Furnish an Elastic Currency

One of the main reasons for establishing the Fed was to create a "lender of last resort." The Federal Reserve Act passed in 1913:

To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

Over time, this function of the Fed has receded into the background, but it is now again front and center, as the Fed continues to step up its lending activity, and is now even planning to buy commerical paper. Econbrowser offers an excellent summary of the action, so far, on the Fed's balance sheet.

On the Times' new economics blog, David Leonhardt has praise for Bernanke.

The Economist Asks Some Economists

The Economist has surveyed economists' opinions about McCain and Obama. The results are overwhelmingly in Obama's favor:They didn't just ask any economists - the survey was sent to 683 NBER research associates, an elite subset of academic economists, of which 142 responded. A somewhat broader sample of American Economic Association members (a less elite group - even I am in it) surveyed by Scott Adams also favored Obama, though less overwhelmingly (see this earlier post).

Bailout: Gone With the Windbags?

In reading CBO Director Peter Orszag's useful statement to the House Budget Committee about the bailout, I notice that the official name of the thing is the Troubled Asset Relief Act. Yes, its called TARA (a tribute to Ben Bernanke's southern roots, perhaps?).

And now, it looks like the House Republicans are burning down Tara. Don't they realize that some people still haven't gotten over the last time?

Paul Krugman and Steven Pearlstein gallantly defend Tara, but is it a lost cause? Hopefully things won't get this bad:Update (9/29): In its latest incarnation, the bill is the Emergency Economic Stabilization Act of 2008, which establishes a "Troubled Assets Relief Program" or TARP.

Some Rough Bailout Arithmetic

Large numbers are being thrown around, which is confusing....

So, if the government borrows $700 billion for the bailout, let's say at 4.25% interest (a rate currently between the 10- and 30-year Treasury yield), taxpayers are on the hook for about $30 billion per year in interest. That adds roughly 1.1% to total federal spending, and is about $100 per person per year.

The bailout shouldn't actually cost $700 billion - the Treasury will be buying assets that are presumably worth something. Exactly how much they will ultimately be worth is a matter of great uncertainty, and we don't know yet how exactly, in practice, the Treasury will determine what it is willing to pay (i.e., how hard it will try to get a good deal). So, the $700 billion is an upper bound on the cost (unless, of course, they ask for more....).

That is about 5% of GDP. If we guesstimate (conservatively, I hope) that the full $700 billion is spent, and the Treasury loses 50%, we're talking 2.5% of GDP. So, the question is: in the absence of a bailout, would the additional, credit crunch-induced loss of output be larger than 2.5% of a year's GDP?

Palin on the Bailout, et cetera

As a professor, I have some empathy for those who babble incoherently in front of a visibly skeptical, irritated audience. But I don't think my students have ever had it quite as bad as Katie Couric does here, when she asks Sarah Palin about the bailout:
Hat tip to Ezra Klein, who says: "The question was simple. The answer came from some dreamscape I've never visited."

Modified, Limited Bailout

The Journal's Real Time Economics has the "agreement on principles" from the Congressional negotiations over the bailout package.

Under the heading of "taxpayer protection" it calls for "equity sharing," a suggestion that has percolated through the economics blogosphere (see previous post). Keynes once said "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist." Perhaps now economists don't need to be defunct, just have a web site....

The Congress also wants limits on executive compensation and efforts to facilitate mortgage restructuring instead of foreclosures. They also are only willing to make $250 billion available immediately (though $700 billion remains "authorized").

Via Mankiw, a defense of the Paulson plan. Willem Buiter says its "a useful first step," and he's not a fan of the changes apparently being made by Congress.

In the Washington Post, James Galbraith argues for using the traditional mechanisms for protecting the banking sector instead.

Meanwhile Post columnist David Ignatius is asking the right question: WWJMKD?

What Is To Be Done?

Throw money at it, apparently. The Times reports on the bailout plan. The proposed text of the legislation says:

The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

Sure sounds like blank check.

Ever-snarky Willem Buiter dubs it the TAD (Toxic Asset Dump), but he does have some constructive suggestions on making it work, including:

The price at which the illiquid assets will be acquired by the TAD will be crucial for its effect on future bank behaviour. Prices should be higher than what the banks that own these assets now can obtain in the market, but as far below their fundamental value as is consistent with the survival of these banks. This is both to protect the tax payer and to create the right incentives for future risk taking by the banks. Punitive pricing is therefore essential. If the banks and their shareholders don’t complain loudly about expropriation through under-pricing, then prices are too high.

Since those managing the agency are unlikely to have much of a clue about the fundamental value of these illiquid assets, the TAD should arrange reverse auctions as price discovery mechanism. I recommend a reverse Dutch auction as a particularly effective mechanism to transfer value from the banks to the tax payers.

Paul Krugman, who has generally been a Bernanke-booster, is dubious:

Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

Some are floating an alternative aproach, which would involve the government making equity investments in banks. The Washington Post's Sebastian Mallaby writes:

Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into a bad-loan bazaar and being ripped off by every merchant.

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks' bad loans but by buying equity stakes in the banks themselves. Whereas it's horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Krugman comes to a similar conclusion. Here is Calomiris' FT piece.

Also, Peter Baker profiles Paulson and Bernanke: could the "'The Hammer' and 'Helicopter Ben'" be buddy movie?

Who Is To Blame?

The present financial crisis has prompted widespread recognition of the need for better regulation of the financial system. Even the Republican nominee is currently claiming to be for it (before, he was against it). "Modern History's Greatest Regulatory Failure," says Clinton-era Treasury official Roger Altman. While excessive zeal for deregulation is a prototypically Republican failing, it should be noted the Clinton administration was hardly immune to the zeitgeist, as this example from John Judis of the New Republic reminds us (though David Blake pins the blame on a certain Rand-ite erstwhile Fed "Maestro"). Enough to go around, I suppose.

Survey Says

Economists prefer Obama, by a wide margin:

Overall, 59 percent of our economists say Obama would be best for the economy long term, with 31 percent picking McCain, and 8 percent saying there would be no difference.

That's according to Scott "Dilbert" Adams, who commissioned a survey of over 500 American Economic Association members. No word on who economists thought would be best for the economy short term (since in the long run, we're all dead, of course). Hat tip: Mankiw.

Textbook Case of Market Failure

An interesting feature from the Times on the proliferation of free, on-line textbooks:

SQUINT hard, and textbook publishers can look a lot like drug makers. They both make money from doing obvious good — healing, educating — and they both have customers who may be willing to sacrifice their last pennies to buy what these companies are selling.

It is that fact that can suddenly turn the good guys into bad guys, especially when the prices they charge are compared with generic drugs or ordinary books. A final similarity, in the words of R. Preston McAfee, an economics professor at Cal Tech, is that both textbook publishers and drug makers benefit from the problem of “moral hazards” — that is, the doctor who prescribes medication and the professor who requires a textbook don’t have to bear the cost and thus usually don’t think twice about it.

“The person who pays for the book, the parent or the student, doesn’t choose it,” he said. “There is this sort of creep. It’s always O.K. to add $5.”

In protest of what he says are textbooks’ intolerably high prices — and the dumbing down of their content to appeal to the widest possible market — Professor McAfee has put his introductory economics textbook online free. He says he most likely could have earned a $100,000 advance on the book had he gone the traditional publishing route, and it would have had a list price approaching $200.

“This market is not working very well — except for the shareholders in the textbook publishers,” he said. “We have lots of knowledge, but we are not getting it out.”

He's right. I have moved away from using a textbook for macro principles and I sometimes fantasize about ditching them altogether.

It is not clear what Prof. McAfee himself is maximizing; his behavior seems to be maximizing social rather than personal welfare... He is acting suspiciously like the "social planner" we periodically encounter in economic theory. And not for the first time - see this earlier post on his attempt to fix the academic publishing process.