Policy Parallels: Eurozone and India

I’ve had a chance, over the past 10 days, to debate the details of what’s next for the macroeconomy with leading policymakers in both the eurozone/EU and India. I’m struck by some similarities. In both places, there is little or no concern that inflation will rebound any time soon. At least for people based in Delhi, there is as a result confidence that conventional policy can now act aggressively to cushion the blows coming from the global economy. In the eurozone, all eyes are on monetary policy and the same is true for India – both places have almost the exact debate about whether fiscal policy can do much more than it is already doing, given that government debt levels are already on the high side.

The discordant note comes from people based in Mumbai. They feel that Delhi does not fully understand that the real economy is already in bad shape. Sectors such as real estate and autos are hurting badly. Small businesses, in particular, seems to be bearing the brunt of the blow. The banking picture seems more murky, but is surely not good. And of course the Satyam accounting scandal could not come at a worse time.

Overall, my strong impression is that growth forecasts will need to be marked down for India and the eurozone. Both will likely cut interest rates further quite soon (and have space for additional cuts), but we should not expect much more from the fiscal side in either place. They will both start to look beyond standard macro policies – although India may make progress on this front sooner.

I also heard strong and reassuring opposition to protectionism – although, I must say the case against any kind of trade restriction comes through more clearly in India than in the eurozone.

What If You Only Had $350bn To Spend?

Larry Summers made a convincing case yesterday that Congress should release the remaining $350bn of the TARP. It’s good to see the Obama team emphasizing themes beyond the fiscal stimulus, including banks and housing. Stronger governance and greater transparency are timely commitments for this program, and who can object to limits on executive compensation in today’s environment? Some Congressional debate makes sense and could be productive, but it’s hard to see this request being turned down.

Still, what exactly should the money be spent on? I’m tempted to say: housing, because this continues to be a major unresolved problem that looms over both consumers and their balance sheets. Unfortunately, however, the banks remain a greater priority. The latest developments for both Citigroup and Bank of America suggest the banking situation is (again) seen by insiders as more desperate than we outsiders wished to believe.

The next round of bank recapitalization (again) needs to be big and bold, for example along the lines we have been suggesting for some time (but I’ll take another comprehensive plan, if you have one, with strong expected taxpayer value). The problem today is that we just don’t know if any major bank is well capitalized; there are too many black boxes that may contain toxic assets. At best, this is a brake on the positive effects that should come from the fiscal stimulus. At worst, we still have a major system issue on our hands.

And there is no reason to think that $350bn is enough to handle this problem. The original $700bn was obviously an arbitrarily chosen number, and the money has been spent so far in a rather unplanned manner. What we do next should not be constrained by the fact that there is a check for $350bn waiting to be picked up. We should design a systematic recapitalization program, figure out what it will cost, and get on with it. My working assumption, based on the published analysis of the IMF regarding losses relative to private capital raising, is that $1trn – properly deployed – should do the trick.

Then we should get to work on housing (yes, this needs more money).

Update: Ben Bernanke seems to be thinking aloud along similar lines.

Not Quite the Marketing You Want

Robert Siegel gave GM a priceless gift today: a feature segment on All Things Considered, with a bunch of softball questions and a paean to the Chevy Malibu (which was, to give credit where credit is due, the 2008 North American Car of the Year, which includes foreign imports). Then Bob Lutz, GM’s vice chairman, fumbled the gift and dropped it on the floor, where it smashed into a thousand pieces. When asked what it was like to operate using money borrowed from the federal government, he said:

I’ve never quite been in this situation before of getting a massive pay cut, no bonus, no longer allowed to stay in decent hotels, no corporate airplane. I have to stand in line at the Northwest counter. I’ve never quite experienced this before. I’ll let you know a year from now what it’s like.

At my old company, it was a point of pride to search on price-comparison sites for the cheapest hotels you could find. (I know the argument that it saves money for expensive execs to fly corporate jets rather than flying commercial, because at their hourly rates it’s not worth the time spent waiting in line. I think those arguments are bunk, because they assume that the ten minutes you spend waiting in line are ten minutes of work you will not do that day, while my experience is that in high-level positions the amount of work you do is a function of the amount of work you have to do, not the amount of time you have.)

It may be true, as Bob Lutz claims, that GM makes good cars again. (I happen to own and drive a GM car that I am very satisfied with, but it’s a Chevy Prizm, which may not count.) But GM’s brand reputation today is that it is out of touch, and stories like this don’t help.

More TARP Programs, More Policy by Deal

Back on January 2, the Treasury Department announced something called the Targeted Investment Program. I missed this at the time, along with (according to a quick search – thank you Google Reader!) all of the economics blogs that I read. The press release admitted that this was a program announced after the fact to cover the second Citigroup bailout (the first was under the Capital Purchase Program, the main bank recapitalization plan). In essence, the program says that if Treasury thinks a financial institution is at risk of a loss of confidence, Treasury can invest in it under any terms they want. This is very similar to the Systemically Significant Failing Institutions Program, also announced after the fact (in November) to cover the second AIG bailout, which reads almost identically, except instead of talking about a “loss of confidence” it takes about the “disorderly failure” of a systemically important institution.

This isn’t a power grab by Treasury – they already had this power under the EESA (the main bailout bill passed in October, commonly known as TARP). And I happen to agree that if a systemically significant institution – the kind that whose failure would have a major impact on countless other institutions – is going to fail, it should be bailed out. However, I think these programs have two major failings.

Continue reading “More TARP Programs, More Policy by Deal” →

Accountability Time

With Congress back in session, accountability is the theme of the week. Barney Frank announced the “TARP Reform and Accountability Act of 2009,” which I hope to get to in a day or two. But for now I want to talk about Elizabeth Warren and the Congressional Oversight Panel for TARP, which issued their second report on Friday. Of course, beating the accountability drum at Henry Paulson’s expense is politically easy, and a lot less controversial than, say, designing a stimulus package or a foreclosure reduction plan. But that doesn’t mean it isn’t important.

Back in September, Simon and I wrote an op-ed in the Washington Post that focused on the incentive problems in the initial TARP proposal and cynically predicted:

It is most likely that “governance” over the fund will be provided by periodic hearings of the relevant Senate and House committees during which the Treasury secretary and the fund managers will be asked why they overpaid for banks’ securities and will answer that there was no choice if the financial system was to be saved.

(Recall that the proposal at that point was for Treasury to buy toxic assets from financial institutions, most likely overpaying the process.) However, the governance measures were strengthened in the eventual legislation, and it does seem that Elizabeth Warren and most of her committee (Jeb Hensarling, R-Texas, did not endorse the report) are committed to keeping Treasury under tight scrutiny, which is all good.

Continue reading “Accountability Time” →

A Sliver of Optimism

One of the scary things about this fall’s descent into economic chaos was the failure of economic forecasters to keep pace. Every week economists would predict what they said were terrible things, and then the data would come in much worse, reinforcing the overall impression that no one knew what was going on.

Buried in all the negative reports about the December jobs data was one fact that was a tiny bit encouraging: the December job losses were almost exactly what forecasters expected, on average. This indicates that it’s possible that the macroeconomic community has come to grips with the magnitude of the downturn; if you’re feeling particularly giddy, you might even infer that this means that their GDP forecasts are in the right ballpark, which means (according to the WSJ) that the economy should start growing in Q3.

I wouldn’t go that far, though, and I think that Q3 forecast is too optimistic. It takes time to plan and execute a layoff (I’ve been there), so December layoffs are based on revenue projections based on data from October and maybe November. Because sales continued to fall faster than expected in November, companies will find they have to lay off more people than they initially expected, and that will drag into the new year. Furthermore, no one really knows how much the American household will shift from consumption to saving, and my sneaking suspicion is that it will be more than most people expect.

So all I can offer is a tiny sliver of optimism, that the people in the forecasting business are at least on the same planet as the rest of us. But still no one is sure what planet we’re on.

The Cost of Reputation

Or, more accurately, the cost of caring about your reputation.

My recent article on Risk Management for Beginners closed with some unrigorous speculation about the peculiar incentives of fund managers, who are consistently well compensated in decent and good years and, in bad years, lose their clients’ money and move on to start a new fund. Steven Malliaris and Hongjun Yan have a paper on this topic entitled “Nickels Versus Black Swans:” “nickels” being the typical hedge fund strategy of making a small but consistent return with a small risk of a huge loss, and “black swans” being Taleb’s preferred strategy that makes a small but consistent loss with a small risk of a huge gain.

Simplifying the model, the problem with a black swan strategy is that by the time the huge gain rolls around, you the manager have already been fired (your clients have withdrawn their money) because of your consistent losses. The result is overinvestment in nickel strategies and underinvestment in black swan strategies – even when the latter have a higher expected return. This result holds even when you assume that the investors are sophisticated, because the key factor is the reputational concerns of the fund managers themselves.

Malliaris and Yan also show that the system can reach multiple equilibrium points: the system can be in one equilibrium where most hedge funds are pursuing suboptimal strategies, and then suddenly shift to another quickly, meaning that the hedge fund industry does not allocate capital as efficiently as one might imagine. This might help explain why (a) everyone is saying that AAA-rated mortgage-backed securities are underpriced yet (b) no one is buying them.

This paper might be seen as simply translating common sense into mathematics. Seen another way, though, it helps explain why individually rational behavior (by fund managers) does not produce the efficient outcomes you learn in first-year economics.

Paulson v. Buffett

Bloomberg has a new story out comparing the investment terms achieved by TARP with those achieved by Warren Buffett when he invested $5 billion in Goldman back in September. The results aren’t pretty for the U.S. taxpayer: the government received warrants worth $13.8 billion in connection with its 25 largest equity injections; under the terms Buffett got from Goldman, those warrants would be worth $130.8 billion. (The calculations were done using the Black-Scholes option pricing formula, which has its critics, but which I think is still a good way of estimating the relative difference between similar options.) That’s on top of the fact that TARP is getting a lower interest rate (5%) on its preferred stock investments than is Buffett (10%), which costs taxpayers $48 billion in aggregate over 5 years, according to Bloomberg. The difference in the value of the warrants themselves is due to two factors: (1) Treasury got warrants for a much smaller percentage of the initial investment amount; and (2) those warrants are at a higher strike price – the average price over the 20 days prior to investment, while Buffett got a discount to market price on the date of investment.

The comparison isn’t a new one – we recommended that TARP emulate Buffett back in October – but Bloomberg’s analysis has put the performance gap in striking perspective. Simon has a quote in the article, using the word “egregious,” but the really harsh words came from Nobel prize-winner economist Joseph Stiglitz, who said, “Paulson said he had to make it attractive to banks, which is code for ‘I’m going to give money away,'” and “If Paulson was still an employee of Goldman Sachs and he’d done this deal, he would have been fired.”

Continue reading “Paulson v. Buffett” →

Who’s Afraid of Deflation?

According to the Federal Open Market Committee’s (FOMC) minutes, released on Tuesday, some members think inflation targetting would be a useful way to persuade people that prices will not fall, i.e., forestall deflationary expectations. WSJ.com seems to have the interpretation about right,

“The added clarity in that regard might help forestall the development of expectations that inflation would decline below desired levels, and hence keep real interest rates low and support aggregate demand,” according to the minutes.

In other words, a commitment to an inflation target, say annual growth of 1.5% to 2%, would help keep prices from falling outright and prevent the kind of economic chaos that plagued Japan in the 1990s and the U.S. during the Great Depression.

The Congressional Budget Office thinks there is still time to prevent deflation (or perhaps it is the new measures already in the works that will keep inflation positive). Their forecast for 2009 (see Table 1 in today’s testimony) predicts low inflation, e.g., the PCE price index is expected to be 0.6 percent for 2009 – but note that the CPI is seen as barely positive, at 0.1 percent, over the same period.

Meanwhile, the financial markets (e.g., inflation swaps) predict minus 4 percent inflation in 2009 (part of which is likely due to lower commodity prices) and then a small degree of deflation over the next few years. According to this view, we should next see today’s price level again in about 5 or 6 years.

Of course, the financial markets could well be wrong. It may be that the markets haven’t fully digested or understood the size of the fiscal stimulus, and it may be that further news about other parts of the Obama approach (including the directly on housing and banking) will significantly change inflation expectations.

But it is striking that financial market inflation expectations – e.g., over a five year horizon – have barely moved from their low/near deflation level since it became clear that Mr Obama would win the election or since we first realized that a massive fiscal stimulus would soon arrive (see slide 2 in my presentation from Sunday; the scale is hard to read, but the decline is from around 2% through the summer to around 0% currently). At least for now, whether or not we are heading for deflation remains the key open question.

China and the U.S. Debt

I’m warming up for a longish Beginners-style article on government debt, which will come out next week or so. In the meantime, the New York Times has an article today about China’s diminishing demand for U.S. dollar-denominated debt. Theoretically this could make it harder for the U.S. to borrow money and thereby push up the interest rates on our debt (now at extremely low levels).

China’s voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying American bonds will reduce this dampening effect.

However, the article doesn’t mention one compensating factor. The fall in China’s buildup of its foreign currency reserves is linked to the rise in the U.S. savings rate, which is projected to rise to as much as 6-10% (it was over 10% in the 1980s). Some of that new savings will go to pay down debt, but a lot will go into savings accounts, CDs, money market funds, and mutual funds – which means that depresses interest rates across the board. On the back of the envelope, 6% of personal income is about $600 billion a year in new domestic savings to compensate for reduced overseas investment. Whether this will be enough to compensate entirely I don’t know. But if we were all one global economy in the boom, we’re still one global economy in the bust.

Causes: Economics

We are not short of causes for our current economic crisis. The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to. Capital flows around the world proved much more destabilizing than even before (and we’ve seen some damaging capital flows over the past 200 years.) And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it.

But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles or with how we think about the world. All of our thinking about the economy – a vast abstract concept – has to be in some form of model, with or without mathematics. And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and – unless fixed – will lead to further instability down the road.

This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.” (If you like to check intellectual credentials, start here and if you don’t understand what I mean about models, look at his new book.) To me there are three major points in his essay. Continue reading “Causes: Economics” →

Obama Doubles Down

Barack Obama did not actually predict trillion-dollar deficits indefinitely; more precisely, he said, “unless we take decisive action, even after our economy pulls out of its slide, trillion-dollar deficits will be a reality for years to come” (emphasis added). At the same time, the highly competent Congressional Budget Office projected a $1.2 trillion deficit for fiscal 2009 (year ending 9/30/09).

I was initially surprised by Obama’s forthrightness on the deficit question, but on reflection there are three good reasons for him to do it:

He wants to lower expectations by making the case that we have a serious deficit problem before taking office.
He wants to signal that he is aware of the deficit issue, to try to defuse the attacks he is going to get from fiscal conservatives regarding his stimulus plan.
He wants to use the current crisis – and the political opportunity it gives him, as a new and generally popular president with significant majorities in both houses – to tackle the long-term retirement savings problem.

If you parse the sentence, in saying “even after our economy pulls out of our slide,” Obama is saying that the long-term deficit problem would exist with or without the current crisis – and he is right. A $1.2 trillion deficit, caused by a steep fall in tax revenues, partially by the costs of various bailouts, and a little bit by two ongoing wars, is small compared to the Social Security and Medicare funding gaps ahead. In signaling that he will announce some kind of approach to entitlement spending by next month, Obama is implying that he wants to take on not just the short-term recession, but also the long-term deficit problem.

This is good for two reasons. First, someone has to face the problem. President Bush “tried” (not very hard) to do something about Social Security in 2005, although the general direction of his proposal, in shifting from a defined-benefit to a defined-contribution model, would have shifted risk from the government onto individuals.

Second, there are economic reasons why long-term sustainability should be addressed at the same time as short-term stimulus. Virtually everyone (even Martin Feldstein) favors a large, debt-financed government stimulus package. However, the more the government borrows, the more risk there is that lenders will worry about our ability to pay off the debt. While few people expect the U.S. to default, the more widespread fear is that we will print money (in a more sophisticated form, of course) to inflate away the debt. Because of those fears, large amounts of borrowing will drive up interest rates, especially as the economy recovers, both for the government (increasing our interest payments) and for the economy as a whole (undermining growth). The solution, if there is one, is to put forward a credible plan for dealing with the long-term retirement problem.

The risk, of course, is that Social Security and Medicare can be politically lethal, which is one reason President Bush backed off so fast. But I still think this is the right bet for Obama to make. Insofar as any solution is going to involve some pain (lower benefits, increased benefit age, higher taxes, increased control over health care), it is going to be easier to pass in a time of perceived collective crisis. And being willing to tackle the problem could also help gain support from fiscal conservatives for the stimulus that we need now.

Overweight Fiscal? (The Obama Economic Plan)

Most of the current discussion regarding the Obama Economic Plan focuses on whether the fiscal stimulus should be somewhat larger or smaller ($650-800bn seems the current range) and the composition between spending and tax cuts. President Obama stressed on Tuesday that trillion dollar deficits are here to stay for several years, and it looks like part of the arguing in the Senate will be about whether this is a good idea.

There is at least one key question currently missing from this debate. Is this Plan too much about a fiscal stimulus and too little about the other pieces that would help – and might even be essential – for a sustained recovery? The fiscal stimulus may be roughly the right size (and $100bn more or less is unlikely to make a critical difference), but perhaps we should also be looking for more detail on the following:

1. Recapitalizing banks. Their losses to date have not been replaced by new capital and it is currently not possible to issue new equity in the private markets. If you think we can get back to growth without fixing banks, check Japan’s record in the 1990s.

2. Directly addressing housing problems, including moving to limit foreclosures and reduce the forced sales that follow foreclosures. There is apparently some form of the Hubbard-Mayer proposal waiting in the wings, but we don’t know exactly what – and this matters, among other things, for thinking about the debt sustainability implications of the overall Plan.

3. Finding ways to push up inflation, presumably by being more aggressive with monetary policy. Deflation is looming – according to the financial markets, despite all of the Fed’s moves and recent statements, prices will fall or be flat over the next 3 to 5 years. This fall in inflation, from its previous expected level around 2 percent per year, constitutes a big transfer from borrowers/spenders to net lenders/savers. The contractionary effect is likely to outweigh any fiscal stimulus that is politically feasible or economically sound. (We have more detail on this point on WSJ.com today, linked here.)

So perhaps the issue is not the absolute size or composition of the fiscal stimulus, but rather the role of the fiscal stimulus relative to other parts of the Plan. Hopefully, it’s a more evenly weighted package, and just we haven’t yet seen the details. Still, it’s odd that the presence and general contours of these other important elements have not yet been clearly flagged.

The Economic Crisis and the Crisis in Economics

The Economic Crisis

The global financial crisis of fall 2008 was unexpected. A few people had been predicting that serious problems were looming, and even fewer had placed bets accordingly, but even they were astounded by what happened in mid-September.

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis. (See http://BaselineScenario.com for more on what came before, how events unfolded during fall 2008, and where matters now stand).

1. On the weekend of September 13-14, 2008, the U.S. government declined to bailout Lehman. The firm subsequently failed, i.e., did not open for business on Monday, September 15. Creditors suffered major losses, and these had a particularly negative effect on the markets given that through the end of the previous week the Federal Reserve had been encouraging people to continue to do business with Lehman.
2. On Tuesday, September 16, the government agreed to provide an emergency loan to the major insurance company, AIG. This loan was structured so as to become the company’s most senior debt and, in this fashion, implied losses for AIG’s previously senior creditors; the value of their investments in this AAA bastion of capitalism dropped 40% overnight.
3. By Wednesday, September 17, it was clear that the world’s financial markets – not just the US markets, but particularly US money market funds – were in cardiac arrest. The Secretary of the Treasury immediately approached Congress for an emergency budgetary appropriation of $700bn (about 5% of GDP), to be used to buy up distressed assets and thus relieve pressure on the financial system. A rancorous political debate ensued, culminating in the passing of the so-called Troubled Asset Relief Program (TARP), but the financial and economic situation continued to deteriorate both in the US and around the world.

Thus began a financial and economic crisis of the first order, on a magnitude not seen at least since the 1930s and – arguably – with the potential to become bigger than anything seen in the 200 years of modern capitalism. We do not yet know if the economic consequences are “merely” a severe recession or if there will be a prolonged global slump or worse.

The Crisis in Economics

Does this economic crisis constitute or imply a crisis for economics? There are obviously two answers to this question: no, and yes. Continue reading “The Economic Crisis and the Crisis in Economics” →

The Baseline Scenario