The Econ Bubble Bursts?

At the Atlantic's new Brave New Deal blog, UC Davis' Gregory Clark considers "how the crash is reshaping economics." To paraphrase Keynes, he seems to think economists may become humbled, incompetent people:

[T]he shock to the world of finance has been echoed by a shock to the world of academic economics that is just as profound.

In the long post WWII boom, as free market ideology triumphed, economists have won for themselves a privileged place inside academia.

First there is the cash.... most high ranked economics departments have professors earning in excess of $300,000. Not much by the pornographic standards of finance, but a fat paycheck compared to your average English or Physics professor.

It is not just the stars. Journeyman assistant professors in economics routinely come in at $100,000 or more. And, unlike the hard sciences, they do this fresh from their PhDs, without a publication to their name and without years of low pay as post-docs....

Why did academic economics generate so much prestige? Sure, modern economics is technically demanding. But so, for example, are theoretical physics and archeology, and physics and archeology professors are (relatively) dirt poor.

The technical demands helped limit the supply of economists. But what drove demand was the unquenchable thirst for economists by banks, government agencies, and business schools - the Feds, the Treasury, the IMF, the World Bank, the ECB. Economics had powerful insights to offer the world, insights worth a lot of treasure. Economics was powerful voodoo. Any major university or research institute wanted to arm itself with this potency.

The current recession has revealed the weaknesses in the structures of modern capitalism. But it also revealed as useless the mathematical contortions of academic economics. There is no totemic power. This for two reasons:

(1) Almost no-one predicted the world wide downtown. Academic economists were confident that episodes like the Great Depression had been confined to the dust bins of history. There was indeed much recent debate about the sources of "The Great Moderation" in modern economies, the declining significance of business cycles...

(2) The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.

The bailout debate has also been conducted in terms that would be quite familiar to economists in the 1920s and 1930s. There has essentially been no advance in our knowledge in 80 years.

Well, 73 years... but it is striking how much of the discussion of our current troubles revolves around the textbook Keynesian framework we teach our principles students. While that raises the question of what, exactly, we've been doing since the General Theory (and why anyone is paying us to do it), I'm not convinced its entirely a bad thing for us economists. Introductory economics is, to a large extent, our public face - far more people take intro economics than read academic journals. While Clark may be right that this crisis provokes doubt about the value of some of our research, outside the profession we are not judged by the contents of Econometrica.

I'm actually somewhat heartened that what we teach in macro principles seems more relevant than ever, and the crisis is increasing interest in the subject (one might say we're naturally hedged). I'd like to think many of our past students are coming belatedly to a realization that they learned some very helpful tools for understanding the world in Econ 1 (Econ 202 here - apparently we have a higher rate of course-number inflation than Davis). While it is too late for them to revise their course evaluations, former students certainly could dash off a note to the Dean describing their increased appreciation of their Econ professors...

So, I'm not as gloomy as Clark about the demand for our services, but I do think some self-criticism is in order. Another striking feature of the crisis has been that we find ourselves talking about Keynes more than ever, and names like Irving Fisher and Frank Knight are popping up with increasing frequency. One salutary outcome of this bout of navel-gazing would be more attention to the history of economic thought, which I have urged previously.

But who am I to say? Apparently I haven't even attained "Journeyman" status yet...

Geithner Looking Pretty Good

The Japanese finance minister apparently had a little too much, uh, cold medicine before a press conference at the G-7 confab in Rome:


Wow. The Journal reports:

Japanese Finance Minister Shoichi Nakagawa said Tuesday that he will resign from his post after passage of various budget bills.

"To take responsibility for the trouble I caused (at the Group of Seven press conference), I'd like to submit my resignation after passage of budget bills," he said at a press conference....

Takeo Kawamura, chief cabinet secretary, said at a news conference he understood Mr. Nakagawa's behavior was caused by taking too much cold medicine. But he added: "It wouldn't be true if we said he didn't drink any alcohol."

Irving Fisher!

The financial crisis and recession have renewed interest in Irving Fisher's "debt deflation" theory, a scary portent indeed.... At Vox, Enrique Mendoza offers "Crisis Lessons from Irving Fisher," and he gets a profile in The Economist:

[Fisher] described debt deflation as a sequence of distress-selling, falling asset prices, rising real interest rates, more distress-selling, falling velocity, declining net worth, rising bankruptcies, bank runs, curtailment of credit, dumping of assets by banks, growing distrust and hoarding.

So, is the "Minsky Moment" to be followed by an "Irving Fisher Interlude"? We can count on Ben Bernanke, whose own academic work on the "financial accelerator" follows in Fisher's footsteps, to continue to use all the tools he has - and all that he can dream up - to make sure it isn't.

Update: Krugman is also thinking about Fisher.

Capitalism With Chinese Characteristics

The conventional view of China is one of a country undergoing a continual process of "reform" and economic growth. I've just read Yasheng Huang's new book, "Capitalism With Chinese Characteristics," which is a useful corrective to the standard picture.

Huang argues that China's growth in the 1980s was based on liberalization which allowed entrepreneurial capitalism to develop in rural areas. In the 1990s, however, China turned in the direction of state-directed urban-biased development. While GDP has continued to grow impressively, living standards have lagged (for example, illiteracy has risen). 1990s China was less favorable to private business, and much more prone to corruption. Huang argues that China's development path has taken a turn more akin to Latin America than the East Asian success stories like South Korea.

In chapter four, "What is Wrong with Shanghai?" he writes:

Being urban in this book does not just refer to a geographic characteristic; it is also an ideology. At the political and economic levels, urban China represents the strong hand of the state, a heavy interventionist approach toward economic development, an industrial policy mentality, and an aversion to the messy and often unsightly processes of a free market and low-tech entrepreneurial activities.... Rural entrepreneurship reflects the extent of urban controls. It thrives when urban controls are loose and it languishes when urban controls are tight. Shanghai is the consummate urban China in the sense that it has almost completely emaciated its rural entrepreneurship.

Although visitors are impressed by the skyscrapers and trains, Huang argues that India's "soft infrastructures" are ultimately more important:

The most important implication from an Indian miracle in the making is the importance of what I call "soft infrastructures" to understand economic growth. Soft infrastructures, such as rule of law, financial institutions, and China's directional liberalism in the 1980s, matter more for growth than the massive investments in hard infrastructures.

Here is The Economist's review.

The Twenty-Four Days

Headline in the Washington Post:and yet, we learn just below, it may not be enough.

Zombies: First, We'll Try to Outrun Them

The (sketch of a) plan unveiled by Treasury Secretary Geithner last week left many unimpressed. The main line of criticism is that many of the large banks are insolvent, if their assets are valued at market prices, and that the US should bite the bullet now with a more decisive intervention (e.g., nationalization). Failure to do so means that the economy will be burdened, Japanese-style, by a "zombie" banking sector that does not supply the credit the economy needs.

There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what's called "The Lost Decade." They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn't see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again.

That's, um... President Obama... (via Felix Salmon) who went on to explain why we won't be following the Swedish model:

So you'd think looking at it, Sweden looks like a good model. Here's the problem; Sweden had like five banks. [LAUGHS] We've got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would -- our assessment was that it wouldn't make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America's different. And we want to retain a strong sense of that private capital fulfilling the core -- core investment needs of this country.

And so, what we've tried to do is to apply some of the tough love that's going to be necessary, but do it in a way that's also recognizing we've got big private capital markets and ultimately that's going to be the key to getting credit flowing again.

Matthew Richardson and Nouriel Roubini make the case for nationalization in a Washington Post op-ed, concluding: "We have used all our bullets, and the boogeyman is still coming. Let's pull out the bazooka and be done with it." At Naked Capitalism, Yves Smith has scathing assessment of Geithner's plan (Mussolini, really?!).

However, the banking sector has come through periods of crisis before, without such drastic measures, and without dragging down the economy. This useful analysis by the Times discusses that alternative:

Raghuram G. Rajan, a professor of finance and an economist at the University of Chicago graduate business school, draws the distinction between “liquidation values” and those of calmer times, or “going concern values.” In a troubled time for banks, Mr. Rajan said, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.

“If they had to sell these securities today, the losses would be far beyond their capital at this point,” he said. “But if the prices of these assets will recover over the next year or so, if they don’t have to sell at distress prices, the banks could have a new lease on life by giving them some time.”

That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before.

In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system.

Brad DeLong has some pithy notes on the Geithner plan. Apparently, that screaming CNBC guy likes it (Alexander Hamilton, really?!).

While the Japanese experience has useful lessons, Dean Baker reminds us of some important differences:

[B]anks play a much less central role in providing capital in the U.S. economy. For example, most mortgages are financed through securitized mortgage pools. The same is true of car loans and other types of consumer debt. Large corporations typically obtain short-term capital by selling commercial paper on the market. The Fed and Treasury have taken steps to ensure that this route of obtaining capital is open, which means that the problems of the banks will have less consequence for the U.S. economy than was the case for Japan.

Update: See also Joe Nocera, who is pro-nationalization.
Update #2: Krugman, too.

Senator Collins: Tough on Schools

The need to get over the 60-vote hurdle in the Senate has yielded a compromise stimulus bill that keeps the alternative minimum tax patch (relatively ineffective) added by the Senate, while reducing two effective measures from the House version: aid to states and school construction funding.

It is a sad irony that all the rhetoric decrying government waste will result in cuts in services that had already met the test of being decided worthy priorities by state governments. Furthermore, though critics of the original bill posed as defenders of future generations, the reduction in investment in education today will mean a less productive economy in the future.

But Senator Collins made a point:

Two major sticking points heading into final negotiations were the increased Medicaid payments to states and nearly $20 billion in school construction funding, both top priorities for House Democrats and the White House. But Collins, in particular, opposed creating a separate federal program for school construction, and the Senate bill she helped negotiate included no school-construction provision.

Instead, Senate Republicans agreed to increase a general state fund to $54 billion, a portion of which could be spent rebuilding schools. "We hung tough," Collins said.

That's up from $39 billion in the Senate bill, but down from $79 billion, plus $20 billion separately for school construction in the House bill. That's bad for the economy, but Senator Collins knows that such "Hangin' Tough" makes her a winner in Washington - nobody would mistake her for a new kid on the block.

Spending and the Great Depression

The stimulus debate has revealed some misunderstanding about the Great Depression, e.g.:

When Roosevelt did this, he put our country into a Great Depression. ... He tried to borrow and spend, he tried to use the Keynesian approach, and our country ended up in a Great Depression. That's just history. - US Rep. Steve Austria (R-OH)

A timely, useful corrective is supplied by Washington Post's Steven Mufson, who asked some economists:

But most mainstream economists say the lessons of the Depression, which didn't end until World War II spending kicked in, are different. They say New Deal spending programs instituted by President Franklin D. Roosevelt -- combined with moves to bolster the banking system, loosen monetary policy and end the gold standard -- did help put millions of people back to work. At the same time, they say that federal spending increases under Roosevelt before the war were modest compared with the size of the economy, and not a good test of stimulus spending.

Update (2/13): Bruce Bartlett offers an economically and historically literate conservative's interpretation of the lessons of the New Deal.

DeLong on "The Keynesian Escape Route"

It is a sad irony that some of the most shrill and ignorant critics of the fiscal stimulus bill seem to think it represents some kind of creeping Communism. It was such Keynesian policies that preserved the capitalist system from the more extreme alternatives that seemed to be on the march in the interwar period. In "Economic Possibilities for our Grandchildren" (1930) Keynes wrote:

I predict that both of the two opposed errors of pessimism which now make so much noise in the world will be proved wrong in our own time‑the pessimism of the revolutionaries who think that things are so bad that nothing can save us but violent change, and the pessimism of the reactionaries who consider the balance of our economic and social life so precarious that we must risk no experiments.

Brad DeLong explains how Keynesian policies helped prove their pessimism wrong:

The end in the Great Depression of laissez faire--the idea that the government should keep its hands off of the economy--as a doctrine for guiding economic policy did not mean the end of the market economy as a social resource allocation mechanism. "Keynesianism" and the doctrine of the "mixed economy" that it supported emerged in the nick of time, soon became the ruling ideologies in the industrial core of the world economy, and provided North America and western Europe with a Keynesian escape route from what had seemed the insoluble crises of the interwar period.

The Keynesian escape route opened up key ground in the middle between fascist-style regimentation and socialist-style national planning. Keynes argued that the market economy and capitalist order could be salvaged, and salvaged by relatively minor reforms. An activist welfare-state government with a commitment to full employment had the tools to eliminate Great Depressions, and could put economies back onto the road to Utopia. If only governments would reduce interest rates to get private agents or would themselves spend money freely (without raising taxes) in times when total demand was low, and raise interest rates to reduce private spending and themselves raise taxes (without raising spending) in times when total demand was high, then fiuctuations in employment and production could be greatly reduced, and Great Depressions avoided.

Belief in this escape route was strongly reinforced by facts. Those countries that had tried it by accident during the Depression--had infiated early, printed money, ensured low interest rates, and run large budget deficits--managed to survive the Depression much more easily than others. World War II provided final proof, were any necessary--"vindication by Mars," as John Kenneth Galbraith calls it. That component of unemployment, called "structural" or "permanent" during the 1930s, that was seemingly-immune to both the self-adjusting forces of the market and the armament of the New Deal vanished entirely in the 1940s as the federal budget deficit approached and then exceeded the levels that had long been recommended by John Maynard Keynes. And the United States fought World War II without reducing civilian consumption: all of U.S. war production came from new capacity or from capacity that stood idle at the end of the 1930s.

Demand expansion--deliberate attempts by governments to put the unemployed back to work by deficit spending and loose-money low interest rate policies--was successful in the 1930s and 1940s. It put the unemployed back to work. It did not contain within itself the seeds of a renewed Great Depression. It did not explode into hyperinflation. The coming of "stablization policy" enlarged the policy steps that could be undertaken without forcing a definitive break with the market-capitalist order, and without forcing a choice between Hitler's way and Stalin's.

New Banks?

The Obama administration is due to announce tomorrow what it will do with the second half of the the $700 bn financial sector rescue pot (a.k.a. the TARP). Rather than continuing to put more money into our troubled banks, Paul Romer and Willem Buiter argue for starting new ones. Romer says:

The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage. Right out of the gate, the newly created banks could do what the Fed has already been doing -- buying pools of loans originated by existing banks that meet high underwriting standards.

And:

The brewing backlash against the existing players from the financial sector is almost certain to burn hotter as the recession wears on, and new election campaigns get underway. If the new administration ties its fate to the existing players, it could lose its room to maneuver on countercyclical policy and be put under political pressure to intervene in bank decisions in ever more intrusive ways.

Because they can and will borrow, new banks will be much more effective in leveraging TARP funds. They will undertake more total lending, bring more trading to financial markets, and do more to limit the depth of the recession. As a result, investing the TARP funds in new banks will do more to help the troubled but potentially viable existing banks than giving funds directly to them.

Banks that are not viable, the ones with liabilities that substantially exceed their assets, will lobby vociferously against a return to historical patterns of bank regulation. They will say anything to postpone a looming FDIC takeover. The administration should not listen to threats and pleas from these doomed banks. It does not have to rely on them to get new lending going quickly and on a large scale. New entrants could give us a few good banks. That, plus an FDIC that can do its job, is all we need.

Update: A counterargument from Felix Salmon.