Greg Mankiw Joins the Inflation Caucus
Will Bank Recapitalization Work?

Blogging Krugman's The Return of Depression Economics Over at TPM Cafe...

TPMCafe | Talking Points Memo | What Is Non-Depression Economics?: This discussion has so far one major lack: it does not tell us what "depression economics" is supposed to replace--it does not tell us what non-depression economics is, or was.

So let me try my hand at a definition of non-depression economics.

Non-depression economics believes that:

  • Short-run economic policy should be left to the central bank--the legislature and the executive should focus on the long run and keep their noses out of year-to-year fluctuations in employment and prices.
  • The highest priority for central banks should be to maintain their credibility as guardians of price stability.
  • Once that highest goal has been achieved, central banks can turn their attention to trying to keep the economy near full employment.
  • They should try to keep the economy near full employment by influencing asset prices--pushing asset prices up when unemployment threatens to rise, and pushing them down when an inflationary spiral appears on the horizon.
  • Central banks should influence asset prices through normal open-market operations--by buying and selling short-term government securities for cash, thus changing the safe interest rate and the price of longer-duration assets.
  • Central banks should stand ready to intervene to prevent bank runs. Otherwise, central banks should let the financial sector run itself with a light regulatory hand--financiers can take care of themselves, and the central bank should view itself not as chaperone or duenna but rather as the designated driver in the case of financial speculative excess.

That is what Paul Krugman is arguing is no longer sufficient doctrine for our age.

TPMCafe | Talking Points Memo | What Is Going to Be the New Leading Sector?: What is going to be the new leading sector? What is going to allow us to maintain full employment without running huge long-term budget deficits that will, eventually, sap our rate of economic growth somewhat?

If it weren't for the fact that the furshlugginer dollar refuses to fall in value, the answer would be obvious: we will have a boom in import-competing manufacturing (and exports). But then the rest of the world has a long-run problem: if we decide to no longer be the world's importer of last resort, than what serves as a locomotive to keep it near full employment?

But if the dollar doesn't fall, then we have a long-run problem. The only answer I can think of is for the U.S. to then become the world's largest private-equity fund: they lend us their money, and we then invest the money back in their economies--in industries and companies that then have a very high demand for U.S. high-tech goods and for U.S. services exports.

TPMCafe | Talking Points Memo | What Is to Be Done Now?: Paul Krugman writes:

[M]y main answer to Brad's question is that the events of 1997-1998 were, for me, a wake-up call. Before then I'd taken it for granted that central banks could always pump up demand, but Japan showed that the liquidity trap was a very real danger in a world in which inflation rates were fairly low.... I'd also assumed that bank runs were a thing of the past, but the Asian and LTCM crises showed that events functionally equivalent to bank runs could happen even if depository institutions - the denizens of big marble buildings with "FDIC insured" signs in their windows -- were protected. So I didn't take much comfort in the fact that a makeshift, cobbled-together set of measures managed to contain the crisis; it seemed all too obvious that the next crisis could be too big for improvisation to handle...

So what, in the long run, should the new regulatory and management system consist of?

Back in 1992 Larry Summers and I egged each other on to say that the target rate of inflation should be 5% per year--that anything less leaves you too vulnerable to a liquidity trap, and that as long as inflation is 5% per year it's hard to see any form of debt-deflation-credit-channel taking hold: even minimal principal amortization writes down the real value of debts and hence debt overhang very rapidly. Was this one of the (many) stupid things I have written in my career, or was it a really smart insight?...

We clearly need to extend the lender-of-last-resort umbrella to cover the shadow banking system--which means that someone has to oversee and regulate their portfolio leverage as well...

We clearly need to mandate that the Princes of Wall Street and Canary Wharf be paid not in cash bonuses and option rights but in restricted stock--to bail them into their institutions for a decade or so...

We clearly need to separate capital adequacy regulation from rating agencies that can be gamed in order to eliminate regulatory arbitrage...

But how do we impose capital requirements? Do we require that everybody unwind the derivatives in their portfolios and express them in a stocks-and-bonds-and-currencies basis, and then require monthly capital adequacy checks limiting their functional leverage to less than ten-to-one? I don't understand these issues well enough to have an informed view. And I don't see how I could implement a proper capital adequacy framework even if I were suddenly made head of bank regulation at the Federal Reserve...

And what, in the short run, is to be done with the crisis?

I am swinging around to (a) massive fiscal stimulus, plus (b) profit-making financial intervention: assign Fannie Mae and Freddie Mac to borrow from the Treasury and buy up mortgages at market prices until they have pushed the risky interest rate down to something reasonable. It's time for monetary policy to take on the role not just of managing the risk-free interest rate but managing the risky rate as well.

There is a big question here: is this possible? We know that the Federal Reserve can manage the riskfree rate without breaking a sweat. But I have Ricardian-equivalence worries about whether large scale government financial operations can actually move risky interest rates very far...

TPMCafe | Talking Points Memo | Japan's Fifteen-Year Long Crisis: Paul Krugman writes:

My first answer is that the 1998 crisis was not, in fact, resolved all that easily. Bear in mind that there were really two crises: the high-speed capital-flight crises of Southeast Asia and the prolonged Japanese slump. The capital-flight crisis did subside quickly -- although even there it left permanent damage (Indonesia, with a bigger population than all the other crisis countries combined, has never recovered to its old growth track.) But Japan's woes went on and on. And Japan was the clearest omen for the United States...


TPMCafe | Talking Points Memo | Dean Baker Talks to His Inner Hayek: Dean Baker wrote:

Several Bush administration officials have suggested reducing mortgage interest rates to 4.0 percent, or possibly lower, with the intention of boosting the housing market. While there are markets in which it would be reasonable for the government to intervene to prevent a downward spiral of house prices, it is difficult to see anything good that would come from delaying a full adjustment in the markets that have still yet to fully deflate.

If extraordinarily low mortgage rates can succeed in preventing prices from falling back to trend levels, then house prices in these markets will presumably plummet when the economy recovers and mortgage interest rates return to more normal levels...

I disagree.

The mortgage interest rate is made up of four things. Compensation for inflation--call it 2% per year. Real time preference--the fact that because we will be richer in the future we value future goods at less than par in terms of present ones--call it 2% per year. The default discount--which in a well-run housing market should be small. And the risk discount--the extra return mortgage lenders demand because they are not sure when their payments are going to come exactly or what they will be worth exactly when they do come--and I am under the spell of Richard Thaler and Matt Rabin who argue that this discount should also be very small.

Thus I think that 4.0% per year is what mortgage interest rates ought to be. There is no higher "normal" that they ought to return to. The fact that they are not at 4.0% on average is a sign of a significant market failure--a failure to appropriately mobilize the collective risk-bearing capacity of the y.

But a 4% mortgage rate would push up housing prices. Wouldn't that tend to make housing less affordable? No--because it would also push down the mortgage payment you would have to make to carry a mortgage of a given principal amount. And the two effects should offset each other.

So I say: unleash Fannie Mae and Freddie Mac. Let them borrow at the Treasury rate and buy and buy up mortgages until the mortgage rate is down to inflation plus 2% per year. That seems to me to be a good use of public money--and in all likelihood a profitable one.

TPMCafe | Talking Points Memo | 1998 and 2008: What's Different?: Let me ask Paul two related questions:

Paul, you wrote the first version book a decade ago, back when you were worried that the East Asian financial crisis of 1997-8 was a dying canary in a coal mine, a reflection not of faults in the Asian model but rather a sign that the old business cycle malady that we thought was controlled by monetarist eurythromycin was gaining immunity. But the East Asian financial crisis of 1997-1998--although sharp--was quickly cured (i) once the International Monetary Fund realized that the crisis was not one to be cured by administering painful medicine to governments, (ii) once the U.S. Treasury was freed from the fetters that Alfonse D'Amato and Bob Dole had imposed on it, (iii) once the IMF and the U.S. Treasury understood that their role was that of a lender-of-last-resort, and (iv) once Bob Rubin had bailed the big New York banks into Korea. The old monetarist eurythromycin seemed to work pretty well.

So, first, why did you back in 1998 think that the business cycle malady had developed some immunity?

And, second, why now does it seem as though the business cycle malady has developed some immunity?