Tuesday, September 30, 2008

A Loan Interview

Is deregulation to blame?

Hold on to your seats

The VIX index, shown above, uses options prices to measure expected stock market volatility over the next 30 days. It closed yesterday at an extraordinarily high 46.72. Meanwhile, the TED spread, the difference between the interest rates on inter-bank loans and T-bills, stands at an extraordinarily high 325 basis points, suggesting heightened anxiety about bank defaults.

Warren Buffett has said, "you should get greedy when others are fearful and fearful when others are greedy." If he is right, then this is the time to get greedy. There is no doubt that most everyone else is fearful.

Monday, September 29, 2008

Plan B

Bloomberg reports:
The Federal Reserve will pump an additional $630 billion into the global financial system, flooding banks with cash to alleviate the worst banking crisis since the Great Depression....The Fed's expansion of liquidity, the biggest since credit markets seized up last year, came hours before the U.S. House of Representatives rejected a $700 billion bailout for the financial industry.

More Commentary on the Financial Mess

Palin for President: Two Versions

Physics 101

From a freshman physics quiz given at Princeton a few days ago:

Problem 1. A famous thought experiment in economics involves dealing with a financial crisis by dropping money from a helicopter.

Ben Bernanke, Federal Reserve Chairman and former Princeton Economics Professor, decides to try this out over his old hometown. With his helicopter flying 1.0×10^1 m above the center of Fine Tower and in the direction of Nassau Hall, Ben gently releases a briefcase containing $1 million. Using the information that (i) Fine Tower is 6.0 × 10^1 m high, (ii) Nassau Hall is 1.5 × 10^1 m high and (iii) the centers of the two buildings are 3.0 × 10^2 m apart, and ignoring air resistance as you normally would:

a. [2 pts] How fast should Ben’s helicopter fly so that the briefcase lands in the center of the roof of Nassau Hall?

b. [1 pt] How long is the briefcase in the air?

c. [1 pt] How fast is the briefcase moving when it hits the roof of Nassau Hall?

d. [1 pt] How much faster would the financial relief have reached Nassau Hall if the briefcase had contained $2 million instead?

Thanks to Princeton Professor Shivaji Sondhi for sending this along.

Put your Mortgage-Backed Securities here

Spotted at National Airport, presumably on its way to the Treasury Department.

Thanks to the former student who sent this in.

Sunday, September 28, 2008

Economics Teaching Conference

I will be speaking at the 4th Annual Economics Teaching Conference run by the Gulf Coast Economics Association. It will be held November 6 and 7, 2008, in San Antonio, Texas.

If you are interested in attending, sign up here.

Advice on Course Selection

For Harvard students, from the Harvard Hooligans.

A Note of Optimism

From a new blog by University of Chicago economist Casey Mulligan:

In order to find good predictors of non-financial sector performance, and GDP growth generally, we look to the non-financial sector itself. One of those predictors is the profitability of non-financial capital, or the “marginal product of capital” as we economists call it. The marginal product of capital after-tax is a measure of how much profit (revenue net of variable costs and taxes) that each unit of capital is producing during, say, the last year. When the marginal product of capital after-tax is above average, subsequent rates of economic growth (and subsequent marginal products of capital) also tend to be above average.

Since World War II, the marginal product of capital after-tax averaged between 7 and 8 percent per year. During 2007 and the first half of 2008 – exactly the time when financial markets had been spooked by oil price spikes and housing price crashes – the marginal product had been over 10 percent per year: far above the historical average. Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929. The marginal product of capital was also below average prior to the 1982 recession (in this case, far below average) and prior to the 2001 recession. Thus, the surprise was not that GDP continued to grow 2007-8 despite the bleak outlook from Wall Street’s corner of the world, but that GDP growth failed to be significantly above the average. More important from today’s perspective is that much capital in America continues to be productive, and that this will likely permit Americans to advance their living standards as they have in years past. The non-financial sector today looks nothing like it did in 1930.

Saturday, September 27, 2008

A Sign of the Times

I presume this store is now sticking to Hair, Nails, and Gifts.

Thanks to the reader who sent this in.

Distorting History

In the debate last night, Barack Obama asked a good question about the present financial crisis but then gave an answer that was, at best, incomplete:

The question, I think, that we have to ask ourselves is, how did we get into this situation in the first place? Two years ago, I warned that, because of the subprime lending mess, because of the lax regulation, that we were potentially going to have a problem and tried to stop some of the abuses in mortgages that were taking place at the time....we're also going to have to look at, how is it that we shredded so many regulations? We did not set up a 21st-century regulatory framework to deal with these problems. And that in part has to do with an economic philosophy that says that regulation is always bad.
The main problem, we are led to believe, was a Republican ideology of unfettered capitalism that led to insufficient government involvement in the financial system.

Senator Obama might want to read this NY Times article from 1999:
In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders....Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.
I am not suggesting that the entire crisis should be put in the lap of the Clinton team. There is plenty of blame to go around. Indeed, the problem goes back at least as far as the Johnson administration, which helped set up a housing finance system that was always fundamentally flawed.

If Senator Obama really wants to transcend partisan politics, as he would sometimes have us believe, he might want to give a slightly more balanced view of the history of how this all started. He also might want to take note that the Bush administration warned about some of these problems five years ago and had its reform efforts stymied by prominent members of Senator Obama's own party.

Update: Here is a related news video.

Did anyone say "capital flight"?

This is worrisome:

China banks told to halt lending to US banks

Chinese regulators have told domestic banks to stop interbank lending to U.S. financial institutions to prevent possible losses during the financial crisis, the South China Morning Post reported on Thursday.

The Hong Kong newspaper cited unidentified industry sources as saying the instruction from the China Banking Regulatory Commission (CBRC) applied to interbank lending of all currencies to U.S. banks but not to banks from other countries.

"The decree appears to be Beijing's first attempt to erect defences against the deepening U.S. financial meltdown, after the mainland's major lenders reported billions of U.S. dollars in exposure to the credit crisis," the SCMP said.

Update: Another news report contradicts this one.

Friday, September 26, 2008

The Case against the Paulson Plan

An email from University of Chicago economist Robert Shimer:

Dear Greg:

I read your blog post "If I were a member of Congress..." Although I did not write the letter mentioned in the post (most of the credit should go to Luigi Zingales and Paola Sapienza), I signed it, asked other people to sign it, and discussed with them why I opposed the Paulson plan. I thought I would take your bait and explain my reasoning.

Before doing so, let me be clear that I agree with your comments about Ben Bernanke. I too know him well from the seven years I spent with him on the faculty at Princeton and I share your respect for his intelligence. I also recognize that he is far better informed about the current situation than I am. This does not, however, mean that he is perfectly informed. Indeed, looking back over the last 13 months, it should be clear that the Fed and Treasury have repeatedly underestimated the extent of the problem. In such an environment, the distributed knowledge of professional economists and other imperfectly-informed observers may be superior to the knowledge of the Fed staff. In other words, you write, "In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could." That may be correct, but I am not convinced that he understands the situation better than the collective wisdom of all professors.

Next, let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues, not necessarily the opinion of other signatories of the letter. As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.

When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong
incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information this makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.

With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.

This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. (Of course, it cannot increase too much, or no one would sell to the government. They would wait to sell at the higher market price. I have not worked out the equilibrium of an auction with an option to resell later. It seems complicated.) But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.

The government does have one way tool at its disposal that would allow it to directly address the lemons problem. The clear advantage that a government has over the private sector is its ability to force individuals to participate in mechanisms that cross-subsidize other participants. This ability to coerce can be critical in markets with adverse selection. In this instance, the government could force all financial service firms to raise capital, as proposed by my colleagues Douglas Diamond, Steve Kaplan, Anil Kashyap, Raghuram Rajan, and Richard Thaler in today's Wall Street Journal Asia. This mandate would eliminate the lemons problem. Along the way, the scrutiny from potential buyers might help uncover which firms are in fact insolvent.

Other types of coercion might have similar effects, but superficially seem less appealing. For example, the government could force all owners of MBS to sell them to the government at the expected hold-to-maturity price. This would again be a subsidy to the owners of bad MBS, but now at the expense of the owners of good MBS rather than the taxpayer. Since there is no currently no market for those securities, it is conceivable that everyone would gain from the increase in liquidity. Still,I would imagine that the unforeseen costs of such an extraordinary action would outweigh its benefits and I suspect that market participants would agree.

What else can the government do? First, it can establish stable rules and play by them. Holding out the possibility of distributing vast sums of money in an unspecified manner does not help market participants value the securities or value the firms. Second, it can prevent panics, i.e. Diamond-Dybvig bank runs. This is what it did when it offered insurance for money market mutual funds, an important source of funding in the commercial paper market. So far, that market appears to be holding up. Third, it can reduce the risk that its current actions encourage future misbehavior. We have already seen evidence of moral hazard in these markets, for example in AIG's decision to turn down a $8 billion offer from J.C. Flowers during the weekend before AIG collapsed.

In closing, let me mention one other issue that I take very seriously. I recognize that this might not matter much to my Congressman, but in my view it may be the most important issue for global welfare. The U.S. has long been a beacon of free markets. When economic conditions turn sour in Argentina or Indonesia, we give very clear instructions on what to do: balance the budget, cut government employment, maintain free trade and the rule of law, and do not prop up failing enterprises. Opponents of free markets argue that this advice benefits international financiers, not the domestic market. I have always believed (at least since I began to understand economics) that the U.S. approach was correct. But when the U.S. ignores its own advice in this situation, it reduces the credibility of this stance. Rewriting the rules of the game at this stage will therefore have serious ramifications not only for people in this country but for the future of global capitalism. The social cost of that is far, far greater than $700 billion.

I have gone on too long, but I strongly believe that this is an issue where the input of outsiders like myself is useful. Feel free to post this if you see fit.

All the best,

Robert Shimer

Thanks, Rob, for sharing your views.

The Dark Bailout

If I were a member of Congress...

An economics professor I know who teaches at a leading business school (who prefers anonymity, as he is still untenured) sends me a critique of our profession and a plea:

Dear Greg,

This is a strange email, but these are strange times.

I saw that your name was absent from the Shimer/Kashyap/etc initiated "letter" to the speaker and senate pro tempore. I don't know if that is reflective of your view about the appropriate course of action or not. But as a person with a very large microphone at your disposal I wanted to share the following, which is informed by my experience in the private sector prior to graduate school.

Let me preface this by saying that my personal view is that Ben Bernanke and Hank Paulson are very, very smart people who have better information than anyone who signed that letter, and that questioning their view to the point where it is used by senators to justify inaction is reckless at best--and ideologically driven white-anting at worst.

But I digress. A LOT of payrolls get paid at the end of the month. The next for many companies is September 30. Three different people with hugely relevant knowledge said to me today words to the effect of: "Why don't your economist buddies want [insert fortune 100 company/companies here] to be able to pay their employees on Tuesday. If Washington doesn't do something now, they won't be able to". That just scared the hell out of me. I can go into more details if you like, but all of them involve the four horsemen of the apocalypse.

As I say, I don't know what your view is. And if it is that the problems with the "bailout" exceed the benefits then I obviously respect that.

But I am terrified about the consequences of inaction--and our profession seems to be advocating just that. If you do favor action then please avail yourself of your microphone. If not, free disposal!


[name withheld]

What is my opinion about all this? I am of two minds about the complex situation we find ourselves in.

On the one hand, I share many of the concerns of the letter signers and other critics of the Treasury plan.

On the other hand, I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs and editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.

More Commentary on the Financial Mess

The Problem with Warrants

David Leonhardt responds to my smart friend on the topic of whether the Treasury should get an equity stake as part of the deal when purchasing assets from banks. This could occur, for example, by including warrants (options to buy the bank stock) as a piece of the package, as Warren Buffett did in his deal with Goldman Sachs. The essence of David's view:
By taking an ownership stake in the firms, the government can minimize the consequences of overpaying for the assets. It would own a piece of the very company that was benefited from the overpayment.
There is, however, a significant problem with the warrant idea: It makes designing the auction to get the price right much harder.

Suppose that several banks own a particular type of mortgage-backed security. As I understand it, the Treasury would run a reverse auction to find which bank would sell the MBS at the lowest price. Competition among sellers should drive the price close to the actual value of the asset as judged by the banks.

But if each bank is required to sell the MBS together with a warrant on the bank's stock, then the items being sold are no longer comparable. A warrant on one bank does not have the same value as a warrant on another. How then can you run a competitive auction to find which bank is offering the best deal?

I suppose Treasury could hire option pricing experts to net out the value of the warrant from the price of the package to find the net price of the MBS. But doing so would certainly add noise to the process and make it harder for Treasury's auction experts to make sure the taxpayers is getting the best price for the securities it is buying.

Warren Buffett did not need to worry about this problem. He set the price for his position in Goldman based on his expert judgment, not an auction. But Treasury needs to find a more objective mechanism for setting prices of the things it buys. Auctions are precisely that mechanism, but they would do their job less well if an equity stake in each company is part of the deal.

Update: David's response.

Thursday, September 25, 2008

A Defense of the Paulson Plan

The Treasury proposal to rescue the financial system has gotten a lot of grief lately, especially from the community of economics professors. A smart friend, who knows more about this topic than I do, emails me his response to the critics:

Academic economists don't like the Treasury plan, but nearly all of the Wall Street economists are for it. You don't have to be all that cynical to say that the Wall Street economists are talking their book. But I'd like to think that there is at least in part a sense in which they are more attuned to the reality of the situation in credit markets -- that last week we were a day or two away from a breakdown of the financial system.

Here are three common critiques from the academics and journalists and what they are missing:

1. "Treasury must overpay for this to work because otherwise you are not injecting new capital, only adding liquidity."

Treasury is talking with the experts you would expect -- prominent academics who have designed auctions. It's complex because there are so many different MBS, but Treasury is committed to get the market price as best as it can. It will not intentionally overpay. But the assertion that the plan will not boost capital is wrong. If Treasury gets the asset prices exactly right next week when the reverse auction starts, those prices will be higher than the prices that would have obtained before the program was announced. That difference means that by paying the correct price next week we will be injecting capital relative to the situation ex-ante. Treasury does not need to overpay. And the taxpayer can still see gains -- say if the announcement and enactment removes some uncertainty about the economy and asset performance, but not all. Then prices could rise further over time. But the main point is that it is not necessary to overpay to add capital. I think Krugman is a leading purveyor of the "they must be intending to overpay" assertion.

2. "Taxpayers will be better off if Treasury gets warrants."

This is essentially the assertion made in David Leonhart's column in the NY Times on Wednesday. And it again illustrates that we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again,assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.

3."The plan should be to inject capital instead."

This is the Luigi Zingales criticism. Again, that's a fine plan and might be a good idea. But that's a complement to an asset purchase plan, not a substitute -- and it's one allowed by the Treasury proposal and indeed envisaged in some cases. But that will take much longer to implement than an asset purchase. That's why it's a complement not a substitute -- Treasury needs to act now. The particular ideas from Zingales et al that there should be a forcible capital injection are pure ivory tower, unfettered by the practicalities of legality, enactment, or implementation.

The Theory behind the Rescue Plan

Here is the key passage from President Bush's speech last night:
as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back.
In other words, the premise appears to be that the market is irrationally pessimistic. That might be so. Nonetheless, one has to be at least a bit skeptical about the idea that government policymakers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own.

Wednesday, September 24, 2008

P(bank bailout) = .79

Says Intrade.

Thurday morning update: P = .90

Election Update

Is Intrade suspect?

Maybe so:

Right now, Obama is trading at 52.3 points. That is, Intrade implies that he has a 52.3 percent chance to become the next President....

Over at BetFair, another large UK-based gambling and futures site, you can also buy an Obama contract. But the price there is 1.62, which implies a 61.7 percent chance that Obama will become the next President....

It does seem to be Intrade specifically that's out of line, rather than Betfair. At Iowa Electronic Markets, yet another political futures exchange, the probability of the Democrats winning the popular vote is about 61 percent. They don't have an electoral vote contract, but if they did, presumably that number would be a little higher because of the structural advantages Obama has in the electoral college this year.

A Panel Discussion

...of the Financial Crisis, at Harvard, tomorrow.

Update: You can download a video of the discussion here.

The Meltzer Plan

Talking on the NewHour, economist Allan Meltzer says he does not like the Treasury Plan to end the financial crisis and proposes an alternative:
if they're going to do something, then what they ought to do is make loans, which the financial institutions have to repay with interest. And if you think -- that's an idea which the Chileans have used in a bigger crisis than this for them in 1982, and it worked for them. People paid back the loans. They weren't allowed to pay dividends until they repaid the loans. They weren't allowed to take bonuses until they repaid the loans. I think that's the way -- if we're going to do this, then that's the way we should do it.

Predicting College Success

The Crimson reports:
The best predictor of college success is not the SAT, but rather tests that examine knowledge of a standardized curriculum, such as SAT subject tests, said [Harvard's Dean of Admissions William] Fitzsimmons.
The article also suggests that Harvard might at some point make the SAT optional and, in its place, rely more heavily on SAT subject tests in making admission decisions.

Tuesday, September 23, 2008

Economists against the Paulson Plan


Help Wanted

I am looking to hire a student to work with me as I revise my intermediate macroeconomics textbook. The part-time job requires facility with computers and data, strong writing/editing skills, and the ability to proofread carefully. Compensation will be in the form of mortgage-backed securities.*

If you are interested, please drop off a brief letter, resume, and transcript with my assistant Lauren La Rosa in Littauer 230.

* Just kidding. About the compensation, that is. The job is real. And compensation will be in the form of fiat money, which is worth something, at least for now.


Update: The job has been filled.


The Village Voice (via Cafe Hayek) reports:
Andrew Cuomo, the youngest Housing and Urban Development secretary in history, made a series of decisions between 1997 and 2001 that gave birth to the country's current crisis. He took actions that—in combination with many other factors—helped plunge Fannie and Freddie into the subprime markets without putting in place the means to monitor their increasingly risky investments.

Sen. McCain suggested that he might replace the head of the Securities and Exchange Commission with a Democrat, suggesting Andrew Cuomo, New York state's attorney general.

"He is somebody who could restore some credibility, lend some bipartisanship to this effort," Sen. McCain said on CBS's "60 Minutes."

Commentary on the Financial Mess

Monday, September 22, 2008

More Capital for the Financial System

Doug Elmendorf and Paul Krugman seem to agree that the government should be putting capital into banks and other financial institutions, in exchange for a share of bank equity, rather than using taxpayer dollars to buy bank assets that no one else wants at prices no one else will pay.

See also Sebastian Mallaby, who conveys this proposal:
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.

Sunday, September 21, 2008

Fan Mail

From my in-box:
Thanks for the blog and for your textbook. Your Intro to Econ text was the first required textbook in my academic career that I didn't hate.

Saturday, September 20, 2008

A Blank Check

A friend emails me a link to the proposed bailout legislation and asks,
Has more money ever been given with fewer restrictions on how it is used? Ever?
Update: Naked Capitalism's analysis of the plan is well worth reading.

Need a bailout?

The Problem with Audience Participation

James Taranto reports this recent interchange, during which economist Paul Krugman tries to make the case for a Canadian-style national health care system:

Krugman: --and I wanted to ask, actually two questions, to the audience. First, how many Canadians, would Canadians in the room please raise your hands. [One person applauds, laughter]

Donvan: We have about seven hands going up—

Krugman: OK, not as many as I thought. OK, of those of you who are not on the panel who are Canadians, how many of you think you have a terrible health care system. [pause] One, two--

Donvan: We see—almost all of the same hands going up. [laughter]

Krugman: Bad move on my part.

The GSE Blame Game

Friday, September 19, 2008

Is Paulson wrong?

Yes, says University of Chicago economist Luigi Zingales. His bottom line:
The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.
Thanks to Tyler Cowen for the pointer.

Keeping #@&!* Jobs at Home

The Future of Financial Regulation

Wisdom from David Brooks and Gerard Baker.

Thursday, September 18, 2008

Ben promotes Bipartisanship

The WSJ reports:

Bernanke's Relations With Congress Become Rocky in Wake of AIG Deal

For one day at least in this politically-charged election season, Democrats and Republicans on Capitol Hill appear to have buried the hatchet.

Right into Ben Bernanke.

In the wake of the Federal Reserve's bailout of insurance giant American International Group Inc., Mr. Bernanke's standing with Congress seems rockier than at has been in his two-and-a-half year tenure as Fed chairman.

"Why does one person have the right to grant $85 billion in a bailout without the scrutiny and transparency the American people deserve," asked House Speaker Nancy Pelosi (D., Calif) a reference to the loan the Fed gave AIG with the Treasury's blessing....

House Financial Services Committee Chairman Barney Frank (D., Mass.) suggested Wednesday he was concerned that the Fed and Treasury were intervening in markets without restraint....

Meanwhile, Rep. Jeb Hensarling (R., Texas), leader of the conservative Republican Study Committee, is gathering signatures for a letter to Messrs. Bernanke and Paulson stating that government bailouts "have set a dangerous and unmistakable precedent" for the federal government. "Federal investment in such large amounts of private ompany stock has the appearance of a socialist and not a free-market approach to managing our economy," the letter says.

The F.A.Q.’s of Lehman and A.I.G.

Mishkin on Inflation

The Pigovian Slippery Slope

The French seem to buy into the idea of Pigovian taxes:

Disposable goods targeted by new French tax plan

PARIS - Plastic forks, disposable diapers, drafty houses - if it hurts the environment, make it cost more. That's the message France's government wants to send with a raft of proposed new taxes. France's ecology minister said Sunday the government is considering a "picnic tax" on disposable dishes to encourage people to use reusable plates and cups instead.

Speaking on Europe-1 radio, Nathalie Kosciusko-Morizet said the plan wouldn't stop at picnicware. For example, she said, "We could make it so that in all public maternity wards, you would be taught to use washable diapers."

She said a new carrot-and-stick plan already applied to cars is being spread to other environmentally damaging products such as paints and detergents.

The key question: Are there really significant externalities associated with all of these goods? I would like to see the evidence before I embrace these plans. But I can certainly appreciate the economic logic.

Wednesday, September 17, 2008

Alan Blinder and Harrison Hong on the Financial Crisis

Wise Words on Trade

From Fred Bergsten:
We should be making new compacts to reduce barriers as rapidly as possible rather than fearing to implement those already negotiated, such as the free-trade agreements with Colombia and Korea that are languishing in Congress.

The Next Shock to the Economy

A Reading for the Pigou Club

Tuesday, September 16, 2008

A Poll of the AEA

Scott Adams of Dilbert fame polls AEA economists. Really. Here is what he finds:

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.
The economists were also asked which candidate they thought would do the best job on a group of issues. Here are the results:
Thanks to MR for the pointer.

Rogoff on Bailouts

Monday, September 15, 2008

A New Beginning

Today is the first day of Harvard's academic year, and the first day of a new year of ec 10. I will give the introductory lecture at noon.

I would like to thank all my friends on Wall Street for doing so much to spark interest in economic issues. You have gone beyond the call of duty, and your timing could not have been better.

Sunday, September 14, 2008

Biden's Charity Aversion

The most surprising fact I learned yesterday:
Democratic vice presidential nominee Sen. Joe Biden released 10 years of tax returns Friday...The Bidens' joint gross income hovered between $215,000 and $320,000 a year during this period...The amount they gave to charity during this period never exceeded one-half of 1% of their annual income. The Bidens never gave more than $995 to charity in any of the tax years, and usually gave much less.(Source)
Compare Biden's behavior to that of a typical American:

The IRS reports that those who itemize deductions on their income tax returns have claimed, since 1975, that between 1.6 percent and 2.16 percent of their income went to charitable concerns. (Source)
This contrast is an example of a broader phenomenon:
conservatives who practice religion, live in traditional nuclear families and reject the notion that the government should engage in income redistribution are the most generous Americans, by any measure. Conversely, secular liberals who believe fervently in government entitlement programs give far less to charity. They want everyone's tax dollars to support charitable causes and are reluctant to write checks to those causes. (Source)
If Biden's below-average charitable giving is typical of those with his political views, why am I surprised by it? Because this man has run for President more than once. He must have known there was a good chance that his tax returns would at some point be made public and undergo close scrutiny. He had a far greater-than-average personal motivation for charitable giving and, nonetheless, chose not to chip in.

Update: TaxProf provides a nice table summarizing Biden's tax history:

Saturday, September 13, 2008

Rent Control

Some economist (I forget who) once called it "the best way to destroy a city, other than bombing." Click here for a nice discusssion from today's paper.

Update: Robert Bartley says the economist is Assar Lindbeck.

Friday, September 12, 2008

No Longer the Underdog

According to the betting at Intrade, John McCain is now the most likely next President. The market probability of his winning is just a bit more than 50 percent.

Fun with Statistics

Princeton economist Alan Blinder says Democratic Presidents are better for economic equality between rich and poor.

Chicago economist Casey Mulligan says Republican Presidents are better for economic equality between men and women.

My take: These articles are completely persuasive, as long as you buy into the axiom that correlation=causation. Otherwise, not so much.

The GSE Blame Game


Thursday, September 11, 2008

My Whereabouts

I am spending today and tomorrow here.

Wednesday, September 10, 2008

Equality in Health Spending

Robert Samuelson reports:
It is widely assumed that health care, like most aspects of American life, shamefully shortchanges the poor. This is less true than it seems. Economist Gary Burtless of the Brookings Institution recently discovered this astonishing data: on average, annual health spending per person -- from all private and government sources -- is equal for the poorest and the richest Americans. In 2003, it was $4,477 for the poorest fifth and $4,451 for the richest. Probably in no other area, notes Burtless, is spending so equal -- not in housing, clothes, transportation or anything. Why? One reason: government already insures more than a quarter of the population, including many poor.

Show Me the Money

Top Recipients of Fannie Mae and Freddie Mac Campaign Contributions, 1989-2008

1. Dodd, Christopher J, D-CT
2. Kerry, John, D-MA
3. Obama, Barack, D-IL
4. Clinton, Hillary, D-NY


N.B.: Senator Dodd is Chairman of the U.S. Senate Committee on Banking, Housing, and Urban Affairs.

Update: Here.

A Reading for the Pigou Club

Tuesday, September 09, 2008

McCain's Likely Tax Policy

What kind of tax policy will we get if John McCain is elected President? He says he wants to make the Bush tax cuts permanent. But is he likely to deliver that outcome in the face of a presumptively Democratic Congress? We can get some insight into this question using Intrade betting and some basic rules of conditional probability.

The top income tax rate is now 35 percent. According to the betting at Intrade, the probability that the top income tax rate in 2011 will exceed 38 percent is 0.87. Call this P(tax hike).

Barack Obama has made such a tax hike part of his campaign promises, and there is no reason to think the Congress won't deliver for him. So let's assume Obama is certain to get the tax hike if he wins. That is, P(tax hike / Obama) = 1.0. (If this assumption is wrong, and this conditional probability is less than one, then my conclusion below would be even stronger.)

According to Intrade, the probability of Obama being the next president is 0.53. Call this P(Obama). And P(McCain) = 0.47.

Now we can calculate the probability of a tax hike conditional on McCain winning. It comes from the formula

P(tax hike)
= P(tax hike/Obama) P(Obama) + P(tax hike/McCain) P(McCain),

and plugging in the above numbers. It tells us that

P(tax hike / McCain) = 0.72.

That is, according to the Intrade betting, we are likely to see a significant hike in the top income tax rate even if McCain is elected President.

Monday, September 08, 2008

Thoughts on the GSE Takeover

I have three reactions:

1. It was likely to happen eventually, so it is better to get on with it, as Treasury did yesterday.

2. I am saddened whenever any private profit-seeking enterprise gets bailed out, whether it is Chrysler, Long-term Capital Management, Bear Stearns, or the GSEs. Such bailouts sow the seeds of the next financial crisis by fostering expectations of future bailouts and encouraging excessive risk-taking. (And before anyone emails me that the GSE equity holders are not exactly getting a good deal here, let me point out that the debt holders are. In a capitalist system, you want those extending both debt and equity finance to bear the consequences of the risks they undertake. If the taxpayer is chipping in, someone is being insulated from risk.)

3. The problem is far from over, as the future of these institutions and a large segment of the financial system is still to be determined. The worrisome part is that this future will be determined by a political system that both created the GSEs and failed to provide sufficient oversight, even when many economists suggested reform was needed. To believe that the Congress will do a good job of it would be the triumph of hope over experience.

Saturday, September 06, 2008

Post-Partisan Tax Policy

Here is my column in tomorrow's NY Times.

The bottom line: On the issue of dividend taxation, Barack Obama may be the candidate with the best chance of preserving George Bush’s legacy.

Is TV bad for kids?

Today's Wall Street Journal reports about economists who do research on the effects of television. Here is the Journal's summary of research results from Matthew Gentzkow and Jesse Shapiro, both relatively recent Harvard PhDs:

The best way to determine television's impact would be in a laboratory that put some toddlers in front of TV sets and kept some away from it -- an implausible undertaking. But over the past 30 years, economists have developed statistical methods aimed at teasing out cause and effect in complex relationships where controlled experiments aren't possible. That has allowed them to take advantage of "natural experiments," where variations that occur naturally are used in place of the controlled conditions of the laboratory.

Economists have used such methods to look into everything from daylight saving time's effect on energy consumption to how better teeth affect incomes.

The variation Mr. Gentzkow and Mr. Shapiro exploited was the timing of the introduction of TV into different cities. Television began taking off in the U.S. in 1946, after a wartime ban on TV production was lifted. But the Federal Communications Commission stopped granting new commercial television licenses from September 1948 to April 1952 while it made changes in allocating broadcast spectrum. There was a long lag between when some cities got television and when others did.

The economists then looked at results of a survey of 800 U.S. schools that administered tests to 346,662 sixth-grade, ninth-grade and 12th-grade students in 1965. Their finding: Adjusting for differences in household income, parents' educational background and other factors, children who lived in cities that gave them more exposure to television in early childhood performed better on the tests than those with less exposure.

The economists found that television was especially positive for children in households where English wasn't the primary language and parents' education level was lower. "We don't exactly know why that is, but a plausible interpretation is that the effect of television on cognitive development depends on what other kinds of activity television is substituting for," says Mr. Shapiro, 28.

Post-Partisan Health Policy

The PEP blog draws our attention to this trenchant analysis of health policy:
The most promising way to move forward in all three dimensions – coverage, cost, and long-run fiscal situation – is to replace the employer exclusion with a tax credit, a step that has been proposed many times before (e.g., Butler 1991 and Pauly and Hoff 2002). Firms would still be allowed to deduct the cost of their contributions to employee premiums, just as they can deduct wages and other expenses today for the purpose of calculating taxable income. But workers would now have to include employer contributions to health insurance in their earnings for the purpose of calculating taxes (precisely which taxes is discussed below). In exchange for, workers who purchased qualifying insurance would get a refundable tax credit. Qualifying insurance would be along the lines proposed by the President in his standard deduction for health insurance, including limits on out-of-pocket payments, coverage of a general range of medical care, and guaranteed renewability by the provider (Treasury 2008).
The PEP blog then points out,
This is a pretty fair description of the McCain health care plan. The funny thing is, this is not be found in McCain campaign literature or on his senate website, but rather in a paper written by Jason Furman, Obama's Economic Policy Director.
All true. This description is from the McCain campaign website:
John McCain Will Reform The Tax Code To Offer More Choices Beyond Employer-Based Health Insurance Coverage. While still having the option of employer-based coverage, every family will receive a direct refundable tax credit - effectively cash - of $2,500 for individuals and $5,000 for families to offset the cost of insurance. Families will be able to choose the insurance provider that suits them best and the money would be sent directly to the insurance provider. Those obtaining innovative insurance that costs less than the credit can deposit the remainder in expanded Health Savings Accounts.
Obviously, there is a lot of common ground between Furman and McCain on this specific policy reform. My guess is that most health economists would endorse the Furman-McCain plan.

Friday, September 05, 2008

Ed's Dream

Two Good Weeks for John McCain

According to the betting at Intrade, over the past two weeks, while the two political conventions were taking place, John McCain added about four to five percentage points to his probability of becoming the next president. He is still the underdog, but the race is closer.

The Shiller Solution

Thursday, September 04, 2008

The Pigou Club Manifesto - Director's Cut

On my Harvard website, I have posted a talk I gave earlier in the year, called Smart Taxes: An Open Invitation to Join the Pigou Club.

Regular readers of this blog will recognize the issue and many of the arguments, but I thought it would be useful to collect the ideas in one place and to develop the case a bit more thoroughly than is possible in a blog post or in a newspaper op-ed.

Economic advisers go at it

Bad Money, Bad Book

When Co-teachers Collide

A letter in today's Wall Street Journal:

In regard to Martin Feldstein and John B. Taylor's "John McCain Has a Tax Plan to Create Jobs" (op-ed, Sept. 2): Barack Obama is proposing large middle-class tax cuts to reward work, encourage wealth accumulation, and stimulate economic growth. John McCain is proposing little in direct tax relief for middle-income families and has proposed a health plan that would, over time, represent a significant tax increase for most American families.

You don't have to take my word for it. The National Review editorial board recently complained that Sen. McCain's plan "offers very little in the way of direct benefits to Americans in the middle of the income scale." Rea Hederman, senior policy analyst at the conservative Heritage Foundation praised Sen. Obama's tax plan as "a great step in the right direction," and explained that "the middle class would likely pay less under Mr. Obama's plan than Mr. McCain's." And even the conservative Tax Foundation confirmed as "correct" that 101 million tax filers would get nothing from Sen. McCain's middle-class tax cuts.

Faced with these facts, Martin Feldstein and John Taylor are forced to misrepresent the Obama and McCain plans. They say Sen. Obama is proposing only a one-time $1000 rebate. In fact, Mr. Obama has proposed a permanent $500 per worker/$1000 per two-earner-family tax credit to offset the payroll tax. They say that under Sen. McCain's health-insurance plan "most taxpayers will also pay less in tax." In fact, Mr. McCain's plan introduces a new tax on employer-provided health insurance benefits together with a new tax credit that does not rise with the cost of health insurance. As health-care expenditures rise faster than overall inflation, the tax increase in his plan rises much more quickly than the value of Mr. McCain's health-insurance tax credits -- resulting in a net tax increase for tens of millions of working families.

Jeffrey Liebman

Cambridge, Mass.

Mr. Liebman is an economic adviser to Sen. Obama and Professor of Public Policy at Harvard University where he co-teaches "American Economic Policy" with Martin Feldstein.

Update: Rea Hederman emails me a clarification:

I saw this morning that you posted a letter by Dr. Liebman on your blog (to which I subscribe). The letter does not accurately reflect my comments on the Obama tax plan. Dr. Liebman has sliced my quotes well out of context. If you read the full article in the NY Sun (August 15) you will see that my quote--'great step in the right direction'--refers to reductions in the tax rates for capital gains and dividends to 20%, which is far lower than the 25% or 28% that seemed to be contained in Senator Obama's tax plan at beginning of the summer. Heritage and the Tax Policy Center both started our initial assessments of Senator Obama's tax plan with the capital gains and dividends tax rate being raised to 25%. I do think it's a step in the right direction that the Obama campaign has decided not to raise the cost of capital by as much as they planned in the beginning of the summer. But, as I noted later, it would be even better not raise taxes on capital at all.

Dr. Liebman also did not include my comments that Senator Obama is reducing middle class taxes in the wrong way. He complicates the tax code with messy tax credits that will do a host of harm to growth and fairness in the tax code.

Update 2: A rejoinder from Jeff:


Three points regarding Mr. Hederman's email.

First, I note with interest that he did not disavow his statement that the middle class would likely pay less taxes under Mr. Obama's tax plan than under Mr. McCain's. The simple fact is that Heritage has now confirmed what the Tax Policy Center and others have said – Obama has larger middle class tax cuts than McCain. Of course Heritage has different ideas about how taxes should be cut, but that wasn't the Feldstein-Taylor argument. They were disputing the relative comparisons of the size of the tax cut. So I do not think I was unfair to Mr. Hederman in using him as a reference on this point.

Second, I think his beef about being misquoted belongs with the NY Sun, not with me. Look at the subheadline of the Sun piece "Heritage Hails 'Great Step in the Right Direction'" and at the second paragraph "And even some conservatives are praising him for it." It is clear that the Sun reporter concluded Mr. Hederman was enthusiastic about the overall Obama tax plan, not just a limited component of it. I obviously wasn't a party to that conversation, so I can't tell if the reporter treated Mr. Hederman fairly. But as far as I am aware, there was no letter to the Sun from Heritage objecting to this portrayal.

Third, on capital taxes Mr. Hederman wants to reframe Obama's "great step in the right direction" as a less egregious step in the wrong direction. This is simply a question of what baseline is being used. In your blog, you have often used the CBO "current law" baseline (see here). This is a baseline under which much of the tax code reverts to how it was at the end of the Clinton years. Under this standard, what Obama is proposing is a big tax cut for dividends (from 39.6 to 20 in the top bracket) and keeps capital gains the same or lower as under the baseline. So under your blog's preferred baseline, it seems like "great step in the right direction" is the correct interpretation (I personally am not a fan of the CBO baseline, but what is most important is being consistent in which baseline one uses).

And thanks for helping to build interest in Econ 1420 "American Economic Policy" for the spring. Marty and I do four joint appearances in that class and try hard to help students see why we disagree and not just that we disagree (and, perhaps more importantly, that there is much we agree on).


Thanks, Jeff. (Just for the record: I don't think this blog has taken a general position on a "preferred baseline"--each baseline gives information about a somewhat different counterfactual. That is not a major issue, in my view, but I did want to clarify.)

Wednesday, September 03, 2008

High Finance

Source: Calculated Risk.

I am a friendly guy

I now have over 2500 friends on facebook. Call me a pushover: I am ready to befriend anyone. (Try me again if, inadvertently, I have ever ignored your request in the past).

The problem is, I have no idea what it all means.

The Problems with Census Data

Robert Samuelson notes three problems:

First, comparisons are made to an artificially high benchmark -- the late 1990s "tech bubble." Second, immigration distorts commonly cited statistics. Third, the census figures understate income gains by not counting fringe benefits.
I would add one more problem with these data: The income used to measure the poverty rate fails to include the support from numerous anti-poverty programs. The NY Times reports:
Officials also point out that the current [poverty] measure only counts cash as income. They say a more accurate model would include government assistance like food stamps, housing subsidies and tax credits. Such aid has been devised to help support the poor, but its impact is not calculated by the current measure.
Update: The CD blog points out a fifth problem: Data on household income does not adjust for declining household size over time.

Tuesday, September 02, 2008

The McCain Tax Plan

Cross-Price Elasticity of Demand XIII

The next in the series:

Fuel prices have grounded an unexpected frequent-flyer: Sean "Diddy" Combs....

The hip-hop mogul said he is now flying on commercial airlines instead of in private jets, which Combs said had previously cost him $200,000 and up for a roundtrip between New York and Los Angeles.

"I'm actually flying commercial," Diddy said before walking onto an airplane, sitting in a first-class seat and flashing his boarding pass to the camera. "That's how high gas prices are."

Monday, September 01, 2008

Allocating Airport Landing Slots

The Washington Post reports on a debate over whether market prices should be used to allocate scarce resources at the nation's busiest airports:

the [Bush] administration is now proposing to auction off some takeoff and landing slots to the highest bidder.

The proposal has the support of New York Mayor Michael R. Bloomberg (I), but it has sparked an ideological battle over how far market controls should extend in the skies, attracting fierce opposition from figures such as Sen. Charles E. Schumer (D-N.Y.)....

"The resource is scarce and the best way to allocate it is a price mechanism," said Tyler D. Duvall, the Transportation Department's acting undersecretary for policy.

"It's part of a larger picture: We've got congestion on the roads, in our ports, in our airports," Duvall added, outlining the wider policy of the current administration. In each of these cases, he said, the market can best clear the way.

But others say auctions will do nothing to resolve the capacity problem, and could cause more confusion and incur more costs for customers than they relieve.

"This is an ideological, untested experiment from those in an ivory tower," said Schumer, who has introduced a bill to block the auctions.

You can probably guess who I agree with. But then again, I work in an ivory tower.

Update: Hal Varian emails me a comment:
Hi, Greg.

In your blog you cite a Washington Post article that says "But others say auctions will do nothing to resolve the capacity problem..." This isn't quite right. In certain circumstances, the optimal congestion prices send the right signals for marginal capacity expansion. Hence expanding capacity by using the present value of the optimal congestion fees will result in thesocially optimal level of capacity. This is sometimes know as the Strotz-Mohring theorem; see here, pages 6 and 11, for the simple argument.
Thanks, Hal.

Update 2: A NY Sun editorial on the issue.