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: