Emerging economies who thought that they had protected themselves from sudden swings in capital flows by maintaining large reserves and running large external surpluses are discovering that their efforts to reduce their exposure to volatile global capital flows added to their exposure to a global slump in trade.
For quite some time, but in particular since the late 1990s, the world has experienced a chronic shortage of financial assets to store value. The reasons behind this shortage are varied. They include the rise in savings needs by aging populations in Japan and Europe, the fast growth and global integration of high saving economies, the precautionary response of emerging markets to earlier financial crises, and the intertemporal smoothing of commodity producing economies.The immediate consequence of the high demand for store-of-value instruments was a sustained decline in real interest rates. Conventional wisdom blames these low rates on loose monetary policy, but this position is difficult to reconcile with facts from the period of the so-called “Greenspan conundrum’’ – when tightening monetary policy had virtually no impact on long rates. In my view, the solution to the apparent conundrum is that low long rates were driven by the large demand for store-of-value instruments, not short-term monetary policy considerations.
That is, Bernanke's famous "savings glut," with an added tilt towards risk aversion. The "subprime" mess is a result of the attempts of the financial sector to manufacture assets to meet this demand:
Under this perspective, there is a more subtle angle on subprime mortgages than simply being the result of unscrupulous lenders. The world needed more assets and the subprime mortgages were helping to bridge the gap. So far so good.
However, there was one important caveat that would prove crucial later on. The global demand for assets was particularly for very safe assets – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash.
Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets; the market moved to create synthetic AAA instruments. This consisted of pooling subprime mortgages on the asset side of a Structured Investment Vehicle (SIV), and to tranch (slice) the liability side to generate a AAA component buffered by the now ultra volatile “toxic” residual. The latter was then pooled again into Collateralized Debt Obligations (CDOs), tranched again, and then into CDO-squared, and so on. At the end of this iterative process, many new AAA assets were produced out of some very risky subprime mortgages.
In a second column, he argues the financial system is afflicted with "Knightian uncertainty" - the possibility of truly unknowable outcomes, as opposed to standard "risk" where economists and financiers can attach a probability distribution to a set of known outcomes. The appropriate policy solution, therefore, is for the government to step in and take an increased role as an insurer (like it did for Citi): Essentially, the US (and other) financial markets are experiencing the modern version of a systemic run as we had not seen since the Great Depression. It used to be that depositors ran from banks. Some of this still happens, but runs in modern financial markets, to be systemic, have to involve a larger class of assets. A run against explicit and implicit financial insurance is essentially a run against virtually all private sector financial transactions but for those with the shortest maturities. Thus, the modern lender-of-last resort facility has to be a provider of broad insurance, not just deposit insurance. This is what it will take to get us back into a reasonable equilibrium where we can initiate a recovery from a (more) “normal” recession.
We will see if the second round of the TARP and future Fed improvisations incorporate more of an insurance component, which would involve the government taking on more contingent liabilities, rather than spending directly (which might be a way of getting around budget limits imposed by Congress, for better or worse). One thing we can be sure of is that the ballooning deficit means that the federal government will be making plenty of safe assets (Treasury bonds) available.
The recession of the early 1980s doesn’t have a catchy name, and almost half of Americans are too young to have any real memory of it. But it was terrible — qualitatively different from the mild recessions of 1990-91 and 2001.I'd suggest another reason - the reduction in macroeconomic volatility after the mid-1980's (formerly) known as the "great moderation." There were only two recessions between 1982 and the current one, and they were both relatively short and minor, which means that we are much less accustomed to big economic swings now than we were 27 years ago. In 1982, however, the turbulence of the 1970's was still a fresh memory. The "double dip" recessions of 1980 and 1981-82 came only a few years after the severe 1973-75 recession, so perhaps it is not surprising people felt like this:The first big blow to the economy was the 1979 revolution in Iran, which sent oil prices skyrocketing. The bigger blow was a series of sharp interest-rate increases by the Federal Reserve, meant to snap inflation. Home sales plummeted. At their worst, they were 30 percent lower than they are even now (again, adjusted for population size). The industrial Midwest was hardest hit, and the term “Rust Belt” became ubiquitous. Many families fled south and west, helping to create the modern Sun Belt...
So why are public opinion polls showing Americans to be even gloomier about the economy today than they were back then? I think there are two main reasons.
First, the economic expansion that just ended wasn’t as good as the 1970s expansions. The ’70s get a bad rap, and deservedly so in many ways. But median family income still rose 2 percent during the decade, after adjusting for inflation. Over the past decade, it has fallen.
Second, people seem to understand that the worst is yet to come — that the economy has not yet worked off its excesses.
...I have argued that higher education, properly understood, is distinguished by the absence of a direct and designed relationship between its activities and measurable effects in the world.This is a very old idea that has received periodic re-formulations. Here is a statement by the philosopher Michael Oakeshott that may stand as a representative example: “There is an important difference between learning which is concerned with the degree of understanding necessary to practice a skill, and learning which is expressly focused upon an enterprise of understanding and explaining.”
Understanding and explaining what? The answer is understanding and explaining anything as long as the exercise is not performed with the purpose of intervening in the social and political crises of the moment, as long, that is, as the activity is not regarded as instrumental – valued for its contribution to something more important than itself...
This ideal, he says ruefully, is on its way out:
Except in a few private wealthy universities (functioning almost as museums), the splendid and supported irrelevance of humanist inquiry for its own sake is already a thing of the past.He goes on to discuss the argument of a new book, "The Last Professors: The Corporate University and the Fate of the Humanities," by Frank Donoghue. One of the main supporting pieces of evidence is the growing use of adjunct and temporary faculty. That may reflect shifting priorities, but I would partly attribute it to Baumol's cost disease - the relative cost of personally delivered services has tended to rise over time because their productivity growth is slow. That is, the price of professors relative to cars has risen, because the manufacture of cars requires much less labor than it did a generation or two ago, while teaching requires about the same amount of human effort.
I think the broader problem, what Fish describes as a "shift from a model of education centered in an individual professor who delivers insight and inspiration to a model that begins and ends with the imperative to deliver the information and skills necessary to gain employment," is more a consequence of the increasing college wage premium. 
(figure swiped from Goldin and Katz). Because the gap in earnings between those who hold college degrees and those who don't has grown significantly over the past several decades, young adults (and their parents) have come to regard college as a stepping stone - or obstacle - to "success." It is not surprising that they therefore believe that universities should deliver some sort of "useful" job-specific knowledge.
Unfortunately, many people inside the university seem to make the same error. There are several reasons why they are wrong -
The economics argument would be that college is really a signaling mechanism, as Christopher Caldwell explained in the Times:
But the education kids are rewarded for may not be the same education their parents think they are paying for. Economists would say that a college degree is partly a “signaling” device — it shows not that its holder has learned something but rather that he is the kind of person who could learn something. Colleges sort as much as they teach. Even when they don’t increase a worker’s productivity, they help employers find the most productive workers, and a generic kind of productivity can be demonstrated as effectively in medieval-history as in accounting classes.
Another argument, that I have made before, is that liberal education develops broadly applicable skills, like critical thinking and writing.
But Fish's view is the one that I like best, that seeking to understand and interpret the world is an enterprise of intrinsic value. I hope someday the college wage premium will disappear, so we can overcome the confusion about what we are really here for.But the return of cheap gasoline has already dampened hybrid sales. Throughout the show, auto executives emphasized that stable fuel prices, or a coherent government energy policy, would help them anticipate what consumers would buy next. Because of wild swings in fuel prices, “Every six months we get called stupid for having the wrong products,” said Robert A. Lutz, G.M.’s vice chairman.The Post's Steven Mufson writes:“Far be it for me to be the first auto executive to call for a gas tax,” Mr. Lutz said. “But right now, it’s like fighting obesity by requiring clothing manufacturers to make nothing but small sizes.”
Electric cars did generate the show’s central irony: the models that will most impress Detroit’s new overseers in Washington will also drag down the automakers’ bottom lines for several years.
Goodness knows, President-elect Obama has his legislative hands full. Maybe that explains why he has taken the idea of increasing gasoline taxes off the table, saying that Americans had enough economic burdens at the moment. Nominees like Steven Chu, the Nobel Prize winning physicist who will become Energy Secretary, dutifully echoed Obama's view even though in Chu's case he has long supported higher fuel taxes.But by failing to raise the gasoline tax, the president-elect risks complicating another problem: Fixing the U.S. automobile industry.
Here's the problem. Obama and leading members of Congress keep saying they want ailing automakers to make more fuel-efficient vehicles. But the automakers in the past made more money on the guzzlers; in the future, they will have trouble charging enough to make money on new cars using costly new technologies for plug-in or hybrid cars. So the car company of the future may be a money-losing operation, just like the car company of the present.
Raising the gasoline tax would increase consumer demand for more fuel-efficient vehicles. That could help automakers charge more for them and make more money on sales of plug-ins, hybrids or more efficient conventional engines. Not surprisingly, Ford and General Motors both belong to the U.S. Climate Action Partnership, which this week proposed a detailed blueprint for a cap-and-trade system for carbon dioxide emissions. Such a system would put a price on carbon and would effectively tax gasoline and all other fossil fuels.
After being burned last summer by sky-high gasoline prices, do Americans really need higher gasoline taxes to get them to buy fuel-efficient cars? Yes, actually. Americans have an astonishingly short memory about gasoline prices. Sales of the Toyota Prius have hit the skids now that gasoline prices are back below $2 a gallon. And sales of SUVs are relatively strong compared to many other models.
(Hat tip: Mankiw). The principle applies more broadly - the best way to induce investments in "green" technology would be policies that credibly ensure that the price of (non-renewable) energy will rise in the future, like a phased-in carbon tax. Done right, this could even have a positive effect on current investment by creating an incentive to replace inefficient equipment before the higher costs kick in. That is, a (future) tax increase could be a stimulus today... not to mention addressing a problem - global warming - that is ultimately far more serious than the recession.
Politically, it isn't an easy sell, but it should be less difficult now, in the wake of a fall in global energy prices, than it will be once they go back up. Chu's comments were not encouraging, but presumably a climate/energy proposal is in the works that will result, perhaps indirectly, in higher costs for transportation fuel. Still, I worry Matthew Yglesias may be right when he says: "my best guess is that Obama’s climate proposals are too ambitious to be enacted and too timid to avert catastrophe."There's been a lot of grousing lately about the Treasury's $700 billion bailout program, which, according to its many critics, has accomplished nothing other than line the pockets of undeserving bankers and their shareholders.Indeed, Calculated Risk finds that some measures of credit market stress have improved considerably.Maybe I'm missing something, but I don't see how it's possible to rescue the banking system without rescuing banks. That's not because anyone thought banks or bankers were particularly deserving of public charity or even sympathy -- clearly they weren't. But by last summer, with investors, lenders and depositors running for the exits, there was a genuine fear that the banking system could collapse and bring the whole global economy down with it. To prevent that outcome, the Treasury asked for $700 billion that it could use not only to mount rescues of individual institutions, but also to try to get ahead of the crisis by taking proactive steps to shore up the financial system.
Sure, you can question how the money was used -- many of us have -- but you can't quarrel with the fact that a financial meltdown has been avoided as a direct result of the government's extraordinary interventions...
Their estimates are based on a plan of $775 billion, spread over two years, including both spending and tax cuts. Paul Krugman says: Kudos, by the way, to the administration-in-waiting for providing this — it will be a joy to argue policy with an administration that provides comprehensible, honest reports, not case studies in how to lie with statistics.
But the stimulus is not enough:
So this looks like an estimate from the Obama team itself saying — as best as I can figure it out — that the plan would close only around a third of the output gap over the next two years.Here are the CBO's projections of the output gap (the difference between potential and actual GDP), assuming no stimulus:
(The graph is from these charts, which accompany the latest Budget and Economic Outlook)
I agree with Paul that this fiscal boost plan is too small, but I do want to admit that doing this well is harder than it looks. The tax-cut part does not look terribly effective as a stimulus--it is a step toward compensating for higher income inequality and a political play to make it more likely that Republicans will lose politically by trying to block the package rather than a significant boost to employment. Thus I do not think you would want to make the tax-cut part larger. And it is hard to find a lot of additional spending projects that can be ramped up quickly and do a lot of good--relatively soon in that endeavor the short-term fiscal multiplier falls below one. They are trying their best.At Econbrowser, Menzie Chinn notes that, with the output gap expected to last for a while, we shouldn't be so concerned with the "lags" in implementing infrastructure spending (a point also made by Krugman in this column).
The implicit assumption here seems to be that the recovery will be slow, as it was following the 1990-91 and 2001 recessions. In both of those cases the unemployment rate continued to drift upward after the business cycle peak declared by the NBER. 
In terms of magnitude, it looks like we're now in a more serious recession, comparable to 1973-75 and 1981-82. Those recessions had bigger spikes in unemployment, but also much brisker recoveries. Unemployment peaked at 10.8% in December 1982 and fell to 8.3% at the end of 1983 - a decline of 2.5 percentage points in 1 year. The unemployment rate declined 1.6 points from May 1975 (9.0%) to May 1976 (7.4%). In both cases, the recoveries were quicker than what is envisioned by Romer and Bernstein or by the CBO.
It may indeed be that the 'jobless recovery' is the new 'normal' pattern. If the dynamics of earlier recessions were driven by manufacturing firms responding to unintended inventory accumulation, improvements in inventory management and the declining share of manufacturing might help explain the changing pattern. However, part of the reason economies can bounce back quickly (Milton Friedman once compared recessions to plucks of a guitar string) is that idle resources can be put back to work fast. And it looks like we will have no shortage of idle resources this time around.
calls to mind a favorite passage from ch. 3 of Keynes' General Theory: But although the [classical] doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation; - a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. For there would obviously be a natural tendency towards the optimum employment of resources in a Society which was functioning after the manner of the classical postulates. It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away.
The "economists" featured in the Times story are mostly corporate forecasters, and, indeed, Candide-like:
That said, though I haven't hazarded any forecasts, I have also been of the belief that the gloominess has been overdone. My reason for optimism is that we seem to be re-learning our Keynesian lessons quickly (most of us, anyway - there are some exceptions of course) and enough of the madmen in authority are on board that we can expect monetary and (soon) fiscal policy to be conducted with due regard for the principle of effective demand.They base their forecasts on computer models that tend to see the American economy as basically sound, even in the worst of times...
Those models also take as a given that the natural state of a market economy like America’s is a high level of economic activity, and that it will rebound almost reflexively to that high level from a recession...
“Most of our models are structured in a way that the economy is self-righting,” said Nigel Gault, chief domestic economist for IHS Global Insight, a consulting and forecasting firm in Lexington, Mass.
Looks good, but as Brad DeLong pointed out in "Productivity Growth, Convergence and Welfare: Comment," (AER, 1988 [JSTOR]) the finding suffers from a selection problem. All of the countries in the sample are wealthy in 1979, so, of course, if they started out poor, they caught up. As a way around, with limited data, DeLong instead chooses a sample based on the initial level of income in 1870. Doing so adds several countries like Portugal and Argentina, that did not converge.
Some of the nominees at MR have much more cosmic importance, but this case is a good example of how smart people - not just Baumol, but the editors and referees at AER, too - can make mistakes that seem obvious, but only in retrospect after another smart person points them out.
