Encroachment of Ideas

The Treasury's apparent shift towards using its $700 billion war chest for recapitalization instead of asset purchases suggests they are coming around to a view that many academic types have held all along. The Journal reports:

Many economists believed that the heart of the government's initial plan to pay $700 billion for toxic assets was aimed at the wrong target. Purchasing mortgage securities from banks wouldn't do anything to kick-start lending and get credit flowing again, they said. Rather, banks would use the proceeds they got from the Treasury to pay off debtors, and those debtors would use the proceeds to buy safe assets.

They said a wiser course -- the one the Treasury now seems to have come around to -- was for government to rebuild the badly depleted cash levels on bank balance sheets. That would cushion institutions against future losses, giving them the wherewithal to lend again. Other hitches in the original plan include coming up with a price for mortgage securities that is above the "fire sale" level they would draw on the open market, but not so high that taxpayers end up getting taken for a ride.

The Treasury move is a sign of how, as international efforts to contain the crisis continue this weekend at meetings of the International Monetary Fund and World Bank, economists' ideas for solutions are influencing policy and entering the public discourse.

Hat tip (not surprisingly) to Mankiw, who says "score one for the ivory tower."

Near the end of the General Theory, Keynes wrote: "Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back." Perhaps we should make that: "blogger of a few days back."

That's the sentence immediately after the one I cited in this recent post, noting that the Congressional modifications to the proposal included opening the window for an equity component which Paulson is now jumping through (nice work, Senator Dodd).

Here's the quote in context, which closes the General Theory:

At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous, for good or evil.

Keynes continues to be very relevant.

The Failure of Supply-Side Tax Policies

Writing in the Times' Economix blog, Princeton's Uwe Reinhardt makes the case against the argument - now standard boilerplate "supply side" Republican rhetoric - that tax cuts lead to higher investment and GDP:

From a macroeconomic perspective, however, changes in tax rates are but one of many factors that drive the time path of gross domestic product (G.D.P.), savings, investment, employment and other such variables. By itself, changing tax rates steers the economy about as much as would tapping an elephant on the leg with a chopstick. There may be some effect, but typically it is small and dwarfed by other effects.

He provides a chart showing that the share of investment in GDP fell during the Reagan/Bush years (i.e., in the wake of the 1981 tax cuts), rose in the Clinton years (i.e., following the 1993 tax increase), and has fallen again since the 2001 and 2003 tax cuts. A point he doesn't make: this pattern would be consistent with the hypothesis that "crowding out" prevails - i.e., that government borrowing, which ballooned in the Reagan and (to a lesser extent) G.W. Bush administrations, displaces private investment.

Nonetheless, some economists are still apparently on board, as this statement released by the McCain campaign shows. Jonathan Chait writes:

First, 100 economists is not actually all that many, given the number of economists in our country. Second, the list of signatories actually has only 90 economists on it. (Count for yourself.) This trouble with basic arithmetic might explain the McCain campaign's stated beliefs in such fallacies as tax hikes always cause revenues to fall.

Was the campaign unable to find 100 economists? The list certainly does not suggest excessive discrimination about credentials. It's heavily larded with GOP apparatchiks now residing in the right-wing think tank world (my favorite is "economist" George Schultz of the Hoover Institution), as well as two signatories who list their affiliation as "McCain-Palin 2008." The takeaway here is that, even with the most generous standards, the campaign couldn't find 100 economists in the country to badmouth Obama's proposals, let alone endorse their own.

I'd disagree slightly: some of the signatories do actually have pretty strong academic credentials. But we do know that most economists support Obama; I'm sure if his campaign tried, they could gather a more impressive list.

Hmm... back in July, McCain had an endorsement from 300 economists... have 210 of them jumped ship?

Professor Obama

Noam Scheiber says that Barack Obama's experience as a professor gave him the edge in last night's debate:

Obama really benefitted from his years as a law professor. He was fluent and very much at ease walking and talking at the same time. He had a professor's knack for making eye contact and maintaining it while he walked a questioner through a multi-step response. And his answers were much more concrete and intuitive than I'd ever heard them. It's as though it took fielding questions from ordinary people to remind him of this latent professorial talents.

I have found that such talents, unfortunately, do not come automatically with being a professor.

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?