Economics/Finance

I’ve been working away on my series of ideas about economic history, theory, policy that have been refuted, or at least sharply challenged by the experience of the bubble economy and the global financial crisis. Not wanting to overwhelm CT with econowonkery, I’ve posted the most recent ones on my blog. For those who like econowonkery, here’s a current list of the posts at my site

#1 The efficient markets hypothesis: Also posted at CT

#2 The case for privatisation: Also posted at CT

#3 The Great Moderation

#4 Individual retirement accounts

#5 Trickle down

The speed with which bank nationalisation has risen to the top of the policy agenda has found the economics profession largely unprepared. The literature on property rights that developed in the 1970s produced a range of arguments in favour of private as opposed to public ownership which had at least some influence on the widespread adoption of privatisation policies in the 1980s and 1990s. Although subsequent theoretical and empirical developments, such as the discovery of the equity premium puzzle and developments in agency theory cast doubt on the claims of the original literature, the profession as a whole had moved on, and showed little interest in revisiting the issues. The situation was a bit different in Australia.

As Joshua Gans observes,

the main contributions have come from Australian economists who did this research a decade ago only to be told by international journals that as privatisation had occurred everywhere by then, no one was interested in the conditions under which government ownership would be preferable.

and notes “I guess that view is wrong.” Unsurprisingly, I was among those who tried, with limited success, to interest the international profession in this question.

As Joshua’s post suggests, there’s a feeling here that Australia tends to get the short end of the stick in the economics profession. Australia has made some notable contributions to economic thought, with relatively limited recognition. Examples include the work of Trevor Swan (arguably the most significant economist never to win a Nobel prize), Colin Clark on national accounting, and before that the “Australian case for protection” developed by the Brigden Commission and later formalised as the Stolper-Samuelson theorem. In the 1970s, the “Gregory thesis” was an independent analysis of what became known internationally as “Dutch disease”. As these examples suggest, we tend to suffer a bit from being on the far side of the planet from the main centres of activity in the profession.

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As James Surowiecki points out here, my views on what’s entailed in bank nationalisation differ significantly from those of Paul Krugman. [1] Krugman, like quite a few other advocates of nationalisation, has in mind models like the Resolution Trust Corporation and the Swedish nationalizations of the 1990s, where the government took insolvent institutions into temporary public ownership, liquidated the bad assets and returned them to the private sector. These solutions worked well because the global financial system as a whole was solvent and liquid, even though some sectors (US S&Ls, Swedish banks) were not.

What’s needed in the present case is not only to fix the problems of individual banks, problems on a much bigger scale than have been seen before (even in the leadup to the Great Depression, the financial sector played a smaller role in the economy than in the recent bubble), but to reconstruct a failed global financial system. It’s kind of like rewiring an electrical system in near-meltdown, while keeping the power on (this is possible, but tricky and dangerous). The job is likely to be much slower than the rescues mentioned above, and the institutions that emerge from it will be very different from those that went in.

But, contra Surowiecki this time, this only strengthens the argument for nationalisation. Financial restructuring is going to be a huge challenge, involving both a radical redesign of national regulations and the construction of an almost completely new global financial architecture. To attempt this task while leaving the banks under the control of discredited managers nominally responsible to shareholders whose equity has, in the absence of massive transfers from taxpayers, been wiped out by bad debts, seems like doing live electrical work while wearing a blindfold and standing in a pool of water.

fn1. Krugman is well-known for being right when lots of others have been wrong, so take this into account in assessing the arguments.

All reasonable^TM commentators now agree that nationalisation of big banks like Citigroup, Bank of America and Royal Bank of Scotland must take place soon, explicitly or otherwise. As I said at just before the second (failed) Citigroup bailout) banks like Citi are not only too big to fail, they’re too big to rescue with any of the half-measures that have been tried so far.

It’s obvious that “If it were done when ’tis done, then ’twere well It were done quickly” and cleanly, without any dodges designed to hide the reality of nationalisation. The longer these zombie institutions are allowed to run on public money, but under the existing discredited managers, legally answerable to the private shareholders, the bigger the costs the public will ultimately face.

Nationalisation would resolve a lot of the difficult questions around ideas such as the creation of a “bad bank” to hold all the toxic assets accumulated during the boom. That’s critical as long as policy is aimed at turning the troubled banks around while keeping them private, but it’s unimportant once all the debts and assets have been taken on to the public balance sheet. Once the big banks are nationalized, the government can take its time salvaging whatever assets are still worthwhile and preparing for the reconstruction of a private banking system under a completely new system of regulation, a task that is likely to take several years.

The big question is, what should governments do with the banks once they own them? Clearly, there’s an imperative for banks to start lending again, but there is no benefit in making yet more bad loans. And, right at the moment, credit-worthy borrowers are hard to find. The immediate concern must be to ensure that commercially sound loans aren’t being constrained by the need to bolster bank balance sheets. Then, governments need to consider whether some form of support for loans, such as interest rate subsidies or guarantees (secured against assets seen as having a long-term value that exceeds their current market value) should be part of the policy response to the recession. Such policies have plenty of risk associated with them, but the risks are mitigated a bit if the guarantor and the bank owner are ultimately the same (in this case, the public).

Obviously, this is not the kind of question economists have spent a lot of time thinking about until fairly recently. I don’t imagine many of us would have expected, a year ago, to be reading the Wall Street Journal castigating Henry Paulson and the Bush Administration for the (partial) nationalisation of the Bank of America. No doubt plenty of mistakes will be made. But there is no time for leisurely reflection here. As in 1933, the next hundred days will make a big difference, one way or another.

Donated Kidney is Center of Divorce Dispute:

A Long Island doctor is demanding that his estranged wife give him back the kidney he donated to her seven years ago. Dr. Richard Batista’s lawyer Dominic Barbara says his client would also be satisfied with the value of the kidney: $1.5 million. Newsday reports that Batista married wife Dawnell in 1990 and that he donated the kidney in 2001. According to Batista, their marriage was on the rocks then, but “My first priority was to save her life. The second bonus was to turn the marriage around.” Dawnell Batista filed for divorce in 2005. Dr. Batista told WCBS 880, “She had an affair, then would not reconcile, then handed me divorce papers as I was going into surgery trying to save another person’s life.

All in all the very archetype of a wacky organ donation story, right down to the mandatory quote from Arthur Caplan.

Over at my blog, I’ve started a series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion. I’m crossposting here in the hope of getting more discussion, but readers who aren’t interested in econowonk stuff may want to skip this series.

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There’s been a lot of talk about the idea that the GFC (the in-group shorthand for ‘global financial crisis’) is an example of a ‘black swan’, that is, an event that would be treated as impossible on the basis of induction from past experience, and hence that could not be encompassed by formal models of the kind used by risk managers. All this talk has of course been great for Nicholas Taleb who has a book with this title. It’s good in a lot of ways, but I found it ultimately insufferable in the continuous repetition of the message that only Taleb was smart enough to see all this. ( To be fair, Taleb predicted a global financial crisis, and didn’t simply claim it in retrospect as an unpredictable Black Swan).

I spend a lot of my time working on how to think about unforeseen contingencies and I’m not at all convinced that the GFC should be described in this way. Of course, the models used by the risk managers in investment banks didn’t include this as a possibility; if they had, the implication would have been that all sorts of much-desired deals should not go ahead. But as I pointed out a while ago, very simple models based on well-established principles predicted that the bubble economy would end badly.

The crisis then, involved something more like dark matter, the ‘missing’ matter in the universe that must exist if it is to work as it does, but can’t at presented be detected. Given that risk can’t easily be made to disappear*, it was obvious that the risk associated with lending of all kinds (most obviously, mortages offered to people with no capacity to repay) was being borne by someone, and probably someone who was unaware of it.

The big problem for the Cassandras (and we were certainly both correct and disregarded) was that it was easy to see that the bubble could not continue and much harder to foresee how it would end – it’s one thing to say that dark matter must exist and another to work out what it is really like. Like Brad and Brad, I expected that the problems would emerge first in the form of a run on the US dollar, given that holders of US dollar assets were receiving very little compensation for the obvious risk of large capital losses. In fact, the US dollar actually rose in the early stages of the meltdown, though it has been falling more recently.

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I wrote a piece for the Centre for Policy Development on Public Private Partnerships which was also picked up by the Canberra Times. This bit may be of interest to UK readers

The British government, which has nationalised or bailed out large parts of the banking sector is now suggesting that banks may be forced to lend to private investors in public projects under the Private Finance Initiative. In effect, the government will be lending money to itself, while paying the costs of a series of complex transactions (some of them highly vulnerable to exploitation) along the way.

That’s the new target interest rate announced by the US Federal Reserve today (with a margin of up to 25 basis points). It’s also, following the $50 billion Madoff fraud and the increasingly widespread suspicion that the entire bailout scheme has been operated to promote the interests of Goldman Sachs at the expense of its competitors and the general public, an upper bound for the credibility of the global financial system. And it’s a pretty good estimate of the probability that we’re going to avoid a recession worse than any since the Great Depression.

Without a household name like Citigroup or GS going bust, it’s hard to convey the seriousness of the latest news in an environment where we are already inured to financial cataclysms. But it seems pretty clear that the last couple of days spell the end for both hedge funds (many of which have lost a fortune with Madoff and all of which are subject to invidious comparisons with his decades-long Ponzi scheme) and money market funds, which can’t possibly cover their costs given a funds rate of 0.25 per cent.

The _Financial Times_ published an article based on an interview with Jean-Claude Trichet today (the article itself seems to be borked, along with the rest of the FT’s website, but the interview itself, which is more informative in any event, is available “here”:http://www.ecb.int/press/key/date/2008/html/sp081215.en.html ). In the interview, Trichet suggests that large scale deficit spending is a bad idea because of ‘Ricardian effects.’

Consider the Ricardian effects, the level of confidence or the lack of confidence that you observe in the various constituencies of economic agents, particularly at the level of households: they suggest that there are certain situations where if you do not behave properly you might lose more in terms of confidence than what you are supposed to gain through the additional spending.

and

Every nation has its own Ricardian effects and its own assessment of the situation. I do not want to comment on any particular country, because my duty is to look at the continent of 320 million fellow citizens as a whole. But I fully accept that there are differences in the capacity of households in various cultures to accept a deterioration of their situation, and again, the Ricardian channel tells us that one might lose more by loss of confidence than one might gain by additional spending.

Is this plausible? The broad political economy literature on consumer behaviour that I’m aware of would suggest that this argument rests on some fairly heroic assumptions about individual information (and in particular their awareness of the possible long term consequences of government spending – and this leaves aside the claim that for some reason they will systematically _overestimate_ the consequences tomorrow of deficit spending today). As best as I’ve been able to tell from a quick glance at the WWW, the claim that Trichet is making is a controversial one, which lacks solid empirical support. But then, my understanding of macro theory is based on fast-disappearing memories of my BA coursework. So is there any solid empirical basis for the claim that strong Ricardian effects exist and are a real issue for policy makers? Or is this just a theoretical figleaf to cover over the less abstract political-economic reasons (to do with institutional prerogatives, inter-state relations, worries about defection etc) why the European Central Bank really wants to keep controls on national spending? This is not a rhetorical question – I honestly don’t know the answer, and would appreciate information from those who know this literature better than I do.

As it has become evident that the financial crisis is comparable, in important ways, to the early stages of the Great Depression, there has been a lot of debate about the lessons to be learned from the responses to the Depression in the US, most notably the various policies that made up the New Deal. There’s a lot to be learned there, but it’s also important to remember that the Depression, in the US and elsewhere, continued throughout the 1930s before being brought to an abrupt end by the outbreak of World War II.[1]

Not only did the slump end when the war began, it did not return when the war ended – a huge difference from previous major wars. Instead the three decades beginning in 1940 were a period of unparalleled prosperity for developed countries, with economic growth higher and unemployment lower than at any time before or since.

What lessons can we learn from this experience?

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Can’t imagine “how we missed this”:http://www.boston.com/news/local/articles/2006/02/16/summers_should_go_ex_harvard_dean_says/ the first time around …

Over lunch not long after Summers took over the presidency in 2001, Ellison said, Summers suggested that some funds should be moved from a sociology program to the Kennedy School, home to many economists and political scientists. ”President Summers asked me, didn’t I agree that, in general, economists are smarter than political scientists, and political scientists are smarter than sociologists?” Ellison said. ”To which I laughed nervously and didn’t reply.”

Via “Josep Colomer”:http://jcolomer.blogspot.com/2008/11/normal-0-21-false-false-false.html.

I haven’t had time to digest the implications of this story which has been around for at least a month, but only now seems to be attracting attention (I’ve seen it in a few different places today). Apparently, short sellers in the US Treasury bond market are failing to deliver the securities they’ve sold. As long ago as 1 October, the shortfall was more than $2 trillion by one report. Via Felix Salmon, here’s Helen Avery in Euromoney.

I’m not an expert on this stuff, but it seems to raise the question of whether bond markets can or should continue to exist in their current form. Maybe the US and other Treasuries should be selling bonds directly, and offering repurchase options to provide liquidity, perhaps using the banks they’ve already part-nationalised to handle the mechanics.

The failure of Citigroup, which looks increasingly likely to happen in the near future, would mark the end of the beginning of the financial crisis. Until now, the prevailing view has been that the crisis and recession will pass in a year or so, after which things will go back, more or less, to the way they were, with a few less financial institutions, and a bit more regulation. A Citigroup failure would put paid to that idea.

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