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August 2011

Why Are People So Willing to Hold U.S. Treasuries?

Gillian Tett:

Cash-rich investors choose crazy Treasury returns: Why does money keep flooding into the short-term Treasuries market…?. There are plenty of explanations around…. [T]here is another factor investors should watch: what companies and asset managers are doing with their spare “cash”…. Zoltan Pozsar…. The issue at stake revolves around the “cash” which companies, asset managers and securities lenders (such as custodial banks) hold on their balance sheets. Two decades ago, these cash pools were modest, totalling just $100bn across the globe…. But in recent years, these pools have exploded in size, as the asset management sector has consolidated and companies have centralised their treasury functions. Institutional cash managers now control between $2,000bn and $4,000bn globally….

That is startling. But what is more striking is where this “cash” has ended up. Two decades ago, it typically was placed in bank accounts. But in recent years, cash managers have started to avoid banks: in 2007, for example, just 16-20 per cent of these funds were on deposit. Why? Pozsar thinks the key factor was risk management…. [T]hey have hunted for alternatives that seemed liquid and safer than uninsured bank accounts, such as repurchase deals (backed by collateral), money market funds (often implicitly backed by banks), or highly rated short term securities (such as triple A rated asset backed commercial paper or mortgage bonds.) Pozsar argues that this has created a big distortion in the monetary aggregates….

Since 2008, large parts of the shadow banking world have all but collapsed. Thus cash managers are now frantically searching for new places to put their “cash”. Some has flooded into money market funds (which buy government bonds) or the repo world (often backed by bonds); some money has entered the T-bill market directly. Either way, the net result is a shortage of T-bills, particularly since banks and clearing houses are also gobbling up T-bills for regulatory purposes. Hence the low yields. From an investment perspective, these returns may seem crazy; but they are still attractive to cash managers because T-bills are liquid – and, most crucially, seem less risky than uninsured bank deposits…

Martin Wolf Looks the Economic Situation Squarely in the Eye

And boy is it depressing. Martin Wolf:

Struggling with a great contraction: In neither the US nor the eurozone, does the politician supposedly in charge – Barack Obama, the US president, and Angela Merkel, Germany’s chancellor – appear to be much more than a bystander…. Obama wishes to be president of a country that does not exist. In his fantasy US, politicians bury differences in bipartisan harmony. In fact, he faces an opposition that would prefer their country to fail than their president to succeed….

In the long journey to becoming ever more like Japan, the yields on 10-year US and German government bonds are now down to where Japan’s had fallen in October 1997, at close to 2 per cent (see chart). Does deflation lie ahead in these countries, too? One big recession could surely bring about just that. That seems to me to be a more plausible danger than the hyperinflation that those fixated on fiscal deficits and central bank balance sheet find so terrifying.

A shock caused by a huge fight over fiscal policy – the debate over the terms on which to raise the debt ceiling – has caused a run into, not out of, US government bonds. This is not surprising for two reasons: first, these are always the first port in a storm; second, the result will be a sharp tightening of fiscal policy. Investors guess that the outcome will be a still weaker economy, given the enfeebled state of the private sector. Again, in a still weaker eurozone, investors have run into the safe haven of German government bonds….

Nouriel Roubini, also known as “Dr Doom”, predicts a downturn. “A stopped clock”, some will mutter. Yet he is surely right that the buffers have mostly gone: interest rates are low, fiscal deficits are huge and the eurozone is stressed. The risks of a vicious spiral from bad fundamentals to policy mistakes, a panic and back to bad fundamentals are large, with further economic contraction ahead.

Yet all is not lost. In particular, the US and German governments retain substantial fiscal room for manoeuvre – and should use it. But, alas, governments that can spend more will not and those who want to spend more now cannot. Again, the central banks have not used up their ammunition. They too should dare to use it. Much more could also be done to hasten deleveraging of the private sector and strengthen the financial system. Another downturn now would surely be a disaster. The key, surely, is not to approach a situation as dangerous as this one within the boundaries of conventional thinking.

Ben Bernanke Disappoints Ryan Avent: Federal Reserve Communication Edition


Monetary policy: The Fed's have-it-both-ways policy: I appreciate that [Bernanke] lectured the government on its heedless fiscal policymaking, but I found the tone on monetary policy to be confusing and timid…. I just hope that whatever the Fed opts to do in September is spelt out more clearly than its August decision…. [T]he frustratingly vague nature of the August statement… is part of a broader pattern at the Fed of failing to use the expectations channel effectively…. It is absurd to speculate about whether the Fed has the ability to provide more of a boost to the economy while the expectations tool is sitting on the shelf. I think Mr Woodford is right in suggesting that the main value of Fed purchases is in demonstrating the central bank's commitment to achieving its stated goals. By leaving those goals vague, the Fed seriously undercut its own stimulative effort. I don't know why. I just hope the Fed works through its hang-ups about clearer signalling by the conclusion of the September meeting.

Who Is the Pain-Austerity Caucus at the Federal Reserve Talking to?

Paul Krugman quotes the arguments of the three Federal Reserve Bank Presidents who called for pain and austerity at the last meeting:

Incoherence at the FOMC: Messrs. Fisher, Kocherlakota, and Plosser dissented because they would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an “extended period,” rather than characterizing that period as “at least through mid-2013.”

Mr. Fisher discussed the fragility of the U.S. economy but felt that it was chiefly nonmonetary factors, such as uncertainty about fiscal and regulatory initiatives, that were restraining domestic capital expenditures, job creation, and economic growth. He was concerned both that the Committee did not have enough information to be specific on the time interval over which it expected low rates to be maintained, and that, were it to do so, the Committee risked appearing overly responsive to the recent financial market volatility.

Mr. Kocherlakota’s perspective on the policy decision was shaped by his view that in November 2010, the Committee had chosen a level of accommodation that was well calibrated for the condition of the economy. Since November, inflation had risen and unemployment had fallen, and he did not believe that providing more monetary accommodation was the appropriate response to those changes in the economy.

Mr. Plosser felt that the reference to 2013 might well be misinterpreted as suggesting that monetary policy was no longer contingent on how the economic outlook evolved. Although financial markets had been volatile and incoming information on growth and employment had been weaker than anticipated, he believed the statement conveyed an excessively negative assessment of the economy and that it was premature to undertake, or be perceived to signal, further policy accommodation. He also judged that the policy step would do little to improve near-term growth prospects, given the ongoing structural adjustments and external challenges faced by the U.S. economy.

And Krugman comments:

So, let’s see: Fisher thinks that the problem is “uncertainty” caused by our Muslim socialist president “fiscal and regulatory initiatives”. This happens to be just wrong, as shown by lots of evidence; businesses aren’t expanding because of lack of demand, not because they fear Obamacare. But even if it were true, you don’t have to refill a flat tire through the hole: monetary policy is what you use when demand is insufficient, for whatever reason.

Kocherlakota basically says that the Fed has already done enough, because unemployment is down since the Fed’s last policy change, while inflation is up. But the Fed’s policy was supposed to put unemployment on a steadily declining trend, which hasn’t happened, while inflation was clearly a temporary bulge from commodity prices, now fading out.

Plosser thinks things are better than they seem, or something. (Why do I think of Oscar Wilde saying that Wagner’s music was better than it sounds?) He also, if I read this right, believes that our problems are largely structural or external or something; maybe he thinks we’re suffering from a lot of structural unemployment, despite strong evidence to the contrary.

Indeed. I guarantee you that Kochrlakota's claim that the job market had improved and the inflation outlook worsened was believed by nobody around the table except for his two peers. Why not? Because it was false: the job market had not improved and the inflation outlook had no worsened. And I guarantee that everybody around the table (except perhaps for his two peers) rejected Fisher's argument for the reason Krugman gave: you don't refill a flat tire through the hole. And I can derive no coherent view of the economy and economic policy from Plosser at all. These do not seem to me like arguments intended to persuade anybody who has contact with reality.

As Krugman writes:

The point is that all three dissents sound like people who have decided that they’re against easy money, and are looking for reasons to justify that decision. I sort of knew that, but it’s useful to have that demonstrated so clearly.

Yet Another Atlantic Monthly Fail

Why oh why can't we have a better press corps?

Megan McArdle:

Megan McArdle: "Before I was a journalist, I used to wonder why journalists were suppressing obvious important facts; after I became a journalist, I realized that it's often incredibly hard to know that there's a fact you're missing.  I seem to recall a scathing editorial about mortgage financing in maybe 2005, in which the outraged writer pointed out that banks were booking the asset value of the loans as if they were going to realize 100% of the payments . . . even though some of those loans would go bad!  Fraud!  Malfeasance!

. . . er, accounting.  Anyone who knows anything about accounting knows that what the writer was saying is absolutely true . . . and that if you look on the other side of the balance statement, you find that they have booked a corresponding allowance for bad debts.  You can argue that in 2005, those allowances weren't big enough--hell, I think at this point, it's not an argument, but a fact.  Nonetheless, the opinion column was ludicrously wrong.

And yet, understandably wrong. I'm sure that the writer had been fed the story by a consumer activist (I can probably name the group).  He looked at the financial statements, and the numbers checked out.  He'd never heard of such a thing as an allowance for bad debts, so how was he to know it was there?

No. It was not understandably wrong.

You write about what you know--so you know what facts to look for.

If you don't know about it, you don't write about it.

And even if you do know about it, you ask experts if you are missing something. And if you don't know any experts, you don't write about it.

The idea is to add to, not to subtract from the stock of knowledge.

A First Week of Class Platonic Dialogue

Adeimantos: Did Glaukon make it back from Jackson Hole yet?

Thrasymakhos: Yes, but his contribution was overshadowed by that of IMF honcho Christine Lagarde.

Adeimantos: I heard about that. She really took a left-wing fringe position, didn't she?

Thrasymahkhos: Calling for highly-leveraged banks to be adequately capitalized is a left-wing fringe position these days?

Adeimantos: It seems to be. The response from the Great and Good of Europe was that she did not understand the difference between "illiqudity" and "insolvency"--that the banks are not undercapitalized but merely illiquid.

Thrasymakhos: And if nobody doubts their solvency the reason the banks are illiquid is…?

Adeimantos: I agree. She is not the one who was confused. And, meanwhile, Charles Evans of the Federal Reserve Bank of Chicago calls for faster growth of nominal demand.

Thrasymakhos: Now that is a left-wing fringe position!

Adeimantos: So to require that nominal GDP follow a stable and predictable track is now part of left-wing beyond-the-pale radicalism these days?

Thrasymakhos: Touché…

Charles Evans of the Chicago Fed is a Mensch, and He Sees the Situation Clearly

Robin Harding reports:

Fed official makes plea for more stimulus: A leading Fed policymaker made an aggressive call for more monetary stimulus on Tuesday as it emerged that staff of the US central bank have permanently cut their growth forecasts. In an interview with CNBC, Charles Evans of the Chicago Fed said that he would “favour more accommodation” and became the first policymaker on the rate-setting Federal Open Market Committee to explicitly countenance letting inflation rise above the Fed’s target of 2 per cent in the short-term. “If 1 per cent was not a catastrophe, 3 per cent is not a catastrophe,” said Mr Evans. Ben Bernanke, Fed chairman, has strongly resisted all calls for temporarily higher inflation. Mr Evans is one of the most dovish members of the FOMC but his comments show the extent of division between hawks and doves at the central bank.

Minutes of the FOMC’s August meeting – which forecast that interest rates will stay exceptionally low until mid-2013 – showed the Fed’s staff had cut growth forecasts for the rest of 2011 and 2012 “notably”. More important, recent revisions to past growth data “led the staff to lower its estimate of potential [gross domestic product] growth, both during recent years and over the forecast period”. Mr Evans argued that the mid-2013 commitment did not go far enough. “I favour being much clearer and [more] specific about the economic markers that it would take in order for us to alter that,” he said. He added that this could mean a promise to keep rates low until unemployment fell from its current level of 9.1 per cent to 7.5 or even 7 per cent, as long as medium-term inflation stayed below 3 per cent. The minutes, however, showed that only a “few” FOMC members supported this approach.

Other easing options pointed out by “some” participants included further asset purchases – in effect a “QE3” programme, or third round of quantitative easing – or switching the Fed’s holdings towards longer-term assets. The minutes revealed that a “few” FOMC members, likely to include Mr Evans, had pushed for even stronger action in August but were willing to accept the mid-2013 guidance “as a step in the direction of additional accommodation”. That balanced out the three FOMC members who dissented. One of those dissenters, Minneapolis Fed president Narayana Kocherlakota, said in a speech on Tuesday that the Fed could “lose control of inflation” if monetary policy was too loose, forcing it to jack up interest rates. He argued that with unemployment falling and inflation rising, monetary policy was already as loose as it could be without risking a rise in inflation above 2 per cent.

As I have said before, it is hard to understand who Narayana Kocherlakota is talking to--in the sense that it is hard to imagine anybody who knows about the issues finding his arguments credible. There is no requirement in the Federal Reserve Act that the Federal Reserve never "risk" a rise in inflation above 2 percent. There is a requirement for price stability--and right now prices and demand are unstable downward in the sense that both are far below the values that everybody making plans back in 2007 counted on their being right now. It is not just that Kocherlakota and company are ignoring the employment and purchasing power parts of the Federal Reserve's dual mandate--they are ignoring the "price stability" part as well.

I must say if I were on the Federal Reserve Board of Minneapolis's Board of Directors right now, I would have a duty to find a President for the Bank who understood and would follow the Federal Reserve's dual mandate...

Our Medium-Term Deficit Is Solved by a Presidential Promise to Veto Every Bill That Is Not Ten-Year Deficit Neutral


Why Obama did not make such a promise and January 2009 and why he has not repeated it every day is beyond me.

Roberton Williams:

CBO’s Simple Story about the Deficit: A graph on the cover of the Congressional Budget Office’s summer budget update illustrates two policy paths we could pursue over the coming decade. One would essentially keep our deficit manageable through 2021. The other would make things much worse…. [I]f Congress lets the 2001-2003 tax cuts expire in 2013, stops patching the alternative minimum tax (AMT), and allows scheduled cuts in Medicare payments to physicians to occur [or requires offsets]. Under that scenario, the deficit would shrink to just 1.2 percent of GDP, a sustainable level in a healthy economy…. If Congress doesn’t let current law play out for those three policies, the deficit would grow over the decade, reaching a level nearly four times the current law deficit in 2021…. Almost all of the increase in the deficit would come from extending the tax cuts and the interest payments on the debt increase…

We Don't Understand Ben Bernanke...

James Kwak:

Ben Bernanke Doesn’t Get the Message: [I]n my opinion, Bernanke drew the wrong lessons…. He was very clear that the problem today is unemployment, not inflation…. He even said that we are in a situation where economics stimulus would improve the economy’s long-term performance…. But what is Bernanke going to do about it? He declined to offer any new efforts to reduce unemployment, saying only that the Fed “is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.” And mainly he relied on the political branches to solve the country’s problems, calling not only for “good, proactive housing policies” but also for policies that would improve K–12 education for underprivileged households and lower health care costs.

I don’t think it makes sense to criticize the political system for being dysfunctional and then rely on the political system to rescue the economy. I understand that traditional monetary policy tools don’t work that well in this environment: short-term rates can’t go any lower, and lowering long-term rates won’t make companies invest if they don’t think there is demand for their stuff. But there’s always, you know, dropping cash out of helicopters….

[T]he option of increasing the inflation target from 2 percent to 4 percent while simultaneously buying long-term bonds to keep nominal rates from rising too much…. [B]oth Ken Rogoff and Olivier Blanchard have argued for higher inflation, given current economic circumstances. As Blanchard says, “There was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.”

I’m not sure it would work; maybe even raising the inflation target wouldn’t actually increase inflation. But doing nothing is be the wrong policy conclusion to draw from Bernanke’s observations, which seem spot-on.


Project Syndicate: [F]inancial markets were glued to the speech [Bernanke] gave in Jackson Hole, Wyoming on August 26.  What they heard was a bit of a muddle.

First of all, Bernanke did not propose any further easing of monetary policy to support the stalled recovery – or, rather, the non-recovery…. Finally, Bernanke claimed that “the growth fundamentals of the United States do not appear to have been permanently altered by the shocks of the past four years.”

Frankly, I do not understand how Bernanke can say any of these things right now. If he and the rest of the Federal Open Market Committee thought that the projected growth of nominal spending in the US was on an appropriate recovery path two months ago, they cannot believe that today. Two months of bad economic news, coupled with asset markets’ severe revaluations of the future – which also cause slower future growth, as falling asset prices lead firms to scale back investment – mean that a policy that was appropriate just 60 days ago is much too austere today.

[B]y the time this lesser depression is over, the US will have experienced an investment shortfall of at least $4 trillion. Until that investment shortfall is made up, the missing capital will serve to depress the level of real GDP in the US by two full percentage points. America’s growth trajectory will be 2% below what it would have been had the financial crisis been successfully finessed and the lesser depression avoided. There is more: state and local budget-cutting has slowed America’s pace of investment in human capital and infrastructure, adding a third percentage point to the downward shift in the country’s long-term growth trajectory.

After the Great Depression of the 1930’s, the vast wave of investment in industrial capacity during World War II made up the shortfall of the lost decade. As a result, the Depression did not cast a shadow on future growth – or, rather, the shadow was overwhelmed by the blinding floodlights of five years of mobilization for total war against Nazi Germany and Imperial Japan. There is no analogous set of floodlights being deployed to erase the shadow that is currently being cast by the lesser depression. On the contrary, the shadow is lengthening with each passing day, owing to the absence of effective policies to get the flow of economy-wide nominal spending back on its previous track.

Moreover, there is an additional source of drag. A powerful factor that diminished perceived risk and encouraged investment and enterprise in the post-WWII era was the so-called “Roosevelt put.” Industrial-country governments all around the world now took fighting depression to be their first and highest economic priority, so that savers and businesses had no reason to worry that the hard times that followed 1873, 1884, or 1929 would return.

That is no longer true. The world in the future will be a riskier place than we thought it was – not because government will no longer offer guarantees that it should never have offered in the first place, but rather because the real risk that one’s customers might vanish in a prolonged depression is back.

I do not know by how much this extra risk will impede the growth of the US and global economies. A back-of-the-envelope estimate suggests that a five-year lesser depression every 50 years that pushes the economy an extra 10% below its potential would reduce average investment returns and retard private investment by enough to shave two-tenths of a percentage point from economic growth every year. As a result, America would not just end this episode 3% poorer than it might have been; the gap would grow – to 7% by 2035 and 11% by 2055.

This is the shape of things to come if steps are not taken now to recover rapidly from this lesser depression, and then to implement policies to boost private capital, infrastructure, and education investment back up to trend. Perhaps that would be enough to reassure everyone that policymakers’ current acquiescence in a prolonged slump was a horrible mistake that will not be repeated.

Barton Gellman Says Dick Cheney Is a Liar

So what else is new?

Barton Gellman:

In New Memoir, Dick Cheney Tries to Rewrite History: On March 10, Bush sent White House Counsel Alberto Gonzales and Chief of Staff Andrew Card to obtain Ashcroft’s signature as he lay in intensive care. When Ashcroft refused, Cheney’s lawyer drafted and Bush signed an order renewing the warrantless surveillance over explicit Justice Department objections.

Cheney’s version of this story adds a stunning twist: Ashcroft told Bush on the phone, before Gonzales and Card arrived, “that he would sign the documents” to certify the surveillance as lawful. But the two men found Comey there when they arrived, Cheney writes, and “it became immediately clear that Ashcroft had changed his mind.”… [I]t is very difficult to see how Cheney’s claims on either point could be true.

Comey and four other officials with contemporary knowledge told me in interviews that Janet Ashcroft, the attorney general’s wife, refused two attempts that evening by the White House operator to patch a call to her husband. Doctors said he was far too sick to speak. According to contemporary notes from Ashcroft’s FBI security detail, quoted in an inspectors general report of 2009, she refused to put her husband on the phone even when Bush joined Card on the line…. Bush implied in his memoir that he did reach Ashcroft, but said he told him only that “I was sending Andy and Al to talk to him about an urgent matter.”

Even if Ashcroft picked up the phone, there are many reasons to doubt Cheney’s version of the call. It would mean that Bush discussed a codeword-classified intelligence program on an open phone line; that Ashcroft took exactly the opposite position that he took before and after the call; and that the attorney general was even coherent…. Even harder to credit is Cheney’s suggestion that the White House did not know until that moment that Comey had assumed Ashcroft’s powers. David Ayres, Ashcroft’s chief of staff, called deputy White House chief of staff Joe Hagin from the emergency room a full week earlier, on March 4, to say the attorney general was incapacitated….

Cheney misstates another crucial point, alleging that it was not until “the spring” of 2004 that Justice began “raising concerns” about the surveillance program. In fact, the chief of the Office of Legal Counsel, Jack Goldsmith, started expressing strong doubts in December 2003, and Comey joined him in January….

It is very likely true, on the other hand, that Bush was unaware of the crisis until the last moment. My reporting supports the president’s published account that he did not know about the Justice Department’s objections until the day before the program was set to expire. The sudden news, portrayed by Card and Cheney as a sudden turnabout by Comey, is what prompted Bush to dispatch his aides to the hospital. Even then, it was not until the next morning – when he discovered that Comey and FBI Director Robert Mueller were about to resign – that Bush understood his presidency was at risk.

Cheney’s biggest contributions to the history of this episode are his matter of fact acknowledgment that the surveillance program was his initiative, that Addington drafted and held the only copy of its crucial documents, and that he disagreed with Bush’s decision to give in to “threats of resignation.” Cheney urged Bush to stand his ground, and he clearly implies that the president lost his nerve.

Bush tells it differently. “I had to make a big decision, and fast,” he wrote in his memoir. “Some in the White House believed I should stand on my powers under Article II of the Constitution and suffer the walkout…. I was willing to defend the powers of the presidency under Article II. But not at any cost. I thought about the Saturday Night Massacre in October 1973, when President Richard Nixon’s firing of Watergate prosecutor Archibald Cox led his attorney general and deputy attorney general to resign. That was not a historical crisis I was eager to replicate.”

The Bush-Cheney relationship never fully recovered from that day. Bush wrote, without naming Cheney, that he “made clear to my advisers that I never wanted to be blindsided like that again.” March 11, 2004 was the day the president of the United States discovered that the vice president’s zeal could lead him off a cliff…

The Short-Term Deficit Isn't a Problem But a Blessing. The Long-Term Deficit Is All About Health Costs. And the Medium-Term Deficit Is Only a Problem If We Make It One

Matthew Yglesias:

Debt Reduction By Doing Nothing: Given the amount of griping about debt reduction in Washington, it’s remarkable how little attention is paid to the fact that doing nothing solves the medium-term problem.

When we argue about the long-term deficit, we’re arguing about health care costs. But when we argue about the medium-term deficit, we’re primarily arguing about how to keep the deficit manageable consistent with extending a bunch of tax cuts. Politicians who are genuinely obsessed with the deficit as such should simply be saying, “I won’t vote for any tax cuts or spending increases that aren’t offset.

Felix Salmon Approves of Christine Lagarde of the IMF

"Leads from the front" is a dig at claims that on Libya Barack Obama has "led from behind"...


Lagarde leads from the front on Europe: Going into the Jackson Hole conference, everybody was breathlessly awaiting Friday’s speech from Ben Bernanke, which turned out to be incredibly boring. The most important speech of the meeting, by far, came on Saturday, and came from the new head of the IMF, Christine Lagarde. In decidedly undiplomatic prose she came right out and said what needed to be done:

Two years ago, it became clear that resolving the crisis would require two key rebalancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties… the actual progress on rebalancing has been timid at best, while the downside risks to the global economy are increasing….

I’ll start with Europe…. Banks need urgent recapitalization…. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns…

The United States needs… future consolidation—involving both revenue and expenditure…. At the same time, growth is necessary for fiscal credibility…. Second—halting the downward spiral of foreclosures, falling house prices and deteriorating household spending. This could involve more aggressive principal reduction programs for homeowners, stronger intervention by the government housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment.

The diagnosis of what needs to be done in the U.S. is spot-on…. But it’s Lagarde’s diagnosis of her native Europe which is proving highly controversial. Anonymous “officials”, quoted in the FT, rapidly said that she had it all wrong…. [But] anybody who knows anything about banking knows that the distinction between a liquidity problem and a solvency problem is not nearly as clear-cut as this makes out. Indeed, if there weren’t any worries about European banks’ solvency, then they wouldn’t have any kind of liquidity problems…. And if the markets are worried about a bank’s solvency, then that bank’s solvency is what must be addressed — perception is reality in such matters…. Where Lagarde sees a huge systemic problem, European officials, it seems, still thinks it can patch things up by triaging the worst banks and applying band-aids….

[T]he FT does manage to find a sliver of a silver lining: Lagarde, they write, “has said publicly what most policymakers have avoided addressing since the crisis began”. Maybe she’s just leading from the front, here: even if policymakers don’t embrace her position immediately, they might come round to her way of thinking as the world’s developed economies continue to stagnate and financial markets continue to fret over a possible sovereign crisis…

Implementation of the Affordable Care Act

Health reform implementation in one map  Ezra Klein  The Washington Post

Sarah Kliff informs us of an Affordable Care Act implementation map from the Center on Budget and Policy Priorities.

So what happens in 2014 if (a) a Republican governor vetoes the exchange law, or (b) a Republican legislature refuses to pass an exchange law, and (c ) the Republican House attaches a rider to the HHS appropriation stating that no federal funds are to be used to set up exchanges in any states?

Do the Republican legislators at the state level then revolt? Or not?

Two Books I Should Reread...

Jo Walton writes:

Hugo Nominees: 1998: Let’s start with the one I like, Walter Jon Williams City on Fire, a wonderful innovative book, sequel to Metropolitan. They’re smart science fiction books about a world where magic is real and powers technology. I’m planning to do a proper post about them soon — they’re not like anything else, and they’re on a really interesting border between SF and fantasy. City on Fire is about an election. This would have had my vote, had I been at Baltimore, but I expect it suffered in the voting from not being a standalone. It’s not in print, and it’s in the library in French only, thus reinforcing my perception that Walter Jon Williams is massively under-rated.

Oh Dear… the Economist Should Be Doing Better Than This: Arguments for Expansionary Fiscal Policy Watch

Poor Richard Koo talks sense. But his adversary in the pages of the Economist is… Allan Meltzer.

When the U.S. government can borrow at a real interest rate of -0.65%/year for five years, the case for larger deficits now--for pulling spending forward from the future into the present and pushing taxes back from the present into the future--is unanswerable: of course the government should borrow more on such terms: households value the taxes they will pay in the future if taxes are pushed back as much less painful than the taxes they would otherwise pay today, and a huge number of government spending programs offer at least a zero percent real rate of return via their effect on the productive capacity of the economy. Even if expansionary fiscal policy had no effect on capacity utilization and unemployment bigger deficits now while the government can borrow on such terms would be a no-brainer. And since expansionary fiscal policy does have such effects, it is something that you should advocate even if you have less than no brain at all--even if you have a negative brain.

But Allan Meltzer finds a way to oppose pulling spending forward into the present and pushing taxes back in the future. However, the way he finds is by not dealing with any of the arguments for expansionary fiscal policy at all:

Allan Meltzer: The Obama stimulus is an example of bad advice leading to bad policy. Much of the pressure for additional stimulus now comes from those who want to repeat their error…. [T]emporary tax cuts have been tried repeatedly. Stacks of research support the theory. It is not enough to point to the number of unemployed and part-time employed to claim that something must be done. Mistaken actions do much more harm than good in part because they destroy confidence.

The analysis on which pressure for more spending rests is incomplete and flawed. There are two major omissions in the argument. Temporary spending to shore up or expand the welfare state directs resources mainly to saving not consumption. A well-designed policy that increases productivity is the key to creating good jobs at good wages. Also, increased spending financed by selling debt offsets much of any temporary stimulus. The public understands that higher debt today requires higher taxes tomorrow. Proponents of short-term spending ignore the financing; the public does not.

The simple models used to demonstrate the effectiveness of more government spending invoke a spending multiplier to show that those receiving an increase in demand for their product spend part of the proceeds, thereby generating additional demand, and invoking still further rounds of spending. After more than 50 years of estimating the size of the multiplier, the answer is that no one can be certain of its size. Estimates range from negative (yes negative) values to two, three or higher. A negative value means that spending is crowded out; a value of two or higher means that each dollar of government spending adds two or more dollars to total spending. Shouldn't the public demand that the case for more spending have a better foundation?

It takes at least 200,000 new jobs every month to lower the unemployment rate. Suppose the unlikely happens: new, temporary stimulus triples the growth rate of the first half of 2011, so it rises to 2.4% in the second half. Even that would not make a major dent in the unemployment rate. I know of no one who believes that a short-term fix will pull the American economy back to its long-term growth path. We face years of recovery. The correct response is to avoid more policy mistakes and concentrate on steps to raise investor confidence. That does not mean doing nothing. It means taking actions that remove some of the massive uncertainty that investors face. When you do not know what the tax rate will be, or what the government will do to raise energy, health care, finance and other costs, you cannot make a reasonable estimate of the uncertain return on new investment. Cash is your friend, so you hold it. And that is what investors are doing…

It is certainly not the case that Allan Meltzer is talking to me. I know that uncertainty about future tax rates was as great in 2006, when the unemployment rate was 4.5%, as it is today when unemployment is 9%. So was uncertainty about what the government was going to do to solve its long-run health-care spending problems, deal with global warming, deal with dependence on foreign energy sources, and regulate finance. Yet--as Allan Meltzer surely knows--investors weren't holding cash in 2006.

It is certainly not the case that Allan Meltzer is talking to anybody who knows about the labor market. As Allan Meltzer surely knows, the fact that a fiscal stimulus would not solve our entire excess unemployment problem has no bearing on whether such stimulus is a net benefit.

It is certainly not the case that Allan Meltzer is talking to us fellow economists. As Allan Meltzer surely knows, a higher multiplier than expected is not an argument against but rather an argument for fiscal stimulus, and claims of a negative multiplier--that measures like the surge of federal spending in World War II actually reduced measured GDP--lack all credibility.

It is certainly not the case that Allan Meltzer is talking to anybody who knows about how American government works. Aid to state and local governments does not increase saving but rather increases government consumption and investment. Debt-financed government spending crowds out private investment only when it raises interest rates--which it is definitely not doing now.

The real arguments against pulling spending forward and pushing taxes back right now are three:

  1. Such policies would reduce unemployment in the next eighteen months and so raise Barack Obama's reelection chances--and it is very important for the future of America that Barack Obama be defeated.
  2. It is much more important to keep government spending low than to reduce unemployment.
  3. Even though financial markets are extremely willing to hold seemingly-unlimited quantities of U.S. Treasury debt at astonishingly high prices right now, markets are on a knife-edge and the issuance of relatively small amounts of additional U.S. Treasury debt will panic the markets and cause a sovereign debt crisis in the U.S.

The problem, I think, is that those who believe in arguments (1) and (2) know that they are political losers--that most Americans do not believe that it is good to crash the American economy in order to achieve the twin goals of defeating Barack Obama and shrinking the U.S. government. And those who believe in argument (3) know that there is no empirical evidence for it right now at all.

Thus we get things like this.

Surely Greg Ip, as moderator of this debate, has a duty to point out to the Economist's readers that uncertainty was as great in 2006 as it is today, that it is better to do some good than no good at all, that uncertainty about multipliers is not a persuasive argument against fiscal stimulus, and that with interest rates at their current levels crowding out is a complete red herring?

Alan Krueger Is a Superb Choice for CEA Chair

Paul Krugman knows: he reads Alan's mail:

Economics and Politics: [W]hile the battery lasts: Alan is a fine choice as chief economic adviser. He’s done excellent work, he’s a really good guy, whom I know pretty well, since we keep getting each others’ mail. Now the question is whether anyone in the administration listens to him….

Alan may write about labor markets, but he knows macro and is pretty salt-water and activist by inclination, as far as I know. His advocacy of job tax credits comes from an attempt to work within political constraints, not lack of interest in more decisive solutions. And I think the administration was looking for a high-profile, first-rate economist willing to take the job, rather than tilting toward a particular field.

Also, the reason we get each others’ mail is that Princeton relies on the advanced mail-processing technology known as pigeon-holes, and our slots are next to each other in the Woodrow Wilson School set.

The Disaster That Is American Macroeonomic Policy

Paul Krugman reads the CBO forecast:

Five Trillion Dollars: A couple of notes on the most recent Congressional Budget Office Projections:

  1. They offer a portrait of an economic catastrophe. Here’s the CBO estimates of potential real GDP — the amount the economy could produce without causing inflationary pressure — and actual GDP, in trillions of 2005 dollars per year. No, I don’t know where that recovery in 2015 is supposed to come from; my guess is that it’s basically the CBO unwilling to project a depressed economy more or less forever. But even with that bounceback assumed, the projection says that we’ll have a cumulative output gap of $5.1 trillion…. Surely it would have been worth making an extraordinary effort to avoid this outcome. In particular, an $800 billion stimulus, a significant fraction of which was stuff that would have happened anyway (like extending the patch on the alternative minimum tax) looks ludicrously underpowered. Yet policy has been timid and conventional.

  2. The CBO also projects unemployment staying above 8 percent until late 2014 — again, with no clear explanation of why it should fall sharply in 2015. This translates into a human catastrophe for the long-term unemployed. It also says that there will be no good reason to raise interest rates for the foreseeable future.

I think if you had told people back in, say, 2007 that this would happen, they would have asserted with confidence that generating a faster recovery would be at the top of the political agenda. The fact that it isn’t — that deficits are still dominating the conversation, even as interest rates plumb record lows — is truly remarkable.

Department of "Huh?!"

Susie Madrak is skeptical of the story of Darrell Issa staffer Peter Simonyi aka Haller:

Former Goldman Employee Who Works For Issa Says He Changed His Name To Honor His Grandfather. Really?: What a touching story:

A staffer working for Rep. Darrell Issa's Oversight Committee on financial regulation issues has come under scrutiny by ThinkProgress for changing his name after he left his previous position at Goldman Sachs. The story implied that he changed his name three years ago to hide his background with the company. But Peter Haller, formerly known as Peter Simonyi, said in a statement to TPM that he and his sister switched their names a few years back to respect the last wish of his grandfather to carry on his mother's family name. His mother's father, Alfred haller-koi gr Haller, was killed by fascists in Budapest in 1944 when he tried to stop children from being conscripted into the military, Haller said.

My mother, whose maiden name is Theodora Maria Theresia haller-koi gr Haller (in the U.S., Dora Haller), married Imre Gabor Simonyi and took his name. Her father Alfred haller-koi gr Haller was killed in Budapest in 1944 by fascists as he attempted to prevent children from being conscripted into the military. Prior to his return to Hungary in 1944, he served under Regent Miklos Horthy, as a Hungarian diplomat stationed in England supporting the British in opposition to Germany. His last request was that if Theodora marries, her husband and children would carry on the Haller name…

Indeed. Inasmuch as Britain declared war on Hungary on December 7, 1941, it is unclear how there could have been Hungarian diplomats in Britain working for fascist-allied Regent Admiral Miklos Horthy in 1944…

John Kay on Grand Theft Econ

John Kay:

Economics: Rituals of rigour: "The two branches of economics most relevant to the recent crisis are macroeconomics and financial economics…. [Macroeconomics's] dominant paradigm is known as “dynamic stochastic general equilibrium” (thankfully abbreviated to DSGE) – a complex model structure that seeks to incorporate, in a single framework, time, risk and the need to take account of the behaviour of many different companies and households. The study of financial markets revolves meanwhile around the “efficient market hypothesis”… and the “capital asset pricing model”…. A close relationship exists between these three theories. But the account of recent events given by proponents of these models was comprehensively false. They proclaimed stability where there was impending crisis, and market efficiency where there was gross asset mispricing….

[M]istaken claims found substantial professional support. In his presidential lecture to the American Economic Association in 2003, Robert Lucas of the University of Chicago, the Nobel prizewinning doyen of modern macroeconomics, claimed that “macroeconomics has succeeded: its central problem of depression prevention has been solved”. Prof Lucas based his assertion on the institutional innovations noted by Mr Greenspan and the IMF authors, and the deeper theoretical insights that he and his colleagues claimed to have derived from models based on DSGE and the capital asset pricing model. The serious criticism of modern macroeconomics is not that its practitioners did not anticipate that Lehman would fall apart on September 15 2008, but that they failed to understand the mechanisms that had put the global economy at grave risk….

The academic debate on austerity versus stimulus centres around a property observed in models based on the DSGE programme. If government engages in fiscal stimulus by spending more or by reducing taxes, people will recognise that such a policy means higher taxes or lower spending in the future. Even if they seem to be better off today, they will later be poorer, and by a similar amount. Anticipating this, they will cut back and government spending will crowd out private spending. This property – sometimes called Ricardian equivalence – implies that fiscal policy is ineffective as a means of responding to economic dislocation.

John Cochrane, Prof Lucas’s Chicago colleague, put forward this “policy ineffectiveness” thesis in a response to an attack by Paul Krugman, Nobel laureate economist, on the influence of the DSGE school…. Cochrane at once acknowledged that the assumptions that give rise to policy ineffectiveness “are, as usual, obviously not true”. For most, that might seem to be the end of the matter…. But Prof Cochrane will not give up so easily. “Economists”, he goes on, “have spent a generation tossing and turning the Ricardian equivalence theory, and assessing the likely effects of fiscal stimulus in its light, generalising the ‘ifs’ and figuring out the likely ‘therefores’. This is exactly the right way to do things.” The programme he describes modifies the core model in ways that make it more complex, but not necessarily more realistic, by introducing parameters to represent failures of the model assumptions that are frequently described as frictions, or “transactions costs”.

Why is this procedure “exactly the right way to do things”? There are at least two alternatives…. Joseph Stiglitz – another Nobel laureate – and his followers favour a model that retains many of the Lucas assumptions but attaches great importance to imperfections of information…. Another possibility is to assume that households respond mechanically to events according to specific behavioural rules, rather like rats in a maze – an approach often called agent-based modelling…. Another line of attack would discard altogether the idea that the economic world can be described by any universal model…. [M]odels, when employed, must be context specific. In that eclectic world Ricardian equivalence is no more than a suggestive hypothesis…. The generation of economists who followed John Maynard Keynes engaged in this ad hoc estimation when they tried to quantify one of the central concepts….

Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds, such as the “plug-and-play” environments of DSGE – or the Grand Theft Auto computer game.

For many people, deductive reasoning is the mark of science…. But this is an artificial, exaggerated distinction. Scientific progress – not just in applied subjects such as engineering and medicine but also in more theoretical subjects including physics – is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works. Not within the economics profession. There, deductive reasoning based on logical inference from a specific set of a priori deductions is “exactly the right way to do things”…. Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.

The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it. Economists – in government agencies as well as universities – were obsessively playing Grand Theft Auto while the world around them was falling apart.

Nick Kristof Makes Duncan Black Unhappy

Duncan writes:

Eschaton: Years Later: Pampered over-privileged scribe finally discovers that it's kinda bad when people don't have any jobs or money. Better late then never I guess.

Indeed. Nick Kristof:

Did We Drop the Ball on Unemployment?: WHEN I’m in New York or Washington, people talk passionately about debt and political battles. But in the living rooms or on the front porches here in Yamhill, Ore., where I grew up, a different specter wakes friends up in the middle of the night.

It’s unemployment.

I’ve spent a chunk of summer vacation visiting old friends here, and I can’t help feeling that national politicians and national journalists alike have dropped the ball on jobs. Some 25 million Americans are unemployed or underemployed — that’s more than 16 percent of the work force — but jobs haven’t been nearly high enough on the national agenda.

When Americans are polled about the issue they care most about, the answer by a two-to-one margin is jobs. The Boston Globe found that during President Obama’s Twitter “town hall” last month, the issue that the public most wanted to ask about was, by far, jobs. Yet during the previous two weeks of White House news briefings, reporters were far more likely to ask about political warfare with Republicans.

(I’m an offender, too: I asked President Obama a question at the Twitter town hall, and it was a gotcha query about his negotiations with Republicans. I’m sorry that I missed the chance to push him on the issue that Americans care most about.)

Why oh why can't we have a better press corps?

Is There a Useful "Neoclassical Macroeconomics"?

Tyler Cowen writes:

“Neoclassical macroeconomics” is not totally out to lunch, and it is ignored at our peril.

He is quoting Stephen Williamson:

Williamson: The scarcity we are observing is not a traditional currency scarcity. As such, we can’t correct the scarcity by using conventional central banking tools – open market operations in short-term government debt…. [T]he inability of monetary policy to correct the liquidity scarcity problem has nothing to do with the zero lower bound on short-term nominal interest rates, as the key problem is a contemporary liquidity trap, not Grandma’s liquidity trap…. If monetary policy cannot do it, that leaves fiscal policy…. But the problem here is financial, and it’s not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia. One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.

Alas for Tyler! From my perspective this "neoclassical macroeconomics" is merely Hicks (1937) (or perhaps Wicksell (1898)) "plus", as Rüdi Dornbusch liked to say, "original errors".

One thing that I think is wrong is in the passage Tyler quotes. It is the claim that what we have now "is not a Keynesian inefficiency associated with real rates of return [on savings vehicles] being too high; in fact real rates of return are too low". In the Keynesian-or perhaps it would be better to say Wicksellian--framework, when you say that real rates of return are "too high" you are saying that the market rate of interest is above the interest rate consistent with full employment, and with savings equal to investment at full employment. Wicksell called that interest rate the "natural rate of interest" and it is relative to that natural rate of interest that Wicksellian (and Keynesians) speak of interest rates being "too high" and "too low". Thus Williamson is wrong when he say that what we have now--when the natural rate of interest on relatively safe securities is negative and the market rate of interest is not--is "not a Keynesian [or Wicksellian] inefficiency". It is precisely such an inefficiency. To claim that it is not misinterprets Keynes (and Hicks, and Wicksell), and misleads readers trying to understand what they did and did not say.

This has consequences. A second thing I think is wrong is Williamson's claim that while things could be (or perhaps should be) improved by shifting the IS curve out and to the right by (or, if you prefer to speak Wicksellian language, raising the natural rate of interest by) cutting taxes now and committing to raise them in the future after the economy has recovered, things could not (or perhaps should not) be improved by pulling government spending forward from the future into the present. Why does pulling spending forward into the present fail while pushing taxes back into the future works? They both, after all, involve the issue right now of the additional safe and liquid financial assets that private savers are desperate for, and the absence of which is leading them to cut back on their spending. As far as the troubling shortage of safe, liquid, savings vehicles is concerned the two different policies are almost symmetrical, aren't they?

I do not find the explanation illuminating:

there is a tendency, particularly in the blogosphere, to frame the problem in Old Keynesian terms… so it might seem natural to have the government employ people directly by spending more. But the problem here is financial, and it's not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia…

And yet a third thing I think is wrong is Williamson's claim that "the Fed is powerless" because "swap[s of] reserves for T-bills or reserves for long-maturity Treasuries… essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect". But such swaps take various forms of duration and default risk onto (or off of) the Fed's and thus taxpayers' balance sheets and off of the private market and thus investors' balance sheets. These are different (but overlapping) groups who perceive risks differently, have different resources, and react to risks differently. The fact that the private market could undo any particular Federal Reserve policy intervention does not mean that it will.

I would say go back to Hicks, Keynes, Fisher, and Wicksell, and think about them carefully: they were smart. A "neoclassical macro" that does not start from them has little chance of getting much of anywhere.

Who Are the Obama Dead-Enders Talking to?

One such is Jonathan Alter:

You Think Obama’s Been a Bad President? Prove It: "From the left: “He should have pushed for a much bigger stimulus in 2009.” That’s the view of New York Times columnist Paul Krugman, now gospel among liberals. It’s true economically but bears no relationship to the political truth of that period. Consider that in December 2008, Pennsylvania Governor Ed Rendell, a hardcore liberal Democrat, proposed a $165 billion stimulus and said he would be ecstatic if it went to $300 billion. President- elect Obama wanted to go over $1 trillion but was told by House Democrats that it absolutely wouldn’t pass. In exchange for the votes of three Republicans in the Senate he needed for passage, Obama reduced the stimulus to $787 billion, which was still almost five times Rendell’s number and the largest amount that was politically possible…

It's very hard to figure out who Jonathan Alter is talking to. He certainly isn't talking to me. Or to Paul Krugman. Or to pretty much everybody technocratic who has now been calling for three years for Obama to do more--via the Treasury, via the Federal Reserve, via FANNIE and FREDDIE--to boost spending. Or to pretty much everybody who was in 2009 and 2010 calling for Obama to use the Reconciliation process and so get the Senate vote hurdle down from 60 to 50.

The point that congressional supermajorities to pass more stimulus via normal order were not there is not a rebuttal to the technocratic critique of Obama. Rather, it is part of the technocratic critique of Obama.

Matthew Yglesias Damns Slate and Praises Tim Noah

Matthew Yglesias:

Hail Tim Noah: I heard last night that longtime columnist Timothy Noah lost his job at Slate. They’ve always had a reputation for being a certain sort of publication, but Noah — earnest, dedicated to truth and justice and tackling the big issues — never fit the mold. “Laying Tim Noah off will make us a better publication” is, in its way, the ultimate Slate pitch.

His masterwork was his relatively recent series “The Great Divergence” on income inequality, which I thought was a real window into what a “web magazine” might possibly be. But beyond that, Noah’s also been a longtime champion of such important issues as Senate reform, a non-opportunist who wisely urged Democrats to take the plunge back in 2005. It’s really worth taking a moment to step back and consider what a better world we might be living in today had people taken his advice. A somewhat larger stimulus bill, a somewhat better health care bill, a somewhat tougher financial reform bill. But also dozens of extra judges and executive branch nominees. A carbon pricing law. A resolution of the Bush tax cuts. Most likely some form of federal labor law reform. The DREAM Act. It was never “realistic” that Senate Democrats would listen to Noah, but they should have. His dedicated efforts to cover the health care bill as a major event with dramatic implications for the lives of millions of people rather than a small-scale drama with implications for a couple thousand political professionals was also much appreciated on my part.

I’ll be looking forward to whatever he comes up with next.

Latest headline in Slate--what they did with the money they saved by firing Tim Noah: "Why Does Semen Glow in the Dark?"

Why oh why can't we have a better press corps?

Something Seems Very Wrong Here: Economic History of the Great Depression Department

A correspondent emails:

Just watched this animation about Sylvia Nasar's new book... but is the following really true??

1931: President Herbert Hoover responds to the Great Depression with tax cuts, easier money, and public works spending…

It seems extremely off…

Herbert Hoover's Budget Message for Fiscal Year 1932 (July 1, 1931-June 30, 19320:

This is not a time when we can afford to embark upon any new or enlarged ventures of Government. It will tax our every resource to expand in directions providing employment during the next few months upon already authorized projects. I realize that, naturally, there will be before the Congress this session many legislative matters involving additions to our estimated expenditures for 1932, and the plea of unemployment will be advanced as reasons for many new ventures, but no reasonable view of the outlook warrants such pleas as apply to expenditures in the 1932 Budget. I have full faith that in acting upon these matters the Congress will give due consideration to our financial outlook. I am satisfied that in the absence of further legislation imposing any considerable burden upon our 1932 finances we can close that year with a balanced Budget. When we stop to consider that we are progressively amortizing our public debt, and that a balanced Budget is being presented for 1932, even after drastic writing down of expected revenue, I believe it will be agreed that our Government finances are in a sound condition...

Herbert Hoover's Budget Message for Fiscal Year 1931 (July 1, 1930-June 30, 1931):

[E]stimates of appropriations payable from the Treasury in this Budget is $145,696,000 less than the appropriations for 1930. The estimates in the Budget, however, contain no amount for the revolving loan fund for the Federal Farm Board, for which $150,000,000 is included in the appropriations for 1930.... Eliminating this item from the 1930 total the estimates of appropriations in the Budget for 1931 exceed the appropriations for 1930 by $4,304,000.... Through nonrecurring items and justified reductions in other items funds have been found to make increases in certain of our activities without enlarging to any appreciable extent the total of the estimates for 1931 over the appropriations for 1930...

Graphs for Thought and Readings for September 2, 2011 Meeting of Economics 24-1: Understanding the Lesser Depression

The Great Moderation:

Squared Deviations of the Employment-to-Population Ratio from a Ten-Year Trailing Moving Average Trend


  • Johann Carl Friedrich Gauss said that when you are analyzing variability, you should measure it by squaring deviations from the average and then averaging those squared deviations.
  • That is what this figure does.
  • When you measure trends with a trailing ten-year moving average and look at the employment-to-population ratio, four features over the past third of a century jump out at you:
    • The steep economic downturn of the Volcker disinflation around 1980.
    • The rapid rise in the employment-to-population ratio as American feminism took full hold in the late 1980s.
    • The "Great Moderation" that ended just a few short years ago.
    • Our current "Lesser Depression".

The Shift of Leading Sectors in the 2000s:

Equipment and Residential Construction Investment as Shares of Potential GDP

FRED Graph  St Louis Fed 3

  • The dot-com boom of the Clinton years in the later 1990s was driven by great optimism about and a very strong willingness to invest in equipment and software (the blue line)--primarily in the information and communications technologies of Silicon Valley.
  • That came to an end in 2000--not because the technologies turned out to be a bust, but because it was very hard to figure out how to use them to make large profits.
  • Most of the benefits of the new technologies flowed to consumers.
  • Many investors--especially in telecommunications--found that the businesses they had invested in had no sustainable business models.
  • What would replace the lessened share of investment in equipment and software (the blue line)?
  • The answer was investment in housing (the red line) made possible by low interest rates produced by the "global savings glut" and by better "risk management" made possible by derivatives.

Equipment Investment, Residential Construction Investment, and Exports

FRED Graph  St Louis Fed 2

  • Exports also had a potential role to play as a leading sector--but not in the context of the global imbalances of the 2000s.

The Housing Boom and Bubble:

Number of Houses Built in America

FRED Graph  St Louis Fed

  • Figure that the long-run trend is that, with growing population and with increasing wealth leading more people to want second homes, the trend is for us to build about 1.4 million houses a year.
  • The magnitude of the housing boom: 7 years x 800,000/year in peak excess housing construction x 1/2 because the boom is a triangle gives us about 3 million excess houses built between 1998 and 2007, with the bulk of them built after 2004.
  • Figure $150,000 in mortgage debt on these houses that isn't going to be repaid on average, and we have a $450 billion investment loss from the housing bubble.

Price of Houses Divided by the Consumer Price Index

FRED Graph  St Louis Fed 1

  • The price of houses went up a lot in the early 2000s.
  • By how much should it have gone up?
    • Lower interest rates ought to raise the price of housing.
    • Higher energy prices ought to raise the price of conveniently-located housing.
    • An exhaustion of opportunities for transportation improvements ought to raise the price of conveniently-located housing.
    • But by how much?
  • The market's current judgment is that nearly all of house price rises over and above CPI inflation in the 2000s were unsustainable, and a bubble.

The Federal Reserve:

The Money Market

FRED Graph  St Louis Fed 4

  • The Federal Reserve controls the short-term interest rate on 3-Month Treasury Bills--it buys and sells them for cash until that interest rate is where it wants it to be.
  • At least, it controls that interest rate as long as it wants the interest rate to be zero or above.
  • The interest rate more relevant for businesses is the ten-year bond rate--which is best thought of as an average of expected future Treasury Bill rates plus a risk premium.
  • (And because businesses cannot borrow at the Treasury rate and may not be able to borrow at all, there are still further complications we will consider in future weeks.)
  • The Federal Reserve tries to fulfill its "dual mandate" in normal times by nudging interest rates around--by making it easier or harder, cheaper or more expensive for private businesses and households to borrow.
  • Question: Why have a Fed at all? Why this island of central planning in the middle of the economy? Why not just let the market take care of interest rates?

Federal Reserve Policy and Inflation

FRED Graph  St Louis Fed 5

  • It is probably best to evaluate the Fed's policy stance by comparing the interest rate it controls--the three-month Treasury Bill rate--to the current rate of inflation.
  • During the downturn of the early 1990s, the Fed reduced the Treasury Bill rate to the rate of inflation and kept it there for two years.
  • It then concluded that the recovery had become "well established", and rapidly raised interest rates to get them back to a normal spread vis-a-vis the inflation rate.
  • At the end of the 1990s the Federal Reserve raised the Treasury Bill rate as it grew nervous about upward-creeping inflation.
  • But then after the collapse of the dot-com boom and 9/11 it lowered the Treasury Bill rate below the inflation rate and kept it there for quite a while.
  • And then restored a normal spread.
  • As the housing bubble collapsed and the financial crisis began the Federal Reserve lowered the Treasury Bill rate to about 2 percent, and then played wait-and-see.
  • And in late 2008 as the global economy collapsed it lowered the Treasury Bill rate to zero--and now says it will keep it there for two more years, unless things change.
  • Even though some members of the FOMC are very nervous about a Treasury Bill rate so far below the inflation rate.

"Animal Spirits"--or, If You Prefer, Investor Confidence:

The Value of the S&P 500 Index Divided by Potential GDP

FRED Graph  St Louis Fed 6

  • This is the right way to look at whether the stock market is high or low if you think that the capital stock of the S&P 500 firms is a more-or-less constant share of the capital stock of the economy.
  • The long pessimistic slide in relative stock market values during the inflationary 1970s.
  • What we at the time thought was a big stock market boom in the 1980s.
  • The dot-com bubble of the late 1990s.
  • The dot-com and 9/11 crash of the 2000s.
  • "Normalcy" more-or-less in the mid-2000s.
  • A second stock market crash with the financial crisis--very upsetting: such things are supposed to come once a generation, not twice in a decade.

Readings for September 2:

The Great Moderation and the Global Savings Glut:

The Housing Boom:

Economists Try to Understand the Economy: Paul Krugman:

Economists Try to Understand the Economy: J. Bradford DeLong:

Paul Krugman Reminds Us of the Context of Keynes's "Bury Banknotes in the Ground and Dig Them Up" Discussion

And here is Keynes:

General Theory of Employment, Interest, and Money: If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again… the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

The analogy between this expedient and the goldmines of the real world is complete. At periods when gold is available at suitable depths experience shows that the real wealth of the world increases rapidly; and when but little of it is so available our wealth suffers stagnation or decline. Thus gold-mines are of the greatest value and importance to civilisation. Just as wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable, so gold-mining is the only pretext for digging holes in the ground which has recommended itself to bankers as sound finance; and each of these activities has played its part in progress….

In addition to the probable effect of increased supplies of gold on the rate of interest, gold-mining is for two reasons a highly practical form of investment, if we are precluded from increasing employment by means which at the same time increase our stock of useful wealth. In the first place, owing to the gambling attractions which it offers, it is carried on without too close a regard to the ruling rate of interest. In the second place the result, namely, the increased stock of gold, does not, as in other cases, have the effect of diminishing its marginal utility. Since the value of a house depends on its utility, every house which is built serves to diminish the prospective rents obtainable from further house-building and therefore lessens the attraction of further similar investment…. But the fruits of gold-mining do not suffer from this disadvantage….

Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled wealth, in that it possessed two activities, namely, pyramid-building as well as the search for the precious metals, the fruits of which, since they could not serve the needs of man by being consumed, did not stale with abundance. The Middle Ages built cathedrals and sang dirges. Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York. Thus we are so sensible, have schooled ourselves to so close a semblance of prudent financiers, taking careful thought before we add to the 'financial' burdens of posterity by building them houses to live in, that we have no such easy escape from the sufferings of unemployment. We have to accept them as an inevitable result of applying to the conduct of the State the maxims which are best calculated to 'enrich' an individual by enabling him to pile up claims to enjoyment which he does not intend to exercise at any definite time.

Which reminds me of:

Karl Marx: Theories of Surplus-Value, Chapter 17: This is the childish babble of a Say, but it is not worthy of Ricardo…. Previously it was forgotten that the product is a commodity.  Now even the social division of labour is forgotten.  In a situation where men produce for themselves, there are indeed no crises, but neither is there capitalist production.  Nor have we ever heard that the ancients, with their slave production ever knew crises…

Marx's Half-Baked Crisis Theory and His Theories of Surplus Value, Chapter 17: It seems to me that Marx has two and only two major points to make in a long, uneven, and very discursive chapter. The first is John Stuart Mill's point: a general glut of commodities is the same thing as an excess demand for money…. Marx's second major point is the balanced capitalist growth at full employment is impossible…. Because capitalists extract surplus only to reinvest it and because larger capitals extract more surplus, as a boom continues consumption must fall as a share of full-employment output. Thus the investment share of output must rise. Capitalists must be not just confident that the boom that will continue, but increasingly confident as time passes that the boom will continue faster. From this Marx deduces the conclusion that crisis must come, and will come as soon as capitalists lose confidence in their belief that the boom will continue at an increasing rate.

In this way Marx, I think, links his value theory through Mill's monetary theory to produce a crisis theory. Or, rather, if I were the referee on Marx's chapter 17, that is what I would conclude that he really wanted to say, and that is what I would urge him to revise his chapter when I sent him his revise and resubmit. As it stands the thing is a mess….

What I do not understand is Marx's rejection of monetarist or Keynesian solutions. Marx says the ancient and feudal modes of production did not have crises. Why not? Because they used their surplus for crusade or war or display or elite consumption and not for accumulation, hence the surplus was recycled into demand for labor and there was never any of the interruptions of M-C-M' that we get under the capitalist mode of production when capitalists lose confidence that if they turn their M into C they will then be able to turn it back into M'. For the government to use the surplus for public betterment in a downturn would seem to be just as effective a cure for depression under the CMP as conquering Gaul is under the AMP or building a cathedral is under the FMP…

Economics 24-1: Enrollment Limit: 10. Freshman Seminars: Understanding the Lesser Depression: August 26, 2011: First Class Readings...


Most Fridays 4:10-5:45, Evans Hall 597. Alas, this is a freshman

J. Bradford DeLong [email protected] 925.708.0467.

These freshman seminars are supposed to meet for about 12 hours--50 minutes a week for fourteen weeks. I find that 90 minutes works a lot better than 50, so I propose that we meet most Fridays--a total of fifteen hours plus an end-of-semester lunch.

Proposed topics:

  • Aug. 26: Background
  • Sep. 2: The Great Moderation and the Housing Boom
  • Sep. 9: NO CLASS
  • Sep. 16: Banks, Derivatives, and Risk
  • Sep. 23: NO CLASS
  • Sep. 30: The Collapse of the Housing Bubble and the Start of the Financial Crisis
  • Oct. 7: The Financial Crisis and the Collapse of Demand
  • Oct. 14: NO CLASS
  • Oct. 21: Dealing with the Collapse of Demand: Bernanke, Paulson, Geithner, Bush, and Obama I
  • Oct. 28: Can We Understand the Republican Counter-Narrative?: Viner, "Mr. Keynes on the Causes of Unemployment"
  • Nov. 4: The Obama "Pivot" to "Deficit Reduction"
  • Nov. 11: NO CLASS
  • Nov. 18: Assessing the Obama Administration: Suskind, Confidence Men
  • Nov. 25: NO CLASS
  • Dec. 2: Politics and Sovereigns: The European Crisis
  • Dec. 9: Lunch?


Economists are, overwhelmingly, what one of my teachers, the late Rüdiger Dornbusch, used to call "goldsmiths": they start with a few organizing principles--principles of human psychology and motivation and of market structure--and work them with precision, deducing theoretical corollaries and consequences that can then be used to analyze the actually existing real world out there. We could do that in this freshman seminar, but then we would be simply repeating Economics 1: that would largely waste your time.

Moreover, there is a danger in attempting to be a goldsmith if you are not a very good one. You then become what Rüdi would scornfully call a "plumber": somebody who was obsessed with constructing an elaborate Rube Goldberg-like device without a clear vision of what it would be good for and would find at the end that he had constructed something that gave absolutely no insight into what was going on in the real world.

Preferable, Rüdi thought, to be what he called a "pig": to leap into a subject with vigor and wallow in it until you emerged with a defensible and coherent point of view, even though it did not proceed with goldsmith-like precision from a few organizing principles of human motivation and market structure.

We are going to be pigs--and, for Rüdi, to be called a pig was to be given a compliment.

So let's look first at some data about the recent history and current state of the economy--at the Lesser Depression in which we are enmeshed--and then look at some old-fashioned economists' attempts to think about and understand economic situations like the one we seem to find ourselves in today:


The Civilian Adult Employment-to-Population Ratio

FRED Graph  FRED  St Louis Fed

Civilian adult employment-to-population ratio from the Bureau of Labor Statistic's Current Population Survey.

Things to Notice:

  • Seasonal adjustment
  • Feminism
  • Business cycles
  • Vs and Ls

Actual and "Potential" Real Gross Domestic Product

FRED Graph  St Louis Fed 2

Estimated inflation-adjusted value of all marketed goods and services produced in the United States (plus the imputed rental value of owner-occupied housing a calculated by the Bureau of Economic Analysis, plus government consumption and investment valued at cost), and Congressional Budget Office estimate of "potential".

Things to notice:

  • Long-run growth
    • Population growth at 1% per year or so
    • Real standard-of-living growth: ln(13/2)/60 - 0.01 = 2.1% per year or so
  • Potential output
  • Small relative size of our business cycles

Actual Real GDP Relative to Potential Real GDP

FRED Graph  St Louis Fed 3

BEA estimates of real GDP divided by CBO estimates of potential output.

Total Spending; Nominal GDP

FRED Graph  St Louis Fed 4

#BEA estimate of the current-price value of all marketed goods and services produced in the United States (plus the imputed rental value of owner-occupied housing a calculated by the Bureau of Economic Analysis, plus government consumption and investment valued at cost).

Prices and Quantities: Total Spending and Average Prices

FRED Graph  St Louis Fed 5

BEA estimates of nominal GDP and of the "implicit price deflator" corresponding to its estimates of nominal and real GDP.



  • Jean-Baptiste Say (1821), Letters to Malthus on Political Economy and Stagnation of Commerce, Letters One, Two, and Three.
  • Thomas Robert Malthus (1820), Principles of Political Economy, Chapter 5 Section 4: "Notes on Ricardo's Theory of Profits".
  • John Stuart Mill (1844), Essays on Some Unsettled Questions in Political Economy, "Essay II: Of the Influence of Consumption Upon Production".


  • J. Bradford DeLong (2011), Understanding the Lesser Depression: Background
  • John Maynard Keynes (1936), The General Theory of Employment, Interest and Money, Chapters 1 "The General Theory", 2 "The Postulates of the Classical Economics", and Chapter 3 "The Principle of Effective Demand" Section 3.
  • William Baumol (1999), "Say's Law", Journal of Economic Perspectives

Some Warm-Up Questions:

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Understanding the Lesser Depression 1.3: Background: Conclusion

Understanding the Lesser Depression

J. Bradford DeLong, U.C. Berkeley, August 2011

(1) Introduction

1.3 Conclusion

What should you takeaway from this background chapter? I hope you take four things away from it.

First, I hope you have learned that our market system irregularly but semi-periodically fails in a disturbing and substantial way: it pukes up large numbers of workers—two or three or five percent of the adult population—into excess unemployment, out of which they are only gradually and slowly absorbed. Workers who in normal times have no trouble finding and keeping jobs paying the prevailing wages find themselves unemployed in large numbers, and can stay unemployed for a long time.

Second, economists disagree about the closets and nature of these downturns. There are four groups of economists who I believe are largely if not completely wrong: those who think downturns are on inevitable and unavoidable consequence of previous expectational errors, those who think that if only we got rid of government intervention in financial markets such downturns would cease, those who see their cause in workers’ desires to take a “great vacation”, and those who see their cause in a “great forgetting” of how to make things. I think these four groups simply have not done their homework. They have thus fallen victim to what Joseph Schumpeter liked to call the “Ricardian Vice”. The question of why people would not do their homework would be a difficult one, were not for the fact that this is something that you promised have been doing for sentry witness the name Ricardian vice.

Third, these downturns have their origin in any of a number of different causes all of which however have one thing in common call they all in do's and excess demand for financial assets, and the flip side of this excess demand for financial assets is deficient demand for currently produced goods and services, is a general glut.

Fourth, and excess demand for financial assets is an animal of a different kind then a normal excess demand for a currently produced good or service. The market economy is good at dealing with an excess demand for a currently produced good or service like yoga lessons and its flipside of excess supply of another currently produced good or service like espresso machines. The market can move labor, capital, and resources from the one to the other relatively smoothly. By contrast, and excess demand for financial assets causes large-scale unemployment among those who used to make currently produced good and services, with no countervailing pressure in the system to rapidly absorbed the unemployed into making or doing anything else.

Understanding the Lesser Depression 1.2.4: Background: What Happened, A First Cut: Toward an Understanding of Macroeconomic Downturns

Understanding the Lesser Depression

J. Bradford DeLong, U.C. Berkeley, August 2011

(1) Introduction

1.2 What Happened: A First Cut

Toward an Understanding of Macroeconomic Downturns

Jean-Baptiste Say and Thomas Robert Malthus: For most of human history before 1800 most people spent most of their time working to provide for their own households: gathering their own roots and berries, hunting their own meat, sewing their own furs, growing their own food, weaving and sewing their own clothes, building their own houses. Purchases and sales in the market were a relatively small part of total economic activity.

However, starting in the eighteenth century economic growth brought us to a place where—in northwestern Europe at least—most of what was produced was sold in the marketplace for money—and the money thus earned was used to buy other things in the marketplace, other things that other households had made.

This disturbed people. “What if it all went wrong?” they wondered. They understood how the markets made supply balance demand at an equilibrium price for any one particular commodity. But would the whole hang together as a system? “Could we wind up,” they wondered, “in a situation in which everybody—or a large number of people—are wasting their time making things nobody wants to buy? In which people who want to work can’t find useful employment because nobody will hire them because nobody trusts that they will be able to sell the things that their employees would make because nobody trusts that everybody will have jobs and thus have the income with which to buy?”

French economist Jean-Baptiste Say proposed an answer back in 1803. He said: “no.” Every seller, Say argued, was also a potential purchaser. Nobody would sell anything without intending to buy something with the money. And so purchasing power flows throughout the economy in a circular flow. Workers and property owners only sell and rent their hours and their resources to businesses because they then intend to spend the money they earn buying goods and services. The goods and services that they buy—well, those are the goods and services that the businesses make. So businesses sell final products to households and buy factor services from households, and households buy final products from and sell factor services to businesses.

Thus, Say claimed, the idea that there could be an economy-wide shortage of purchasing power was incoherent. It could be that there would be excess supply of some particular goods and services: perhaps exercise studios were expecting more people to sign up for yoga classes than actually do, and so there are yoga teachers without students and yoga mats without people sitting on them in the Lotus position. But the money people decided not to spend on yoga lessons they decided to spend on something else—espresso drinks, say—and there are long lines and harried, overworked baristas at coffee bars. The economic system would soon adjust to the excess supply in one industry and the excess demand in the other by moving capital and labor resources from industries where they are in surplus to industries where they are in shortage – in our example from the yoga studios to the coffee bars.

It would take something truly extraordinary, Say thought, to break the reliable operation of this circular flow principle—what economists came to call “Say’s Law”. As an economist of a younger generation, John Stuart Mill, put the argument:

There can never, it is said, be a want of buyers for all commodities [and labor]; because whoever offers a commodity for sale, desires to obtain a commodity in exchange for it, and is therefore a buyer by the mere fact of his being a seller. The sellers and the buyers, for all commodities taken together, must, by the metaphysical necessity of the case, be an exact equipoise to each other; and if there be more sellers than buyers of one thing, there must be more buyers than sellers for another...

The economist Thomas Robert Malthus protested that even though Say’s Law sounded good in theory, it failed the test of practice:

[T]he master manufacturers would have been in a state of the most extraordinary prosperity.... But, instead of this, we hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production. It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of the new doctrine on profits and demand, that if one trade be overstocked with capital, it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly understocked, and where high profits have been long pleading in vain for additional capital ? The war has now been at an end above four years; and though the removal of capital generally occasions some partial loss, yet it is seldom long in taking place, if it be tempted to remove by great demand and high profits...11

Indeed, Say’s claim that large macroeconomic downturns like the one we saw begin in 2007 did not pass the test of empirical reality. One such downturn took place in England in 1825-26 as a consequence of the collapse of the early 1820s canal boom. Say did indeed mark his beliefs to market—did recognize and analyze that somehow something going wrong in financial markets had produced a “general glut”, a large excess supply over demand for pretty much every commodity and also for workers willing to work.12 But Say did not then revisit his theory to figure out where he had gone wrong.

John Stuart Mill: It was John Stuart Mill who came up with what I believe is the best answer. In 1829 he wrote (although he did not publish it until 1844):

[Say’s Law] is evidently founded on the supposition of a state of barter; and, on that supposition, it is perfectly incontestable. When two persons perform an act of barter, each of them is at once a seller and a buyer.... If, however, we suppose that money is used, these propositions cease to be exactly true.... Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells.... [When] there is a general anxiety to sell, and a general disinclination to buy, commodities of all kinds remain for a long time unsold, and those which find an immediate market, do so at a very low price.... In order to render the argument for the impossibility of an excess of all commodities applicable to the case in which a circulating medium is employed, money must itself be considered as a commodity. It must, undoubtedly, be admitted that there cannot be an excess of all other commodities, and an excess of money at the same time. But those who have, at periods such as we have described, affirmed that there was an excess of all commodities, never pretended that money was one of these commodities; they held that there was not an excess, but a deficiency of the circulating medium. What they called a general superabundance, was not a superabundance of commodities relatively to commodities, but a superabundance of all commodities relatively to money. What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute...

Mill’s point is that people don’t just plan to buy currently-produced goods and services: they plan to buy currently-produced goods and services and financial assets. And people don’t just plan to spend their incomes: they plan to spend their incomes plus whatever resources they plan to get from selling their financial assets. If everybody (or even a critical mass) of people plan to spend less than their perfectly possible for there to be too little demand for currently-produced goods and services—for the current flow of aggregate demand for goods and services to be less than the cost of the goods and services currently being produced.

Mill’s insight is crucial. Let us see if we can make it clearer:

Consider a normal—microeconomic—shift in demand: Americans decide that they want to spend somewhat less on manufactured goods and somewhat more on consumer services. Suppose, say, they plan to spend less money buying espresso machines and plan to spend more buying yoga lessons, so trading caffeine for inner peace.

Assembly-line workers and businesses that make espresso machines then find that they have made more machines than they can sell. Some manufacturers cut wages and so their workers see their incomes fall. Some cut back on hours and employment and their workers find themselves unemployed.

By contrast, yoga instructors find demand for what they do booming. They work extra hours. Exercise centers raise their prices. Wages and prices fall in manufacturing. Wages and prices rise in the service sector. Deficient demand for manufactured goods and assembly-line workers comes with excess demand for consumer services and service-sector workers. Manufacturing firms close and service-sector firms open. Workers who lose their jobs in manufacturing retrain in order to demonstrate how to do the Downward-Facing Dog.

In a short time the economy adjusts.

Labor exits the manufactured goods and enters the service industry. The economy rebalances with fewer assembly-line workers and more workers in the service sector, the structure of production has shifted to accommodate the shift in demand, and the excess unemployment above normal disappears.

But now consider, instead, what happens when the excess demand in the system is not for something like yoga lessons—currently-produced goods and services—but instead for something like money—financial assets.

Households decide that they want to spend somewhat less on manufactures and to hold more cash in their wallets instead. Instead of spending normally, everybody decides to keep at least one $20 in reserve at all times. Those with less than $20 simply stop spending on manufactures—until somebody buys some of what they have made and they have more than $20 in their pockets. What happens next? Well, what happens in manufacturing is the same thing that happened when there was a shift in demand from manufacturing to services. Manufacturers find that they have made more goods than they can sell. Some firms cut their prices and wages and their assembly-line workers see their incomes fall. Some cut back on hours and employment. Inventories of unsold manufactured goods pile up. Entrepreneurs looking at their growing piles of unsold inventory cut back on hours and production even more.

But there is a big difference: there is no countervailing increase in spending, employment, and hours in the service sector.

Things then snowball. The unemployed assembly-line workers now have no incomes. They cannot afford to buy as much food or as many services or, indeed, as many manufactured goods as they had before. Inventories of unsold goods keep rising, and so employers cut back production and employment even more. Thus there is a second-round fall in demand which renders even more people unemployed—and not just assembly-line workers this time. And then there is a third round. And so on...

Moreover, everybody sees rising unemployment and falling incomes around them. Can you imagine a better signal to make you decide to try to hold onto more cash? Instead of cutting back on spending on coffee when you have less than $20 in your pocket, people start cutting back on all spending when they have less than $40 in their pocket. And the more the prices at which you can sell your goods falls and the higher unemployment climbs, the more desperate people are to pile up more cash in their wallets.

In a normal market adjustment—a fall in the demand for manufactures and a rise in the demand for services—the workers laid off from the shrinking sector (for example manufacturing: espresso machines) would rapidly be hired into the expanding sector (for example the service sector: yoga lessons). But this is not a normal market adjustment: this is macroeconomics, depression economics.

How far down does production and employment decline when the economy gets itself into a recession economics state? How high does unemployment rise? Well, employers keep cutting back employment—and thus keep cutting back their workers’ incomes—until they are no longer producing more than they can sell and inventories are stable rather than rising. And households keep trying to build up their cash balances until their incomes have fallen so low that they do not think that they dare economize on their spending any further to try to boost their holdings of liquid cash money. There the economy will sit, with spending, production, and employment depressed because at that level and at that level only planned spending is equal to income—until something happens to induce households and businesses to attempt on net to sell financial assets and spend more than their incomes on currently-produced goods and services which will induce businesses in aggregate to start hiring more workers again.13

That, in a nutshell, is what happened in 2007-2009—and in 1825, and in 2001, and in 1991, and in 1979-82, and so forth.

Note that, in Mill’s theory, downturns can have different causes. Any of a number of things can cause a sudden excess demand for financial assets. It can spring from a withdrawal of public subsidies from risky investments in railroads (as happened in 1873), it can spring from worries about minting silver coins that induce people to ship their gold overseas which under a gold standard reduces the money stock (as happened in 1893), it can spring from high interest rates abroad that under a gold standard induce money stock-shrinking gold exports (as happened in 1907), it can spring from a Federal Reserve that raises interest rates to fight inflation (as happened in 1979-1982), it can spring from a recognition that a good deal of the financial assets that people had thought their high-tech investments consisted of simply were not there because it would be very difficult to profit from internet technologies (as happened in 2001), or from a host of other causes.

What was the cause this time of this sudden excess demand for financial assets, which carried with it deficient demand for currently-produced goods and services, deficient demand for labor, large-scale extra firings all across the economy, and a persistent shortfall below its normal pace in hiring since? Why was the decline in the employment-to-population ratio so large? Why hasn’t it recovered since? 
Those are all good questions, but they are not for this background chapter.

Understanding the Lesser Depression 1.2.3: Background: What Happened, A First Cut: Economists' Wrong Explanations

Understanding the Lesser Depression

**J. Bradford DeLong, U. C. Berkeley, August 2011

(1) Background

1.2 What Happened: A First Cut

Economists' Wrong Explanations


Economists have a number of theories of why the downturn that started the Lesser Depression was so large and why the recovery from it has been so slow—indeed, to date nonexistent. Some of these theories, those put forward by economists whom Rüdiger Dornbusch would classify as “plumbers”, are simply wrong. We can dispose of them quickly.

A Great Forgetting?: A first group, headed by Arizona State University’s Edward Prescott, has argued for decades that business cycles are the result of—and are socially optimal responses to—uncertainty and stochastic variation in the rate of technological change.

It is certainly the case that good news about technology can produce a boom, with rapidly growing output and employment and productivity above trend: recall the second half of the 1990s. And it is certainly the case that bad news about resource availability can produce a downturn: that was certainly part of 1973-1975 and 1979-1982, and perhaps the larger part of 1973-1975.

But technology does not regress: we do not forget how to make and do things, and thus Prescott’s attempt to attribute a sharp downturn in employment and production to some change in economically-applicable technology—to a “great forgetting”—seems doomed to failure. Indeed, in our Lesser Depression the argument seems to go the wrong way: it is not that the productivity of American workers today is lower than in the past or lower than expected back in 2006, it is rather higher.


A Great Vacation?: A second group, of which the most vocal member is the University of Chicago’s Casey Mulligan, claims that downturns come when workers lose their taste for employment, and that you can tell that this is so by looking at the “Douglas formula” relating movements in labor productivity relative to trend to movements in employment relative to trend.

Indeed, as of the second quarter of 2011 labor productivity was 5% above its 2003-2007 trend, which Mulligan claims reflects a decline in desired work hours by American workers of 15%—much more than the decline in work hours actually seen in the Lesser Depression. According to Mulligan’s theory, the entire fall in the employment-to-population ratio is simply the result of American workers’ sudden desire to work less: to take a great vacation—itself induced, he claims, by the fact that if you have no job the Obama Administration will pressure your lender to reduce the principal amount you owe on your mortgage. 
The big problem with Mulligan’s story is that people did not quit their jobs in unusual numbers in 2008 and 2009: instead, they were fired.

Firings went up, quits went down, and more important new hires went down as firms that would otherwise have expanded found that they did not have the customers to justify expanding employment. Mulligan never asked the very first reality-check question: does my theory of why fewer people are at work today fit with the process of how the decline in employment actually took place? The answer is that it does not.

Most important of all, however, is the question of how the unemployed feel about their status. In Mulligan’s theory they are happy not to have jobs: they could get jobs at the prevailing wage that others are getting, and have decided not to. But few of America’s unemployed today are at all happy with their situation.


A Great Europeanization?: A third group, headed by the University of Chicago’s Robert Lucas believes that the failure of the employment-to-population ratio to recover to normal levels is due to fear of the policies of President Barack Obama. Lucas believes that “[o]ur economy has got a remarkable ability to return to its long term growth trend... quick[ly]: two or three, four years...” But things were not back to normal by 2009, or 2010, or 2011. Lucas’s conclusion? This: 

Liquidity is no longer the problem.... Yet business investment remains very low.... [T]he problem is government is doing too much.... Likelihood of much higher taxes, focused on the “rich”. Medical legislation that promises large increase in role of government. Financial legislation that assigns vast, poorly-defined responsibilities to Fed, others. Are these conditions that foster a revival in business investment, consumer spending?

But the answer appears to be “yes, it is”.

Business spending on equipment and software has recovered very well from its downturn, and is in no wise dragging the economy down by doing worse than average. It is other components of spending—housing construction, government employment, consumer spending by middle-class households now far underwater with their home mortgages—that has failed to recover. The claim that business fear of Obama’s policies is at the root of slow recovery does not seem to pass its first consistency checks with the data.


Paul Krugman observes that much of Lucas’s confidence in his Obama-centric explanation comes from yet another failure of Lucas to mark his beliefs to reality. Obama’s policies have attempted (so far without any notable success) to move the structure and function of the American government closer to those seen in more social democratic western Europe. And it is an item of conservative faith that in western European countries red tape strangles employment and enterprise. A case for such an argument could have been made from the mid-1980s—but not before—until the end of the 1990s—but not since.

Government Guarantees: Yet a fourth group believes that excessively-generous government loan guarantees induced too many working-class households who could not afford to carry mortgages to buy houses and thus too many American construction workers to build too many houses. Since the market system cannot easily deploy the construction workers elsewhere—they are, when not engaged in building houses, zero marginal product workers—we are doomed to suffer depression until the overhang of excess houses constructed during the 2000s housing bubble is worked off.

The problem here is once again a failure to mark the theory to market. During the boom of the 2000s America built perhaps five million houses above trend and financed them with mortgages on which perhaps $100,000 per mortgage will never be paid back. That is a total economic loss to investors in the housing sector due to overconstruction of $500 billion dollars. But the world economy had, in 2007, $80 trillion total of financial wealth. How can a $500 billion loss bring an $80 trillion wealth economy into a depression? That question is never answered.


Moreover, the claim that we have to wait until the overhang of bad capital investment produced by the housing bubble is worked-off would lead us to predict that the U.S. economy would by now be in a healthy boom, because the overhang of housing construction has been worked off. As Figure 11 shows, the housing boom that led to above-trend housing construction has been followed by a housing bust of below-trend housing construction: we now have perhaps one million fewer houses than a simple extrapolation of pre-bubble trends would predict. When people become tired of living in their sisters’ or their in-laws’ basements and resume normal housing purchase patterns we will find that we have not an overhang but a shortage of housing investment.

I believe that all four of these theories illustrate one of the great vices of economics—what Joseph Schumpeter in called “the Ricardian vice”.8 People have started from what they take to be obvious principles of human psychology and markets—that people seeking their own welfare trading in markets will create an efficient system of production in the case of the “great forgetting” and the “great vacation” explanations, that high taxes and tight regulations can impoverish an economy in the “great Europeanization” explanation, and that government guarantees in finance induce “heads we win—tails the government behaves” behavior by lenders—and reasoned to what they take to be logical conclusions without ever doing the elementary sanity or reality checks. The fact that this goldsmith-like reasoning can go so awry in the hands of those who are not very skillful at it or not terribly grounded in reality was the reason that Rüdiger Dornbusch scorned those economists whom he called “plumbers”.

You need to be aware that these theories are out there. And you need to be able to rebut them. But once you are aware of them and do know how to rebut them, do not let them trouble you further.

Let us turn, instead, to attempts to understand the origins and persistence of our Lesser Depression that have promise.

Understanding the Lesser Depression 1.2.2: Background: What Happened, a First Cut: The Lesser Depression

Understanding the Lesser Depression

**J. Bradford DeLong, U. C. Berkeley, August 2011

(1) Background

1.2 What Happened: A First Cut

The Lesser Depression

The third notable thing about Figure 3 is our current downturn, our Lesser Depression. It is itself unique for three reasons: the size of the downturn, the fact that this time the market economy was not shocked into a downturn by something governments did but rather did it to itself, and the failure—so far—of there to be any meaningful recovery from the downturn.


The Largest: First, as a share of the country’s population and labor force, our current Lesser Depression is by far the largest such downturn we have seen since World War II or indeed since the Great Depression of the 1930s itself (which was a much larger relative macroeconomic disaster than the one we are suffering through now). Our Lesser Depression starts with a large, sudden collapse in the adult civilian employment-to-population rate of a magnitude nearly twice as large as the largest previous such post-World War II downturn—the three percentage point of the civilian adult population decline in the Carter-Reagan-Volcker downturn of 1979-1982.

Market-Generated: Second, the Carter-Reagan downturn and the other largest post-World War downturns were in large part caused by government shocks to the market economy. The Carter-Reagan-Volcker downturn was the result of two large and obvious shocks to the market economy administered by governments: the Iranian Revolution of 1979 and the Saudi Arabian acquiescence in the tripling of world oil prices triggered by the conquest of power in Iran by Ayatollah Khomeini and his allies, and Federal Reserve Chair Paul Volcker’s decision that it was time to bring on an economic downturn and depress the employment-to-population ratio by creating a liquidity squeeze of high interest rates by shrinking the money supply in order to reduce inflation by demonstrating that the Federal Reserve would not keep money cheap enough to make it profitable for private businesses to keep borrowing and spending no matter what. By contrast, the 2007-9 downturn saw no correspondingly-large external shock administered to the market economy by the world’s governments as its cause: no large-scale removal of oil rigs from production, no liquidity squeezes by central banks nothing—this time the market economy did it to itself all by itself.


The Flatline: Third, the downturn of the Lesser Depression has, so far, been followed not by recovery but rather by flatline. The civilian adult employment-to-population ratio in late 2011 is what it was in late 2009. Recovery as measured by the course of the civilian adult employment to population ratio has not just been slower than the downturn: recovery has, so far, been nonexistent.

The civilian adult employment-to-population ratio as of August 2011 is lower than it has been at any moment between today and 1983, back when American feminism was only half-formed. So far, at least, there is not even a hope that its end is in sight. As of this writing in August 2011 economic forecasters are by and large predicting that the employment-to-population as of the end of 2012 is more likely than not to be not lower but rather a little bit higher than it is today.

This failure of recovery is worth underscoring. In 1973-1975 the adult civilian employment-to-population ratio fell by about two-fifths as much as it fell in 2007-2009. In 1979-1982 it fell by about three-fifths as much. But after both of those downturn episodes recovery came swiftly and recovery was rapid: the employment-to-population ratio rose almost but not quite as steeply as it had previously risen, giving the track of the employment-to-population ratio on the graph the appearance of a “V”. That has not been the case in this Lesser Depression: so far, at least, this episode looks more like an “L”.

Obama: Bringing a Post-Partisan Rhetorical Stance to a Fusion Bomb Fight

Andrew Samwick:

President Obama's Re-election Chances: Dartmouth welcomed the Gallup Poll's editor-in-chief, Frank Newport, to campus yesterday for the closing lecture in our "Leading Voices in Politics and Policy" series.  His assessment of President Obama's re-election chances was negative:

Ten presidents have run for re-election since we’ve had modern polling, since Harry Truman. Seven of them have been successful, and three have been defeated. … in August before his election year his current 38 percent job approval rating is lower than any other president who was successfully re-elected. So history would say he’s in big trouble.

There has been a rash of commentary in recent weeks about what the Obama Administration could have done better…. President Obama's biggest problem is that he wants to be the president who transcends politics.  The president who wants to transcend politics will be a patsy for a Congress that doesn't. 

At the level of policy, I don't see why Obamacare, Dodd-Frank, and ARRA are not policies that he can run on.  And remember that I am a conservative saying this.  The first provides badly needed insurance reform and greater health care access to millions.  It does so at too high a projected cost (primarily the design of the subsidies up to 400% of the poverty level), in my opinion, but it is a step forward.  The second improves the framework for preventing financial crises and resolving them once they arrive…. And the stimulus package was either too small if it was to be "timely, targeted, and temporary" or simply spent on the wrong things (consumption, not public investment).  But the president can make the case that it provided assistance when assistance was needed.  The economy may not improve rapidly enough for any of this to matter, but I reject any suggestion that he cannot make a credible case for re-election based on his policies.

At the level of tactics, President Obama's actions have been puzzling…. He should never, as a matter of principle, allowed the Bush era tax cuts on the highest income groups to be renewed.  He ran away from a fight, lost credibility with his base, and gained little in return…. I find it hard to believe that his fiscal policy changes he has enacted would have turned out materially worse for him if the Democrats did not have the majority in the Senate and the Constitution did not afford him a veto.

Sometimes, the way to transcend politics is to be extremely good at it.

Understanding the Lesser Depression 1.2.1: Background: What Happened, a First Cut: The Employment-to-Population Ratio

Understanding the Lesser Depression

**J. Bradford DeLong, U. C. Berkeley, August 2011

(1) Background

1.2 What Happened: A First Cut

The Employment-to-Population Ratio


Here in Figure 1 is a time-series chart of the single key quantity you need to study to understand business cycles: the civilian adult employment-to-population ratio.

Every month the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor sends its interviewers around the country to conduct the Current Population Survey (CPS). They ask a random sample of civilian American adults questions. One of the questions is: “last week, did you do any work for pay or profit?”3 The proportion of American adults who answer “yes” to our first CPS question—“did you do any work for pay or profit?”—is the civilian adult employment-to-population ratio: the fraction of American adults who say that they have jobs.


The Seasonal Cycle: The first thing that catches my eye in the chart is the high-frequency annual wiggle pattern. Almost every single year the share of American adults with jobs reaches a peak in the early summer, declines in the late-summer vacation season, climbs to a lesser peak in the fall before Christmas, and then collapses in the winter to rise again in the spring and the early summer.

More people want to work in the (early) summer and fall. Some businesses—construction in the northeast and midwest comes to mind—cannot effectively function in winter. Other businesses see sharp increases in the demands for what they make and sell as the Christmas rush approaches.

These factors together add up to the seasonal cycle.


The BLS uses a statistical procedure, its X-11 time series filter, to remove the seasonal cycle from most of the data it collects so that it can present what it calls “seasonally adjusted” time series. Figure 2 shows both versions of the employment-to-population ratio—the unadjusted and the seasonally-adjusted series—from the start of 2002 to the end of 2006.

Figure 3 plots the seasonally-adjusted employment-to-population ratio since 1950. When I look at this chart, I see three things of immediate note (the seasonal cycle has been removed): American feminism, the business cycles, and the latest and largest post-World War II business cycle—our Lesser Depression.

Feminism: The first is the rise of American feminism.


Between the late 1960s and the early 1990s an extra seven percent of American adults—all of them women—entered the labor force and found jobs. This socioeconomic transformation is one of the most interesting and remarkable features of our time, and everybody should study it in depth, but not here: it is not the topic of this course.

The Business Cycle: The second is the so-called business cycle. Semi-regularly in the post-World War II U.S., in 1953, 1957, 1960, 1970-1, 1973-4, 1979-82, 1991-2, 2001-2, and now 2007-9, the seasonally-adjusted civilian adult employment-to-population ratio crashes.


In a short period of time measured in months or seasons it falls by two or three percentage points from its normal level for that time and that stage of the feminist revolution. It then recovers—although it can stick at its relatively low level for a time (as it did in the early 1960s) and when it recovers it recovers more slowly (sometimes much more slowly) then it had crashed. These crashes are what economists call “downturns” or “recessions”: if the downturn is a large one and if the civilian adult employment-to-population ratio remains relatively depressed for a considerable period of years, then economists resort to the D-word—“depression”.

Understanding the Lesser Depression 1.1: Background: Introduction

Understanding the Lesser Depression

**J. Bradford DeLong, U. C. Berkeley, August 2011

(1) Background

1.1 Introduction

The Lesser Depression

Some call it the “Great Recession”. I call it the “Lesser Depression”. It is the worse episode of macroeconomic distress that the U.S. has seen since the Great Depression itself—although it does remain and will almost surely conclude as far smaller than the Great Depression of the 1930s. It is the largest episode of prolonged high unemployment since World War II. And it is what the American economy is going through right now.

If economics is of any use at all, it should be able to help us understand our current Lesser Depression—to give good and convincing answers to the four obvious questions:

  1. Why, irregularly but semi-periodically, do industrial market economies suffer recessions and depressions?
  2. Why is this particular Little Depression sharper, suddener, and larger than other such episodes we have seen in the post-World War II period since World War II of the 1940s ended the Great Depression of the 1930s?
  3. Why is the economy not recovering nearly as rapidly as the economy did before during other pre-1990s post-World War II economic downturns—why is this Lesser Depression dragging on for so long?
  4. What should the government be doing in order to fix the Lesser Depression—to make it as short and as near-painless as possible?
  5. Why is the government doing what it is doing rather than what we economists advise it to do?

How to Do Economics: Goldsmiths, Plumbers, and Pigs

Before we start to tackle these questions, however, comes a digression on the method of economics as an intellectual discipline.

There are, broadly, three ways to do the intellectual discipline of economics. My old teacher the late Rüdiger Dornbusch gave names to the practitioners of these three intellectual styles.1 He called them “goldsmiths”, “plumbers”, and “pigs”.

Goldsmiths: Goldsmiths start with a few organizing principles—principles of human psychology and motivation and of market structure. They would then work them with precision, deducing theoretical corollaries and consequences to create a finely-crafted, detailed, and beautiful intellectual structure They would then apply that structure to understanding the world. I could follow this style, but then this book would be very much like a Principles of Economics textbook, and there are enough Principles of Economics textbooks in the world already—I am aiming to write something different that will, I hope, be more useful.

Plumbers: Moreover, there is a danger in attempting to be a goldsmith. You might turn out to be a plumber instead. Suppose that you start with your few organizing principles of human psychology and motivation and of market structure, but you get them wrong. Or suppose that you get your organizing principles right but try to apply them to situations that they do not really apply to. Then when you reach the end of your intellectual journey you will discover that you have constructed an elaborate Rube Goldberg-like device that gives no insight into what is going on in the real world.

Pigs: Better, Rüdi thought, to be what he called a “pig”: to leap into a subject with vigor, and then to wallow in the subject until you emerged with a defensible and coherent point of view, even though you did not proceed with goldsmith-like precision from a few organizing principles of human motivation and market structure to their logically-entailed conclusions. When Rüdiger Dornbusch called my other teacher Lawrence Summers “a fearful pig”, he was paying him a high compliment.

We are going to be pigs. We are going to look first at some data about the recent history and current state of the economy—at the Lesser Depression in which we are enmeshed—then we are going to look at some old-fashioned economists' attempts to think about and understand economic situations like the one we seem to find ourselves in today, and last we are going to wallow in the subject and so attempt to assess, explore, and develop the different hypotheses about what is going on that economists have set out.

Let us start wallowing.

Isaac Chotiner Thinks That the Brain Eater is Eating the Brain of Reihan Salam

A more jaundiced view than mine on Riehan Salam's rose-colored view of the world:

Isaac Chotiner:

Conservatives, Nostalgia, And Racism: Reihan Salam….

One thing that is undeniably true is that American conservatives are overwhelmingly white in a country that is increasingly less so. As the number of Latinos and Asian-Americans has increased in coastal states like California, New York and New Jersey, many white Americans from these regions have moved inland or to the South. For at least some whites, particularly those over the age of 50, there is a sense that the country they grew up in is fading away, and that Americans with ancestors from Mexico or, as in my case, Bangladesh don’t share their religious, cultural and economic values. These white voters are looking for champions, for people who are unafraid to fight for the America they remember and love. It’s unfair to call this sentiment racist. But it does help explain at least some of our political divide.

Matt Yglesias, noting the higher tax rates and unionization of the 50s and 60s (which presumably conservatives do not miss), adds, "It’s difficult for me to evade the conclusion that on an emotional level, conservative nostalgics like Boehner are primarily driven by regret at the loss of social privilege by white men."

I would phrase it a little differently. Let's be generous and say that nostalgic conservatives are not driven by the regret Yglesias notes, but are rather longing for other, less problematic aspects of the past. My question for Salam is this: how racially insensitive does one have to be to prefer an America with segregation because he or she saw other advantages to 1950s society? What possibly could outweigh the disgusting racial status quo of the 1950s (I am leaving out the status of women and gays)? To wish for a return to that America, I would argue, one has to be so racially insensitive that bigoted seems like an apt descriptor. The alternative answer, of course, is complete solipsism.

Macro Outlook: We Are, Once Again, Defeated...

S P 500 Index  SPX IND Index Performance  Bloomberg 2

When the S&P collapsed and bond yields headed way down over the past two month I read it as a financial market misreading Washington and panicking. I thought: the financial markets have noticed that Washington is dysfunctional; thus they now fear that nobody in Washington is going to do anything to restore nominal spending to its appropriate track.

And I thought: they are probably wrong; in response to this people will react, and then we will find the S&P 500 bouncing a good chunk of the way back to 1350.

After Bernanke's speech, it is clear that I was wrong. The S&P is not going to bounce back. Nobody is offering anything for the economy.

The Lesser Depression drags on...

A Leader of the Techncratic Left-Wing Keynesian We-Need-to-Do-More-About-Unemplyment Caucus within the Administration Appears to Be… Ex-Morgan Stanleyite Richard Berner

Matthew Yglesias is on the case:

Hail Richard Berner: I’m sure that when the news broke in late April that former Morgan Stanley Chief Economist Richard Berner was joining the Treasury Department to help build the new Office of Financial Research that progressives weren’t exactly jumping for joy. Just another bankster joining the bankstered-up Treasury Department. But close readers of the Shaila Dewan & Louise Story article on mass mortgage refinancing will note that he’s one of the people pressing for this great idea. My guess is that it’s the kind of thing where the introduction of a smart person who’s been outside the bunker and perhaps had a bit more time to think outside the box has done some good.

Be that as it may, I think that if you look back to his November 2010 briefing for Morgan Stanley (PDF) on fixing housing policy, he’s really singing from the progressive hymnal. He advocates action to facilitate mass refinancing, but also talks about the desirability of moving beyond that to principal write-downs. The basic argument is here:

Many options, little will. Many policy options are available to fix America’s dysfunctional housing and mortgage markets. But the political will to deploy them is scarce. Small wonder: None is a panacea, most reward ‘bad’ behavior, some involve government funds, and none will satisfy all parties. Yet all are better than doing nothing, and a combination of carrots and sticks could create incentives for good behavior and real results. Dimensioning housing rot. Housing activity and home prices remain at risk despite a deep recession, record declines in home prices and plunging mortgage rates. Credit is scarce, thanks to the shadow inventory of yet to be liquidated homes, the one-in-four borrowers in negative equity, and putbacks. Absent aggressive policy action, we believe the supply-demand balance won’t correct itself for years.

Two groups of remedies. The first group: Mortgage modifications or refinancings reduce monthly payments. They help mitigate defaults but are far from sufficient to solve the problem. That requires policies from the second group: Writedowns or forgiveness of principal. Only when the cushion of owners’ equity is restored will housing and housing finance begin real recovery.

This is the stuff we need. In general, despite the generally bad odor currently attaching to the institutions, the big-picture economics departments of the large investment banks are staffed with very smart people.

Andrew Gelman: Sowell, Carlson, Barone: Fools, Knaves, or Victims of a Cognitive Illusion?

Why "or"?

Andrew Gelman:

Sowell, Carlson, Barone: fools, knaves, or simply victims of a cognitive illusion?: A colleague writes:

I saw your article on the geographically varying relationship between income and political party. A few years ago I noticed a rebuttal to Thomas Sowell’s claim that Democratic voters must be rich since, in selected states, the richer counties are more Democratic. Classic ecological fallacy. I wonder, though, if you’re right to say that journalists come by this misconception by simple exposure. Isn’t it possible that the idea that Democrats tend to be wealthy is actually part of a disinformation campaign? Sowell, Carlson, and Barone may not be impartial observers of their surroundings, and the idea of rich Democratics—“limousine liberals”—serves a political agenda. Different authors may even have picked the idea up from a common source. It would be interesting to trace this meme’s appearance in journalistic outlets and blogs and see if there’s any evidence for coordination.

I dunno. My guess is that Sowell and Carlson don’t care much about the facts, one way or another. Sowell, at least in his political writings, is an ideologue, and Carlson is a hack. It would be interesting to hear how they would reply to being confronted with their mistakes, but I have a feeling they’d manage to talk their way out of it, one way or another, without admitting they made a mistake. (I could be wrong, though; any of you can feel free to contact either of them and see. I already have Jonathan Chait pissed off at me, so why not add a couple more pundits to the list?)

Barone, though, is a different story. His authority rests on his expertise with election statistics. It’s hard for me to believe he’d want to get these things wrong on purpose. I think he just made a statistical error which happened to coincide with his worldview, so he had no reason to suspect it. (I did send him an email a few years ago to ask him about this income/voting thing, but he didn’t respond. He probably gets so many emails that he doesn’t even see all of them.)

Here I think Gelman is wrong. I don't think Barone has any authority--I think he mortgaged it when he bet big time on Gingrich, and was foreclosed on long ago.

Mark Schmitt on Michael Barone:

Michael's Poor Almanac: The Almanac [of American Politics] has always been what reporters scan before interviewing a member of Congress. The reason is simple…. Its distinctive selling point is an attitude and voice. Since the very first Almanac, published in 1971 on the cusp of an ideological and generational shift in Congress, its preeminent voice has been that of Michael Barone…. By assuming that the most relevant fact about a member of Congress is the place he or she comes from, it allows for a profile of politics that it is about the nation, not Washington. The Almanac’s beautifully crafted descriptions of dying Rust Belt cities and new suburbs are not for political junkies or teenagers alone. At their best, they are reminiscent of John Gunther’s 1947 masterwork, Inside U.S.A.

The Almanac’s profiles of the early Republican revolutionaries—Newt Gingrich, Bob Walker, Vin Weber—were admiring and enlightening. At a time when many dismissed them as irrelevant hotheads, Barone treated them correctly as the equals in skill of Downey or Rostenkowski…. Barone’s recognition of Gingrich’s skills, and his own abrupt move to the political right, culminated in the most extravagant of all his introductions, bearing a title and crazy wrong brilliance worthy of Gingrich himself: “The Restoration of the Constitutional Order and the Return to Tocquevillian America.” In 23 dense pages, Barone argued that the 1994 election had “settled the argument” between New Deal historians like Arthur Schlesinger Jr. who believed that politics turned on economic questions, and those who believed it was a high-stakes “cultural war… in which propagators of liberal values have used government to impose them in every segment of American life.” Not only was the interpretive argument settled but so was the culture war itself: Americans had rejected once and for all the “educated elite” and their weak “culture of caregiving.” Barone in 2003 admitted that his post-1994 introduction had failed to foresee President Clinton’s electoral recovery, but said it was still “in some ways my favorite.” And mine as well, because just as the early Almanacs reflected the temper of that first great turn in the modern Congress, this one is very much a document of the second turn, with all its vicious hubris.

Since the mid-1990s, three developments have challenged the Almanac’s relevance. First, much of the information that was once available nowhere else is now a Google search away…. Second… in an era of strong and ideological political parties and the restoration of the imperial presidency, the “beliefs and idiosyncrasies” of 535 people don’t seem quite as important as they once did…. There is remarkably little payoff in learning the precise differences in temperament and background among Jeb Hensarling, Thelma Drake, Louie Gohmert, and Phil Gingrey—all Republicans with carbon-copy voting records. And the districts they represent are less likely to embody distinct communities than they once did. As in past volumes, many write-ups in the current Almanac begin with a vivid rendering of, say, Jacksonville or Austin, only to admit a few sentences later that the actual district contains only parts of that city, plus a narrow strip of counties extending hundreds of miles out…. Third, Barone’s political evolution didn’t stop at Gingrich—he just kept going, so that he now occupies the rightmost corner even in his current haunts at AEI and Fox News. It’s a strange kind of conservatism, which seems based largely on the conviction that liberals are soft and stupid. Barone also seems to be consciously rejecting everything about his younger self…. [T]he man who in the 1974 Almanac called Nixon “the politician who presided over the most lawless presidential campaign in American history,” now sees Nixon simply as a victim, like Bush, of liberal vitriol and a long campaign to delegitimize conservative rule and the presidency itself.

More significant for the Almanac, Barone has come to embrace a strict dualist view… the culture war between educated elites and “Tocquevillian America”… an incoherent distinction between “crunchy” and “soggy” policies and politicians… books, ideas, policies, and politicians are classified as either “Hard” (good) or “Soft” (bad)…. The early Almanacs were a celebration of America’s pluralism, its 535 idiosyncratic legislators and 50 governors, and the magnificent fluidity of a democracy… what place is there for such pluralism in a world of Hard and Soft, Crunchy and Soggy? If everything is darkness or light, what’s the use of an Almanac of American Politics? What do you really need besides an up-to-date Enemies List?…

Libertarians Who Tell You What to Think

Somehow I don't think Bryan Caplan understands what "liberty" is.

Noah Smith:

Noahpinion: The libertarian solution to inequality: Reviewing a book about happiness, George Mason University professor and Cato Institute blogger Bryan Caplan writes:

[The author] suggests that large differences in relative income can have a large influence on happiness...[but even if he] is right about the unhappy effects of income comparison, you shouldn't conclude that redistribution is the solution. Yes, you could fight inequality of income. But you could just as easily fight comparison of income. Instead of praising those who "raise awareness" about inequality, perhaps we should shame them, like the office gossip, for spreading envy and discontent.

So, the libertarian solution to the problem of inequality is to socially persecute anyone who talks about inequality?… Who wants to live in a society in which certain topics are verboten? Would we really be happier if the words "Gini coefficient" were NSFW? And, more fundamentally, when did restricting the free flow of information - by any means, governmental or social - increase our liberty?

Like I said, a very odd notion of what the word means….

The bottom line, libertarians, is that people care about what they care about. Telling them "No, do NOT care about that, care only about my arbitrary, rigid, and counterintuitive definition of liberty!" is not going to win your movement a lot of followers in the long term.

Michael Tomasky: Barack Obama Needs to Force Congress Into Recess, Make Appointments

Michael Tomasky:

Barack Obama Needs to Force Congress Into Recess, Make Appointments: I’ve been wondering lately the same thing as a lot of liberals in Washington: when and how will the president ever grow some backbone? Sure, the post-debt-deal polls show that he came out of the mess looking somewhat less terrible than the Republicans. But he looks weak, and he’ll keep getting pushed around until he throws down on something. I’m planning an occasional series about what that something could be, and here’s idea No. 1: force the Congress into recess and make a slew of appointments.

What? Force the Congress into recess? Yes. The president has the power under the Constitution to do exactly that. Read Article II, which is, of course, on the executive branch, Section 3, titled “State of the Union, Convening Congress.” It states in full about the president that:

He shall from time to time give to the Congress Information of the State of the Union, and recommend to their Consideration such Measures as he shall judge necessary and expedient; he may, on extraordinary Occasions, convene both Houses, or either of them, and in Case of Disagreement between them, with Respect to the Time of Adjournment, he may adjourn them to such Time as he shall think proper; he shall receive Ambassadors and other public Ministers; he shall take Care that the Laws be faithfully executed, and shall Commission all the Officers of the United States….

First, it must be an extraordinary occasion. Second, the two houses of Congress must disagree about the time of adjournment. Both can be finessed. On the first point, Obama can actually reasonably argue that the number of presidential appointments held up by Republicans (we’ll get to the numbers in a minute) is so large as to constitute an extraordinary circumstance. On the second, all that would take is for the Democratic-controlled Senate to force a “disagreement” with the House about when Congress should adjourn.

Too clever by half? Dirty pool? No cleverer or dirtier than what’s been going on with presidential appointments, which is a scandal and disgrace and gets almost no media attention….

[I]magine the Obama who invoked his constitutional power for a change, forced a congressional adjournment, and put Cordray—and a hundred other appointees doing the limbo—to work? Conservatives would howl that he was behaving like a dictator. But liberals would be enraptured, and I feel certain that most independents would be impressed that the guy finally drew a line in the sand over something…. [A] president doesn’t end partisan gridlock by letting the other party steamroll him. He ends partisan gridlock by trying to banish a practice that has become the epitome of partisan gridlock. It’s really not that complicated.

Some Things that Could Have Been Done--and That Could Still Be Done

Mike Konczal:

Some Things that Could Have Been Done in Housing: Ezra Klein wrote a post… arguing that you “can believe Obama has made pretty significant mistakes, as I do, but also find yourself pessimistic as to the difference a flawless performance by the president — as opposed to a flawless performance by the Federal Reserve or the Congress — would have made to the economy.” What are some suggestions for what Obama could have done early in the administration?....

  1. Use eminent domain to purchase MBS and then writedown the debts to manageable levels.  Legal, a huge move, but with some precedent in the HOLC.  This would have been Obama’s equivalent of Executive Order 6102.  It would have been an extraordinary action but so is the Recession we are going through. Indeed TARP was Obama’s Execuitve Order 6102 – he could be funding an infrastructure bank with it right now if he was willing to push it but is choosing against that. It explicitly has the funding he wanted on mortgage relief that hasn’t been spent through HAMP.  He could have done a ton with it. With the exception of the auto industry bankruptcies, TARP wasn’t used aggressively enough.

  2. FYI when it comes to protecting the banks, Obama has been willing to go to great lengths to avoid Congress.  Look at the Public-Private Investment Program for Legacy Assets (PPIP) program – often referred to as the early 2009 Geithner Plan. That plan involved using FDIC funds to try and get private money to overbid the toxic assets on the banks’ books.  Though there was the nudge and the public put-option, private capital wouldn’t step up – it’s was a job the government needed to do.  But it was tried and created in such a way to avoid Congress entirely…. Clearly this wasn’t the intention of the FDIC fund they were leveraging, but Treasury went with it anyway rather than go back to Congress for more TARP for the banks….

  3. FHFA could writedown mortgages under safety and soundness criterion with homeowners taking a shared appreciation clause – writedown for a loss now, and then taxpayers get part of the upside later.  As Adam Levitin suggested to me, that structure of shared appreciation would look a lot like the TARP warrants that were given to shadow banks during the crisis.  A TARP for Main Street that isn’t a slogan but an actual policy tool here.  New Bottom Line has additional suggestions and numbers along this approach.

  4. FDR was pretty straightforward about what he wanted the price index and monetary policy to do under his administration and the actions they’d take to bring it about.  Getting the Federal Reserve to go didn’t seem to be a concern for the administration one way or the other.

And the Treasury can increase the money supply and carry out quantitative easing operations via high-value platinum coins without having to go through the Federal Reserve at all. Just saying.

Policy right now is contractionary because Obama wants policy to be conctractionary.

We Need a Lot of the Upside: Rescuing Bank of America

Buce writes:

Underbelly: Geithner Rules: Oh dear.  Of course I haven't any idea whether this is true but it sounds like Tim Geithner hasn't learned a thing:

There is a rumor circulated on Wall St. that JP Morgan (NYSE: JPM) will take over Bank of America (NYSE: BAC) within the week. The government will support the deal with a $100 billion investment in preferred shares issued by the combined entity. Alternatively, the government may guarantee the value of a large pool of Bank of America assets. The word is that Treasury Secretary Geithner has discussed the transaction with JP Morgan CEO Jamie Dimon.The “merger” would completely destroy the value of BAC’s common shares.

Translated: okay, so equity gets hosed, which is just as it should be in insolvency. But it sounds like we will be paying $100 bill for something. And that would be? Why, the bondholders, I suppose--who else could it be, with numbers like this and on terms like this. It's been the one abiding principle throughout the Geithner--no matter how parlous the state of whatever, no bondholder gets left behind.  Apparently we need to say it again, guys: capitalism means the risk of failure, and real failure when things go bad.  Bank bailouts that protect bondholders are ring-fencing for which the rest of us pay.  Sheesh, is that so hard to understand?

I'm not that upset at rescuing bondholders of organizations that are genuinely Too Big to Fail--which B of A is.

But the U.S. government needs a big chunk of the equity upside of any such deal. Warrants. Tim Geithner's successors have to be able to stand up and say "we made $30 billion in profit for the taxpayer" for this to be politically viable.

Against Fiscal Policy Nihilism

Mark Thoma sends us to the Spirit of R.G. "They Are Crying 'Fire! Fire!' in Noah's Flood" Hawtrey:

Barro on Keynesian Economics vs. Regular Economics: Readers of this blog may have guessed by now that I am not a fan of The Wall Street Journal editorial page.  (Actually that is not entirely true.  The Journal editorial page is my go-to source of material whenever I am looking for something to write about on the blog.  So the truth is that I am deeply indebted and eternally grateful to the Journal.)  But I have to admit that even I was not quite prepared for Robert Barro’s offering…. Barro, with a good deal more sophistication than [stephen] Moore, draws the contrast not between Keynesian economics and common sense but between Keynesian economics and regular economics. Regular economics is the economics of scarcity and tradeoffs in which there is no such thing as a free lunch…. Barro throws up his hands in astonishment:

If [the Keynesian multiplier were] valid, this result would be truly miraculous.  The recipients of food stamps get, say, $1 billion but they are not the only ones who benefit.  Another $1 billion appears that can make the rest of society better off.  Unlike the trade-off in regular economics, that extra $1 billion is the ultimate free lunch.

Quickly composing himself, Barro continues:

How can it be right?  Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?  Keynes in his “General Theory” (1936), was not so good at explaining why this worked, and subsequent generations of Keynesian economists (including my own youthful efforts) have not been more successful.

Nice rhetorical touch, that bit of faux self-deprecation…. But wait a second.  What does Barro mean by his query:

Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?

Where is the market failure? Hello. Real GDP is at least 10% below its long-run growth trend, the unemployment rate has been hovering between 9 and 10% for over two years, and Professor Barro can’t identify any market failure? Or does Professor Barro, like many real-business cycle theorists (say, Charles Plosser, for instance?), believe that fluctuations in output and employment are optimal adjustments to productivity shocks involving intertemporal substitution of leisure for labor during periods of relatively low productivity?…

[T]wo and a half years ago… Barro had a slightly different take on what is going on….

[A] simple Keynesian macroeconomic model implicitly assumes that the government is better than the private market at marshalling idle resources to produce useful stuff…. [T]here is something wrong with the price system. John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels.  But this problem could be readily fixed by expansionary  monetary policy…

So in January 2009, Barro was at least willing to entertain the possibility that some kind of obstacle to necessary price and wage reductions might be responsible for the failure of markets to generate a spontaneous recovery from a recession…. [I]f that is what Barro believed… it would be interesting to know if he thinks that monetary expansion, which, after all, can be accomplished at very little cost in terms of resources or foregone output is not somehow inconsistent with his conception of regular economics. I mean you print up worthless peices of paper and, poof, all of a sudden all that output that private markets couldn’t produce gets produced, and all those workers that private markets couldn’t employ get employed.  In Professor Barro’s own words, "How can that be right?"… [H]ow is it that monetary expansion works according to "regular economics"?  People get additional pieces of paper; they have already been holding pieces of paper, and don’t want to hold any more paper. Instead they start spending to get rid of the the extra pieces of paper, but what one person spends another person receives, so in the aggregate they cannot reduce their holdings of paper as intended until the total amount of spending has increased sufficiently to raise prices or incomes to the point where everyone is content to hold the amount of paper in existence. So the mechanism by which monetary expansion works is by creating an excess supply of money over the demand.

Well, let’s now think about how government spending works.  What happens when the government spends money in a depression?  It borrows money from people who are holding a lot money but are willing to part with it for a bond promising a very low interest rate. When the interest rate is that low, people with a lot cash are essentially indifferent between holding cash and holding government bonds. The government turns around and spends the money buying stuff from or just giving it to people…. [A] lot of the people who now receive the money will not want to just hold the money. So the government borrowing and spending can be thought of as a way to take cash from people who were willing to hold all the money that they held (or more) giving the money to people already holding as much money as they want and would spend any additional money that they received. In other words, i.e., in terms of the demand to hold money versus the supply of money, the government is cleverly shifting money away from people who are indifferent between holding money and bonds and giving the money to people who are already holding as much money as they want to. So without actually printing additional money, the government is creating an excess supply of money, thereby increasing spending, a process that continues until income and spending rise to a level at which the public is once again willing to hold the amount of money in existence….

[M]onetary expansion… and government spending… are close enough so that if restoring full employment by printing money does not contradict regular economics, I have trouble seeing why restoring full employment by borrowing and government spending does contradict regular economics.  But I am sure that Professor Barro, very, very clever fellow that he is, will clear all this up for us in due course, perhaps in a future op-ed in my go-to paper.

Kudos to the Spirit of R.G. "They Are Crying 'Fire! Fire!' in Noah's Flood" Hawtrey. I have been trying to say this for three years, and have never managed to say it that well.

Indeed, the only way--the only way, the absolutely fracking consistent way for anybody with half the cortical cells of a newt--to claim that monetary policy is effective at boosting nominal GDP and fiscal policy not is to assume a vertical LM curve. That is, as Hicks pointed out in 1937, a denial of the theory of value: a complete and total rejection of the ideas that money holders think at the margin and respond to incentives.

That would be a very very large deviation from "normal economics" indeed...