Tag: politics

The Importance of Battlefield Nuclear Weapons

I’ve been writing a lot about the game of chicken recently, most often in connection with the GM and Chrysler bailouts. On the Chrysler front, the game is in its last hours. Even after a consortium of large banks agreed to the proposed debt-for-equity swap, some smaller hedge funds are holding out for more money, and even the extra $250 million that Treasury agreed to kick in seems unlikely to keep Chrysler out of bankruptcy.

The problem is that bankruptcy is the only weapon Chrysler and Treasury have in this fight, and it’s a strategic nuclear weapon. Bankruptcy is the only threat that can get the bondholders to agree to a swap; but because a bankruptcy carries some risk of destroying Chrysler (because control will lie in the hands of a bankruptcy judge – not Chrysler, Treasury, the UAW, or Fiat), and taking hundreds of thousands of jobs with it, everyone knows that Treasury would prefer not to use it. The bondholders are betting that they can use Treasury’s fear of a bankruptcy to extract better terms at the last minute. (And it’s even possible that the large banks agreed to the swap knowing they could count on the smaller, less politically exposed hedge funds to veto it.) But Treasury may still press the button, because it needs to make a statement in advance of the bigger GM confrontation scheduled for a month from now.

But there’s a much bigger, slower game going on at the same time, and the administration’s basic problem is the same: all it has is strategic nuclear weapons that it absolutely does not want to use. The New York Times had an article today about how “a growing number of banks are resisting the Obama administration’s proposals for fixing the financial system.”  It didn’t have a lot of new information, but it summarized the outlines of the game.

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Guest Post: Too-Big-To-Fail and Three Other Narratives

This guest post is contributed by StatsGuy, one of our regular commenters. I invited him to write the post in response to this comment, but regular readers are sure to have read many of his other contributions. There is a lot here, so I recommend making a cup of tea or coffee before starting to read.

In September, the first Baseline Scenario entered the scene with a frightening portrait of the world economy that focused on systemic risk, self-fulfilling speculative credit runs, and a massive liquidity shock that could rapidly travel globally and cause contagion even in places where economic fundamentals were strong.

Baseline identified the Fed’s response to Lehman as a “dramatic and damaging reversal of policy”, and offered major recommendations that focused on four basic efforts: FDIC insurance, a credible US backstop to major institutions, stimulus (combined with recapitalizing banks), and a housing stabilization plan.

Moral hazard was acknowledged, but not given center stage, with the following conclusion: “In a short-term crisis of this nature, moral hazard is not the preeminent concern.  But we also agree that, in designing the financial system that emerges from the current situation, we should work from the premise that moral hazard will be important in regulated financial institutions.”

Over time, and as the crisis has passed from an acute to a chronic phase, the focus of Baseline has increasingly shifted toward the problem of “Too Big To Fail”.  The arguments behind this narrative are laid out in several places: Big and Small; What Next for Banks; Atlantic Article.

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The Missed Opportunity

For a snapshot of what’s wrong with our banking policy, look at the front page of the business section of today’s New York Times. On the left side: “U.S. in Standoff with Banks over Chrysler.” On the right side: “Banks Show Clout on Legislation to Help Consumers.”

On the left side, a consortium of banks holding Chrysler debt is refusing to agree to the current restructuring plan, which involves bondholders holding $6.9 billion in secured debt getting about 15 cents on the dollar – roughly where the bonds are currently trading, according to the Times.* The banks are playing the ongoing game of chicken with the government, betting that the government will cave and give them a better deal rather than take a risk on a bankruptcy.

On the right side, the banks are using their lobbying clout to block the administration’s proposals to help consumers and households, including the mortgage cram-down provision (which would allow bankruptcy courts to modify mortgages on first homes) and added consumer protections for credit card customers. They currently have all 41 Republican votes in the Senate tied up, which means nothing can pass.

The banks leading the charge over Chrysler: JPMorgan Chase and Citigroup. The banks opposed to cram-downs: Bank of America, JPMorgan Chase and Wells Fargo. The banks blocking credit card protections: American Express, Bank of America, Capital One Financial, Citigroup, Discover Financial Services, and JPMorgan Chase. All or almost all are bailout beneficiaries. But don’t blame them: they’re just doing what they can to maximize their profits at the expense of the taxpayer, which is perfectly legal (and even ethical, depending on your conception of shareholder rights). Instead, you should be wondering why they are in a position to be maximizing profits at the taxpayer’s expense.

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A View from the Inside

If you haven’t picked up on one of the dozens of recommendations from other blogs, I recommend reading Phillip Swagel’s long and detailed account of the view of the financial crisis from his seat as assistant secretary for economic policy at the Treasury Department. It’s particularly useful for people like me who make a habit of criticizing government officials.

The writing is dry, but much of the subject matter is fascinating. It often explains or defends Treasury’s actions during the crisis, but Swagel certainly owns up to plenty of mistakes or shortcomings. For example, discussing the emergency guarantee program for money market funds, he writes, “Nearly every Treasury action there was some side effect or consequence that we had not expected or foreseen only imperfectly.”

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Our Fate Is in Their Hands?

Last month, Representative John Shimkus spoke out against regulating carbon dioxide emissions on the grounds that carbon dioxide is plant food. “So if we decrease the use of carbon dioxide, are we not taking away plant food from the atmosphere?” Shimkus is on the House Subcommittee on Energy and Environment, which means he has a vote on these issues.

In the wake of a financial and economic crisis of at least generational magnitude, our government will be rewriting the rules of the financial industry. And “our government” includes not just the pedigreed scholars in the executive branch (Larry Summers, Christina Romer, Austan Goolsbee, etc.), but Congressional representatives like John Shimkus – “like” in the sense that they were selected for their jobs, and for their committee seats, in exactly the same way that Shimkus ended up discussing the crucial role of fossil fuels in sustaining plant life on this planet. And when it comes to legislation, Summers, Romer, and Goolsbee have exactly zero votes between them; Shimkus has one.

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$3.5 Million or $5 Million?

In the midst of a severe economic crisis that is, among other things, depressing federal tax revenues and adding to the national debt, the debate over the estate tax has flared up again. The basic question is whether the exemption will be raised from $1 million – where it was in 2002-03 and where it is scheduled to return after the Bush tax cuts expire – to $3.5 million (Obama) or $5 million (Lincoln-Kyl) per person; there is also disagreement over whether the marginal rate should be 35% or 45%. (Note that even with Obama’s proposed 45% tax rate, the average effective tax rate on estate would be 19%, because of the $3.5 million exemption.)

There is plenty of debate over this already, so I will confine myself to three points.

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Economics, Politics, Outrage, and the Media

Warning: This is a post about economics and politics; it is a reader response post; but (here’s the warning), it’s also one of those annoying self-referential posts you only see on the Internet discussing a debate among the commentariat.

Last week went something like this:

  1. We learned about the $165 million in retention bonuses at AIG Financial Products.
  2. A lot of people, up to and including President Obama, got mad.
  3. Various commentators, including Ian Bremmer (on Planet Money, around the 14-minute mark) and Joe Nocera, said, in Nocera’s words, “Can we all just calm down a little?”

Their argument is basically that $165 million is small change, the government should be working on bigger issues, and the demonization of AIG is making it harder to solve the real problems.

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Protesting the Banks

In the past, several of our readers have asked if we could help organize some sort of popular political movement to protest some of the policies that we have criticized. That isn’t anything we have any experience or expertise in, however.But in case you are interested, I wanted to let you know about a new group called A New Way Forward that is organizing rallies on April 11. Their platform is pretty straightforward:

NATIONALIZE: Experts agree — Insolvent banks that are too big to fail must incur a temporary FDIC intervention – no more blank check taxpayer handouts.

REORGANIZE: Current CEOs and board members must be removed and bonuses wiped out. The financial elite must share in the cost of what they have caused.

DECENTRALIZE: Banks must be broken up and sold back to the private market with new antitrust rules in place– new banks, managed by new people. Any bank that’s “too big to fail” means that it’s too big for a free market to function.

A New Way Forward is being organized by two people from the Participatory Politics Foundation, although the two groups are not officially related.

By James Kwak

And a Volcker on Top

Or a Volcker in a pear tree, if you prefer.

Quick, name the current head of Council of Economic Advisors. Or the head of the National Economic Council. Stumped?

The head of the CEA is Edward Lazear, a former economics professor at Chicago and Stanford GSB. The head of the NEC is Keith Hennessey (I had to look that one up), a former, um, tester for Symantec (a software company), research assistant at a think tank, staffer for a Senate committee, and staffer for Trent Lott, with a masters in public policy from the Kennedy School. (That’s according to Wikipedia.) They are being replaced by Christina Romer and Larry Summers, respectively, two of the most prominent and respected economists in the world.

And now, for an encore, Obama has named Paul Volcker, now the most respected chairman of the Federal Reserve in recent memory, the hawk who choked off high inflation in the early 1980s, as head of the new Economic Recovery Advisory Board.

Does having an all-star lineup of economists and public servants guarantee a sound economic strategy? No, of course not. After all, you should have only one economic strategy, and we know about kitchens and too many cooks. But Obama is clearly trying to project the impression that he is bringing overwhelming firepower to bear on the problem, in an effort to bolster confidence in the markets. He is also signaling that his administration will follow a centrist, or at most moderate Democratic line. (Volcker first joined Treasury under Nixon, and was appointed Chairman of the Fed by Carter and then re-appoitned by Reagan; Geithner is an independent.)

Remember those charges of socialism in the last weeks of the election? The few socialists out there are sure to be disappointed.

The Race for Treasury Secretary

For those of us following the current economic crisis, Barack Obama’s most important cabinet choice will be his Treasury Secretary pick. Although nothing to be sneezed it, the position has historically been less prominent than the portfolios of State and Defense, but the news of the last six weeks and the urgency created by the current recession make it critical at this moment. The names being floated in a variety of articles on the Internet are, in rough order of likelihood:

  • Tim Geithner, head of the Federal Reserve Bank of New York and a key player in every government action involving Wall Street so far
  • Larry Summers, President Clinton’s last Treasury Secretary and a prominent academic economist
  • Jon Corzine, former head of Goldman, former senator, and now governor of New Jersey
  • Paul Volcker, former chairman of the Federal Reserve
  • Sheila Bair, head of the FDIC
  • Robert Rubin, also a Clinton Treasury Secretary, also a former head of Goldman, and currently board member of Citigroup

Less likely names floated include Warren Buffett, billionaire investor; Jamie Dimon, CEO of JPMorgan Chase; and Paul Krugman, 2008 Nobel Prize winner in economics and an outspoken liberal columnist and Bush administration critic.

The main thing all of the leading candidates have in common is that they are centrists and pragmatists (not a socialist among them, as far as I can tell). There is no reason to believe any of them would reverse the major steps taken by Henry Paulson so far, although several would likely move more aggressively for mortgage relief and broad-based economic stimulus. This is generally a good thing. While Paulson can be accused of some major missteps, and of so far failing to unblock lending to the real economy, his one achievement has been to restore some confidence to the banking sector, and the impact of a wholesale change in policy direction could be highly unpredictable.

My personal opinion, based on nothing, is that the Wall Street connection rules out Corzine and Rubin, and his comments about women while president of Harvard rule out Summers, so I would bet on Geithner, who has knowledge of Wall Street but does not have the political taint of having made a fortune on Wall Street.

Economic Priorities

Even as we celebrate tonight, we know the challenges that tomorrow will bring are the greatest of our lifetime — two wars, a planet in peril, the worst financial crisis in a century. Even as we stand here tonight, we know there are brave Americans waking up in the deserts of Iraq and the mountains of Afghanistan to risk their lives for us. There are mothers and fathers who will lie awake after the children fall asleep and wonder how they’ll make the mortgage or pay their doctors’ bills or save enough for their child’s college education. There’s new energy to harness, new jobs to be created, new schools to build, and threats to meet, alliances to repair.

The road ahead will be long. Our climb will be steep.

Full transcript here.

We’ve been talking for a while now about the short-term economic priorities facing the United States: financial system stabilization, economic stimulus, mortgage restructuring, and re-regulation of the financial system (domestic and international). But even before the current economic crisis, our country was also facing some major challenges that the Obama administration will have to tackle.

In my personal opinion, the top four long-term challenges facing our country are, in order:

  1. Global warming: We know with a high degree of certainty that the world is getting warmer, and that this could have catastrophic effects that we can only partially foresee today. Moving our economy from carbon to sustainable energy sources will require a transformation of large parts of the economy.
  2. Terrorism and nuclear proliferation: While the probability of a nuclear attack by terrorists is extremely low, at present that probability is only going up. This is not particularly an economic issue.
  3. Retirement savings: Despite all the attention Social Security has received, it is dwarfed by the looming Medicare deficit. In addition, there is evidence that private sector sources of retirement income will not fill the gap that they are expected to fill. First, many defined-benefit pension plans (both private and public) may not be sufficiently funded, because of accounting regulations that allow them to assume optimistic rates of return. (The events of the last six weeks, of course, did not help.) Second, many people’s individual retirement savings are sorely insufficient. I’ve seen estimates of the average retirement savings balances of people in their 50s ranging from $50,000 to $140,000 – and that was before the recent stock market crash, which probably took 15-20% off the average portfolio. And even for people with houses, the housing crash has constrained their ability to live off of them.
  4. Health care: Approximately 50 million Americans are uninsured today, and the number will only go up as people are laid off and companies cut health care costs during the recession. In addition, objective indicators show that health outcomes in the US are worse than in most of the developed world.

These challenges will be tougher to solve than the immediate challenges of fixing the financial system and restarting economic growth. Let’s hope that the Obama administration can start solving them.

The Economics of Elections

In honor of Election Day, we bring you a slight change from our usual programming.

There has been a lot of talk about the use of futures markets to predict elections. The granddaddy of election markets (in the US) is the Iowa Electronic Market. The one that gets the most attention these days is Intrade. I used to trade on the IEM during the primaries and made a decent return in just a few weeks, mainly by betting that people would overreact to news. (For example, when Huckabee (remember him?) spiked – I believe he was in the lead on IEM at one point – it was a pretty easy bet that at some point before the convention he would come down to zero.) But then I did a bet on the general election and forgot to close it out at the right time, so on balance I lost a few bucks. (The maximum you can put into IEM is $500, so we’re not talking big sums here.)

FiveThirtyEight.com takes a different approach: they take polling data as inputs, and then run multiple simulations of who will win each state election. A given survey has a midpoint (say, Obama 47 – McCain 45) and an error distribution around that midpoint. By doing repeated simulations, you estimate how often each person would win that election, based on expected variance around the midpoint. If you do this for all states at once, you get an estimate of what the electoral vote tally will be. I don’t know if they account for correlations in the error across different states – the fact that if McCain does 2 points better than expected in Pennsylvania, he is likely to do better than expected in Ohio, too (the two are not independent outcomes). They should take this into account. (I don’t know because I haven’t read the website other than the predictions.)

The problem with both of these approaches is that they take polling data as their inputs – so if there is a problem with the polls (the Bradley effect, for example), they will produce inaccurate results. Polling markets partially compensate for this, because they incorporate people’s expectations of how accurate the polls are. But given the prominence of the polls, I doubt they can correct for polling inaccuracy.

Not surprisingly, economists have developed predictive models for presidential elections based on economic conditions. Mark Thoma provides an excerpt of one (and a link to the whole paper) here. These are statistical models that compare election outcomes to various economic variables at the time of the election. The problem with these models is that presidential elections are overdetermined: the sample size is small enough that you can find many different series of data that seem to predict outcomes accurately, like the Washington Redskins predictor. All of these cute predictive models are based on the same fallacy: with hundreds of sports teams to choose from, and the thousands of ways you can slice the data, it would be remarkable if you didn’t find one that seemed to be a perfect predictor of presidential elections. Economic models are better (though not perfect), because they are based on variables that you would expect should have an impact on election results.

Happy Election Day.

Financial Crises and Democracy, Part Two

We have several times emphasized the need for a large economic stimulus package to limit the extent and damage of the recession that we are almost certainly in already – a need recognized by economists from Nouriel Roubini to Larry Summers to Martin Feldstein. More recently, I speculated on the relationship between democratic politics and economic policy in a time of crisis. Well, as just about everyone in the world knows, things are coming to a head.

Whether we get a large economic stimulus package in the US – the economy whose health affects, for better or worse, just about everyone in the world – could very well depend on who is elected on Tuesday. For a summary of their short-term economic proposals, see here.

If Barack Obama is elected, we are likely to see a large stimulus package. It would probably include the measures that many economists are favoring, including extended unemployment benefits (and suspension of tax on those benefits), immediate cash aid to state governments, increased home heating cost aid, and infrastructure spending. These measures will have a direct impact on the economy by increasing spending now, while increasing it in ways that are necessary (keeping poor people alive) or that are productive long-term investments (infrastructure). Some of his other suggestions will have a more limited impact on the economy, such as a cash tax rebate, or are more or less irrelevant to the economy, such as relaxing the minimum distribution requirements for retirees.

With John McCain, we are not likely to see a stimulus package – or, more accurately, the package we see will be built around tax cuts that are not likely to have a direct economic impact. His proposals include: reducing taxes on retirement account withdrawals; increasing capital loss write-offs; reducing long-term capital gains tax rates; exempting unemployment benefits from taxes; also relaxing minimum distribution requirements; extending all of the Bush tax cuts; and reducing corporate tax rates. Except for the tax cut on unemployment benefits, these proposals suffer from the basic problem that undermined the last stimulus package this spring: in tough economic times, people take their tax rebates (or tax cuts, or cash you give them in any form) and stuff it under their mattresses, or pay down debt. McCain’s plan also includes the famous (or infamous) proposal for the government to buy up and refinance mortgages directly. (Obama favors increased loan modifications and legislation to eliminate some of the legal barriers to modifications.) But while that could potentially help homeowners and lenders, it doesn’t increase economic activity any.

(For an explanation of why different programs have different marginal impacts on GDP, see Menzie Chinn’s post.)

That said, given the way legislation is passed in Washington, the final package is likely to differ from either person’s proposals, whoever is elected. But the next major step that our government takes to combat the financial and economic crisis will depend directly on the outcome of Tuesday’s election.

Financial Crises and Democracy

Lorenzo Bini Smaghi, a member of the Executive Board of the European Central Bank, gave a thought-provoking speech in Milan last week. In particular, he focused on the role of democratic politics in responding to the financial crisis and, more broadly, in how governments manage their economies. Smaghi begins with the premise that it was a mistake to let Lehman fail in mid-September (not everyone agrees with this, but many people do), thereby triggering the acute phase of the credit crisis. He then asks why this happened.

As subsequent events have shown, in particular when the first rescue package was rejected by the US Congress, opposition to providing the financial sector with public funds came not only from within the government, but also from parliament. The Members of the US Congress, many of whom face voters at the beginning of November, feared that such a decision would compromise their re-election. There was opposition to rescuing Lehman Brothers, therefore, not only from within the Administration, but also from Congress and, more broadly, from public opinion. In other words, the decision was largely the result of a democratic process.

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