Signing off until January 5th

Have a peaceful Christmas.

John Taylor on the causes and treatment of the crisis

This essay by Stanford's John Taylor is well worth reading.

In this paper I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework.  While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.

What are the implications of this analysis for the future?  Most urgently it is important to reinstate or establish a set of principles to follow to prevent misguided actions and interventions in the future.  Though policy is now in a massive clean-up mode, setting a path to get back to these principles now should be part of the clean-up.  I would recommend the following:

First, return to the set of principles for setting interest rates that worked well during the Great Moderation.

Second, base any future government interventions on a clearly stated diagnosis of the problem and a rationale for the interventions.

Third, create a predictable exceptional access framework for providing financial assistance to existing financial institutions. The example of how the International Monetary Fund set up an exceptional access framework to guide its lending decisions to emerging market countries is a good one to follow.

Why Europe needs its own New Deal

This column for National Journal [link expires in a fortnight] looks at an international dimension of the economic emergency:

Even weeks ago, the orthodox and unorthodox measures that the Federal Reserve is now resorting to would have seemed scarcely thinkable. The same goes for the fiscal stimulus of $500 billion or more that the Obama administration is preparing. Whether these amazingly bold interventions succeed is another matter, but nobody can question the Fed's or Treasury's willingness to suspend the usual rules and think big.

This zeal for dramatic initiatives is notably absent in Europe.

The European Central Bank, which controls monetary policy in the 15 countries that are members of the euro currency zone, has cut interest rates more slowly and far more reluctantly than the Fed. Most European countries are planning a fiscal stimulus, but there is no meaningful Europe-wide initiative. The individual countries' efforts are collectively very modest compared with what is intended in the U.S. This week the head of the ECB reminded the zone's members of their commitments under the "stability and growth pact" -- an agreement they reached when the euro was created. It forbids members to run fiscal deficits anywhere near as large (in relation to the size of their economies) as the one the U.S. is now contemplating for 2009.

Why is there such a marked difference in attitudes to this economic emergency in the United States compared with Europe -- and what, if anything, does Europe's reticence mean for the U.S. and the world economy as a whole?

You can read the rest here.

China's economic miracle

Yasheng Huang's book on China's economic miracle went on to my reading list when I saw it reviewed in The Economist earlier this year. I promptly forgot about it. This article [registration required] in the McKinsey Quarterly tells me to bump it to the top. (Above "Outliers"? Perish the thought.)

The credibility of American-style capitalism was among the earliest victims of the global financial crisis. With Lehman Brothers barely in its grave, pundits the world over rushed to perform the last rites for US economic ideals, including limited government, minimal regulation, and the free-market allocation of credit. In contemplating alternatives to the fallen American model, some looked to China, where markets are tightly regulated and financial institutions controlled by the state. In the aftermath of Wall Street's meltdown, fretted Francis Fukuyama in Newsweek, China's brand of state-led capitalism is "looking more and more attractive." Washington Post columnist David Ignatius hailed the global advent of a Confucian-inspired "new interventionism"; invoking Richard Nixon's backhanded tribute to John Maynard Keynes, Ignatius declared, "We are all Chinese now."

But before proclaiming the dawn of a new Chinese Century, leaders and executives around the world would do well to reconsider the origins of China's dynamism. The received wisdom on the country's economic miracle--it was a triumph of technocracy, in which the Communist Party engineered a gradual transition to the market by relying on state-controlled businesses--gets all the important details wrong. This standard account holds that entrepreneurship, private-property rights, financial liberalization, and political reform played only a small role. Yet my research, based on a detailed analysis of the Chinese government's survey data and government documents at the central and local levels, indicates that property rights and private entrepreneurship provided the dominant stimulus for high growth and lower levels of poverty.

By the way, you can download Chapter 1 of the book as an MIT Working Paper.

Robert Samuelson: "The Great Inflation..."

[This review ran in the FT earlier in the week and I forgot to post it here. Sorry.]

Robert Samuelson, who writes for Newsweek and the Washington Post, has for years been one of the most interesting economic commentators in the US. He stands for independence and lack of agitation, real or synthetic. He has no time for exaggerated alarms and enthusiasms. He is steady in a boom and steady in a crisis. Except that he writes too well, he might have been a good central banker.

His new book about the "Great Inflation" of the 1960s and 1970s and its far-reaching consequences has a lot to say about central banking, but it strives to put debates about monetary policy in a wider setting. It is an excellent subject and, as he says, a book that needed to be written.

Inflation in the US increased in those decades, he argues, because of good intentions combined with bad economics. After the second world war politicians had fresh memories of the Depression and were sensitive to the costs of unemployment. Maintaining full employment was the good intention. The bad economic idea was that monetary and fiscal policy could be fine-tuned to do this continuously.

Many economists then believed it was possible to exploit a stable trade-off between inflation and unemployment. Accepting a slightly higher rate of inflation would allow a permanently lower rate of joblessness: a small price to pay, many believed. In addition, estimates of how far down unemployment could be pushed were very optimistic: rates of less than 4 per cent were regarded as unambitious. A third ingredient was the view that inflation was not chiefly the result of monetary policy: if inflation crept up, it was because of "cost-push" factors (such as wage demands) which the central bank could not affect.

In the view of most economists, all those ideas now stand discredited. Accepting a higher rate of inflation does not yield a permanently lower rate of unemployment; the "natural rate" of unemployment (the amount consistent with inflation that is neither rising nor falling) is higher than 4 per cent; and expansionary monetary policy does indeed drive inflation up. The views prevailing in the 1960s and 1970s were a formula for policy erring always on the side of expansion, which ratcheted inflation ever higher.

Once US inflation had risen above 10 per cent, it took Paul Volcker at the Federal Reserve, Ronald Reagan in the White House (prepared to give Mr Volcker political cover), and an unexpectedly severe recession in 1981-82 to bring it back down. There followed more than two decades of the "Great Moderation", as it is called: steady growth, low inflation, and muted business-cycle fluctuations. Discussing this in 2004, Ben Bernanke, now the Fed chairman, called the "substantial decline in macroeconomic volatility" over the previous 20 years "a striking development". Was it due to structural economic change, better monetary policy, or good luck, he asked? His answer: monetary policy, mainly. The lessons had been learnt.

Four years on, with the roof falling in, Mr Bernanke's verdict on the new-found wisdom of central bankers looks a little premature. Mr Samuelson's book also feels overtaken by events and, in its last parts, thrown into confusion. He writes, "In many ways, the book's publication - about two years later than I originally expected - is more timely now than if I had written faster and made my initial schedule." I think not. The present crisis overhangs the narrative and demands to be properly integrated. Had the author known what was coming, this is not the book he would have published at the end of 2008. The Great Moderation is over. We are living new and unforeseen chapters, and the book does not have them.

Rather than simply stopping short, the book does attempt some discussion of the crisis. With less than full conviction, it suggests that the Great Moderation fell victim to an internal contradiction: low inflation fuelled reckless optimism which spilled over into speculative excess. No doubt there is something to that, but the idea cuts awkwardly across the theme that Samuelson presumably first had in mind, and which is stamped through the book - that a kind of social contract was struck after 1982, in which people accepted less fine-tuning of the economy in return for low inflation and steady growth. Was that a good deal, as the book seems to want to say? Or was it false advertising - as the view that the Great Moderation carried the seeds of its own destruction would imply?

Like everything Samuelson writes, this is an absorbing read. The main part of it, which deals with settled economic history, can be warmly recommended. But the history is not as settled as one supposed, and suddenly the aftermath of the great inflation seems less interesting, and less important, than the aftermath of the aftermath.

Trade and labor appointments

More rivals? It seems that Obama has chosen Ron Kirk as his USTR and Hilda Solis as his labor secretary. Kirk, a former mayor of Dallas, is said to be a supporter of NAFTA in particular and free trade in general. Solis is apparently a labor advocate and friend of the unions, and not so keen on liberal trade; read Harold Meyerson's endorsement:

What does Rep. Hilda Solis, Barack Obama's selection for secretary of labor, bring to the job? Only a record of passionate commitment to working people, a high level of political smarts, and some genuine displays of raw guts that could make her a star of American liberalism...

In the House, Solis has continued to champion labor causes, immigrants' rights, women's health and environmental protections. She also worked closely with Rahm Emanuel in recruiting Democratic House candidates from the Southwest and Latino-dominated districts, so she brings to her new job a strong relationship with Obama's incoming chief-of-staff. Now, she's in the key position to promote the Employee Free Choice Act, which seems likely to be the most contentious issue on Obama's agenda. But Solis has never been deterred by controversy.

Assuming the appointments are confirmed, we will see how well they can work together. As I have said before, I question the wisdom of combining people with fundamental disagreements in executive (as opposed to advisory) roles. Widely divergent opinions are good in a seminar but not so good in a management setting, where the challenge is not to develop and polish an opinion but to get something done. Much as I admire the man and respect his appetite for countervailing opinion, I'm beginning to wonder if Obama understands this distinction. Dysfunctional quarreling is the obvious risk. A subtler problem is that if you appoint people who disagree with each other to run adjoining or overlapping spheres of policy, you, the boss, cannot delegate. Obama will always have to be there to adjudicate--and his time and energy are going to be very scarce resources.

Brooks on Gladwell

I am steeling myself to approach "Outliers", Malcolm Gladwell's latest. I am not an admirer, but I can hardly complain about this further contribution to the culture--as I hope to in due course--without having read it.

Since the first chapter of "Tipping Point" I have been enduring Gladwell out of an increasingly weary sense of professional obligation. This is what they pay me to do, I tell myself. The man has a nose for interesting tales, I grant you, but his unfailing combination of intellectual parasitism, credulity, false modesty, and self-importance repels me. In "Tipping Point", "Blink" and those of his New Yorker pieces I have read, the formula is always the same: find a scholarly opinion; sanctify said opinion with Gladwellian approval (transforming it from a disputed theory to something "we now know"); season with Madison Avenue terms of art; then deluge with anecdotes of questionable, if any, relevance. And let there be color. Always, the color. Please tell me about that man's wry smile, interesting foreign accent, and cluttered desk (often, as studies show, the sign of a creative mind). I need to know all that.

Well, as I say, I will report back on "Outliers" in due course. For this premature outburst, blame David Brooks. "Outliers" is an "important" book, he says, in an excess of professional courtesy. (Important to whom?) Further compliments follow. In the end he criticizes a little, but quite respectfully. I see no blood on the floor. It's disappointing.

As Gladwell told Jason Zengerle of New York magazine: "The book's saying, 'Great people aren't so great. Their own greatness is not the salient fact about them. It's the kind of fortunate mix of opportunities they've been given.' "

Rather than nodding wisely at this, shouldn't one just laugh? The "salient fact" about Newton was not his greatness but his "kind of fortunate mix of opportunities"? Einstein? Mozart? Does Gladwell actually know what "salient" means? As for the idea that nature and nurture are both involved in determining one's success or failure--am I asked to believe that this is a new insight, for heaven's sake? I learn from other reviews that Gladwell has also arrived, through the research for this book, at the discovery that "practice makes perfect". Yes, I was surprised too; once again conventional wisdom is turned on its head. There is a rather important academic paper about it.

Brooks' main point is to express concern at where these remarkable new findings might lead:

His book is being received by reviewers as a call to action for the Obama age. It could lead policy makers to finally reject policies built on the assumption that people are coldly rational utility-maximizing individuals. It could cause them to focus more on policies that foster relationships, social bonds and cultures of achievement.

Interesting. What might those policies be, I wonder? Are the policies supportive of mixed-economy capitalism--the ones we already have, which policy makers might finally reject--so inimical to relationships, social bonds and cultures of achievement? I mean, as compared to the alternatives, whatever those might be.

I know. None of this changes the fact that I will have to read that damn book.

The long road to healthcare reform

A new column for the FT on Tom Daschle's chances of reforming the health system:

He is a good choice. He combines years of experience in Washington with longstanding expertise in health policy. He watched at close hand as the last big effort to reform US healthcare - the project led by Hillary Clinton in 1993 - came to nothing. He thinks he knows why that project failed and how to do better next time. And he has just published a book on the subject: Critical: What We can Do About the Healthcare Crisis.

Reforming US healthcare is a heroic undertaking, crucial to long-term economic prospects. Now, on top of all the difficulties that sank the Clinton plan, healthcare reform must bid for financial and political resources against the vast outlays that the recession will pre-empt. What are Mr Daschle's chances?

Consider first the errors of Hillarycare. A lot went wrong, says Mr Daschle, but the overall design was not the mistake. The plan was one of many similar schemes to build on (rather than replace) the current mostly private, employer-based system. The plan sketched by Mr Obama during the campaign has much in common with it - so does Mr Daschle's variant; the system already operating in Massachusetts is similar. In each case, the idea is to use subsidies and mandates to fill gaps in coverage, while adding a layer of control to press down on costs.

What killed Hillarycare, Mr Daschle argues, was the process. Behind closed doors, her team devised a 1,342-page law that nailed down every last detail of the new system. Little effort was made to get sceptics invested. The administration then gave its critics an almost infinite number of technical issues around which to organise resistance. Mr Daschle's book suggests a different approach...

The Blagojevich scandal

An interesting post about political corruption on Larry Sabato's site. Though not instantly germane, I thought this was a particularly good point:

A system of government or politics can be at least as corrupting as human nature itself. We have studied politicians in close proximity for years, and as much as it may disappoint the cynics, we have not found politicians to be venal as a class. While there are a number of individual exceptions, most professional politicians, especially those already in public office, want to do good or seek to do the right thing, if doing good is an option that does not result in their political demise. However, if the "normal and customary" practices of campaigning engaged in both parties are seedy, and if a candidate believes "everybody's doing it, and if I don't do it, I may lose," then most politicians will suspend their ethical codes. They will willingly accept a distasteful means that ensures what they regard as the good and essential end of their continued power. In other words, otherwise ethical people are put at a disadvantage by a corrupting system and almost forced to do unto others as they are being done to. Strict ethicists will correctly argue that the truly honorable person would not stoop to conquer, whatever the provocation. Yet reasonable reformers must keep in mind that the professional politician has a "power gene" in his or her genetic code that overrides all usual inhibitions to achieve victory or maintain power--and genetic engineering, however advanced it may become, will never be able to change that reality.

As I say, if the transcripts are any guide, it seems unlikely to apply to Blagojevich himself; he does not seem to fall into the category of "otherwise ethical people... put at a disadvantage". But many if not most offenders probably do.

Scott Turow, author of "Presumed Innocent", has some inside dope.

Blagojevich: It "can't be in writing"

The criminal complaint against Rod Blagojevich, Democratic governor of Illinois,  is well worth skimming. You have to read this stuff for yourself to believe it.

90. Later on November 3, 2008, ROD BLAGOJEVICH spoke with Advisor A. By this time, media reports indicated that Senate Candidate 1, an advisor to the President-elect, was interested in the Senate seat if it became vacant, and was likely to be supported by the President-elect.  During the call, ROD BLAGOJEVICH stated, "unless I get something real good for [Senate Candidate 1], shit, I'll just send myself, you know what I'm saying." ROD BLAGOJEVICH later stated, "I'm going to keep this Senate option for me a real possibility, you know, and therefore I can drive a hard bargain.  You hear what I'm saying. And if I don't get what I want and I'm not satisfied with it, then I'll just take the Senate seat myself."  Later, ROD BLAGOJEVICH stated that the Senate seat "is a fucking valuable thing, you just don't give it away for nothing."

91. On November 4, 2008, ROD BLAGOJEVICH spoke with Deputy Governor A.  This was the same day as the United States Presidential election.  With respect to the Senate seat, Deputy Governor A suggested putting together a list of things that ROD BLAGOJEVICH would accept in exchange for the Senate seat.   ROD BLAGOJEVICH responded that the list "can't be in writing."  Thereafter,  ROD BLAGOJEVICH discussed whether he could obtain an ambassadorship in exchange for the Senate seat.

Jay Leno has a running joke on his show. "What do I love? Stupid criminals"--then he reads a news clipping about a robber who leaves his name and address at the scene of the crime or impales himself on a trash can while fleeing. That shrewd "can't be in writing" belongs in the anthology. That's right, boss. Be careful what you write down, for God's sake.

101. On November 10, 2008, ROD BLAGOJEVICH, his wife, JOHN HARRIS, Governor General Counsel, and various Washington-D.C. based advisors, including Advisor B, discussed the open Senate seat during a conference call.  (The Washington D.C.-based advisors to ROD BLAGOJEVICH are believed to have participated on this call from Washington D.C.).  Various individuals participated at different times during the call.  The call lasted for approximately two hours, and what follows are simply summaries of various portions of the two-hour call.

a. ROD BLAGOJEVICH expressed his interest in figuring out a way to make money and build some financial security, while at the same time potentially participating in the political arena again.  ROD BLAGOJEVICH mentioned the Senate seat, the dynamics of a new Presidential administration with the strong contacts that ROD BLAGOJEVICH has in it, and asked what if anything he can do to make that work for him and his wife and his responsibilities as Governor of Illinois.  ROD BLAGOJEVICH suggested during the call that he could name himself to the open Senate seat to avoid impeachment by the State of Illinois legislature.   ROD BLAGOJEVICH agreed it was unlikely that the President-elect would name him Secretary of Health and Human Services or give him an ambassadorship because of all of the negative publicity surrounding ROD BLAGOJEVICH.

...

c. ROD BLAGOJEVICH said that the consultants (Advisor B and another consultant are believed to be on the call at that time) are telling him that he has to "suck it up" for two years and do nothing and give this "motherfucker [the President-elect] his senator.  Fuck him.  For nothing?  Fuck him."

Too soon to say whether it will hurt Obama. For some reason Democratic corruption does not create a universal presumption of collective guilt in the way that Republican corruption does. (In many of the pieces on this you have to tunnel down quite far to read that Blagojevich is indeed a Democrat, as though that were a point of little significance.) The story so far does not reflect badly on the president-elect. Quite the opposite. Blagojevich wanted more than mere appreciation in return for the appointment of Obama's ally Valerie Jarrett to the Senate seat, and didn't get it. Still, there are some loose ends.

See Jake Tapper:

And, it should be pointed out, Mr. Obama has a relationship with Mr. Blagojevich, having not only endorsed Blagojevich in 2002 and 2006, but having served as a top adviser to the Illinois governor in his first 2002 run for the state house.

In the Democratic gubernatorial primary that year, then-state sen. Obama endorsed former Illinois Attorney General Roland Burris. But after Blagojevich won, Obama came around enthusiastically. At the same time, meanwhile, Axelrod had such serious concerns about whether Blagojevich was ready for governing he refused to work for his one-time client.

According to Rep. Rahm Emanuel, D-Ill., Mr. Obama's incoming White House chief of staff, Emanuel, then-state senator Obama, a third Blagojevich aide, and Blagojevich's campaign co-chair, David Wilhelm, were the top strategists of Blagojevich's 2002 gubernatorial victory.

Emanuel told the New Yorker earlier this year that he and Obama "participated in a small group that met weekly when Rod was running for governor. We basically laid out the general election, Barack and I and these two."

Wilhelm said that Emanuel had overstated Obama's role. "There was an advisory council that was inclusive of Rahm and Barack but not limited to them," Wilhelm said, and he disputed the notion that Obama was "an architect or one of the principal strategists."

(An Obama Transition Team aide emails to note that Emanuel later changed his recollection of this story to Rich Miller's "CAPITOL FAX," saying, "David [Wilhelm] and I have worked together on campaigns for decades. Like always, he's right and I'm wrong.")

Obviously, Obama and Blagojevich moved in the same world--improbable as the contrast between the two men makes that seem. Perhaps now, better late than never, we will begin to read more about that world.

Obama has said he did not talk to the governor about his vacant Senate seat. David Axelrod had to withdraw an earlier statement which said otherwise. There was presumably communication at some level between the two sides, even if it was just the exchange of demand and curt refusal. (Otherwise, Blagojevich would have had no grounds for calling the president-elect a motherfucker.) But the person receiving that demand was under an obligation to do more than just refuse. Perhaps he or she did do more than that. In due course, maybe, we will find out.

Photography: Hitler on the D3x

If you are interested in photography (as I am) you will have noticed that the launch of the Nikon D3x has met with a mixed response.

First things first in the stimulus plan

My latest FT column looks at the design of the forthcoming fiscal stimulus:

"Rule one: never allow a crisis to go to waste. They are opportunities to do big things." Rahm Emanuel, who will be chief of staff in the Obama White House, made this observation to an interviewer recently. The big things he has in mind include comprehensive healthcare reform and a greener energy policy to make the US less dependent on foreign oil.

With a lot of luck, he could be right - and how fine it would be to combine strong macroeconomic medicine and far-sighted microeconomic improvement at a stroke. Grand, but none too likely. For the next year and maybe longer, there are great risks in approaching economic policy this way.

With the economy shrinking at a frightening rate, the new administration needs to focus intently on devising an effective fiscal stimulus. This needs to be large, fast, temporary and do as much as possible to support demand. Most of the items on Barack Obama's broad agenda for reform - including health reform and energy policy - rightly have other priorities. So the new administration needs to think hard about what will be feasible and what matters most.

Housing is still the epicenter

In a new column for National Journal [link expires in two weeks], I argue that one of the most important gaps in the measures taken so far to revive the economy is the lack of effective action on loan foreclosures.

For months now the Treasury and the Federal Reserve Board have been trying everything they can think of to stabilize the financial system and prop up the economy. You can criticize them for many things--for the regulatory failures that let this unfolding calamity happen in the first place, maybe for the slowness of the initial response, and certainly for the failure even now to devise a coherent, intelligible plan for financial intervention. But you cannot accuse them of timidity or of idly standing by.

In a frenzy of initiatives, they have committed trillions of dollars in various kinds of public support for banks and other financial institutions. Further huge outlays, including a second fiscal stimulus, are on the way. Nobody is any longer denying the gravity of the situation; just the opposite. Yet one critical aspect of the problem has barely been addressed--the still-rising tide of home loan delinquencies and foreclosures.
...
Even though the emergency has now broadened--to almost every corner of the U.S. economy and across the world--housing is still at the center. As long as house prices continue to fall, more and more families will find that they have negative equity in their homes (in other words, their outstanding mortgage debt is greater than the current value of their house). The number of delinquent loans will keep rising, and so will the number of mortgage foreclosures. It is a vicious circle, because foreclosures drive house prices lower still. While this goes on, fiscal stimulus or no, a broader economic recovery will be difficult to engineer. The value of mortgage-backed securities will keep sinking, the panic in financial markets will persist, lending will fail to revive, and households will keep trying to retrench.

The article recommends three things: an FDIC-style plan to promote modifications; a change to the bankruptcy code, permitting courts to modify mortgage loans; and temporary tax relief to stimulate the demand for housing, as suggested by Allan Meltzer.

The column had closed before I read that the Treasury is thinking about a plan to lower rates on some new mortgages, and that Ben Bernanke was expressing renewed concern about foreclosures. The Treasury's idea, if it goes somewhere, could be helpful, though I don't know if it would pack the punch of Meltzer's proposal. In any event, this scheme is still not targeted directly at reducing foreclosures. I'm puzzled that this aspect of the problem continues to receive comparatively little attention.

Bernanke and the risk of deflation

My new FT column:

The Federal Reserve recently acknowledged that the risk of deflation in the US, though still small, has grown. Is policy correctly aligned to confront this risk? Not yet.

With Japan as an example, nobody should need reminding that deflation is a uniquely dangerous prospect - but here is a refresher. Persistently falling prices increase the inflation-adjusted burden of debt. Insupportable debts are the core of the US economy's difficulties. If that burden grows even heavier because of falling prices, the contractionary forces will strengthen. The economy will slow further, the deflationary pressure will increase again, debts will become more burdensome, and so on. Since interest rates cannot fall to less than zero, monetary policy cannot follow inflation all the way down. This makes the deflationary circle difficult to break. Nothing is more important than preventing the economy from toppling into it.

Prices in the US fell in October by 1 per cent, the biggest such fall for 60 years. That was an urgent warning - though it does not mean that deflation has arrived just yet. Prices (excluding food and energy) are 2.2 per cent higher than a year ago. Expectations of inflation remain positive, which is crucial since expectations of inflation tend to be self-fulfilling. It would take a stunning and prolonged recession to drive inflation expectations negative, thus pushing the economy all the way over the deflationary edge. But a stunning and prolonged recession may be exactly what the US faces. At the moment, each new economic indicator shows a shocking rate of contraction.