose their jobs – a smaller percentage than when the unemployment system was designed seventy years ago. We have no national health care system to cover job losers and their families. There's no wage insurance. Nothing. And unless or until America finds a way to help the losers, the backlash against trade is only going to grow.

Reich also has some scoop on Clinton's claim that she privately opposed the deal during her husband's administration.

In any event, hopefully this primary race comes to an end Tuesday. If it continues on to Pennsylvania we may get the unedifying spectacle of Clinton and Obama trying to outdo each other in praise of our "antidumping" rules, which are often applied to protect the steel industry.

The first person I ever voted for was Paul Tsongas; if only were still with us to call out the "Pander Bears", sigh...

Update (3/3): New details emerge on l'affaire Goolsbee. Also, Jagdish Bhagwati believes an Obama administration is the "less disturbing prospect" for trade.

Update #2 (3/5): Willem Buiter weighs in, responding to Bhagwati.

Lin on Institutions and Development

We can count Justin Lin, the new chief economist of the World Bank, among those who believe that institutions are crucial for economic growth. He told the Wall Street Journal:

At the beginning, people put a lot of emphasis on resources, and that’s why we had family-planning policy, not only in China but in other parts of the world. [The thinking was that] The more resources per capita, the wealthier the nation. Later on people thought that natural resources may not be so important, they think that capital and technology are important. Now economists start to understand that for all those things — capital needs to be accumulated, technology needs to be adopted, human capital also needs to be accumulated — you need to understand the incentive, the motivation behind those kind of human choices.

These kind of traditional factors of wealth are just some kind of proximate causes. It’s like you say rich people have a lot of money, but you need to understand why they have a lot of money. Now you need to look into what is the deep cause, the real fundamental cause of development. I think increasingly people now understand that institutions are the most fundamental cause.

Because institutions will shape the incentive structure in an economy, about people’s motivation and willingness to engage in work, lending, accumulation of capital. Now people understand that to understand why a country is performing well or performing poorly, institutions are the key. Fundamentally all economic progress needs to be achieved by people’s effort. We need to understand people’s incentives, and people’s incentives are shaped by the institutions in a country.

Although we recognize institutions’ importance, that institutions matter, from what I see, institutions are an area that requires more research. They are often second-best, they are a choice under a certain kind of constraint. If we do not remove those kinds of constraints, if we want to change the institution, you may jump from the second-best to the third-best. Many interventions did not achieve the intended goal, it’s because they did not really address the cause of those kind of distortions.

It sounds like he is reading his Dani Rodrik, and indeed, Professor Rodrik is pleased.