Marginal Revolution

What are the lessons from the New Deal?

This week they put my Sunday column on the web on Friday; I was alerted by the ever-vigilant Mark Thoma.  The intro is this:

The traditional story is that President Franklin D. Roosevelt rescued capitalism by resorting to extensive government intervention; the truth is that Roosevelt changed course from year to year, trying a mix of policies, some good and some bad. It’s worth sorting through this grab bag now, to evaluate whether any of these policies might be helpful.

If I were preparing a “New Deal crib sheet,”  I would start with the following lessons...

The conclusion is this:

In short, expansionary monetary policy and wartime orders from Europe, not the well-known policies of the New Deal, did the most to make the American economy climb out of the Depression. Our current downturn will end as well someday, and, as in the ’30s, the recovery will probably come for reasons that have little to do with most policy initiatives.

Read the whole thing.  For critical responses, perhaps you can try the comments section at Mark Thoma's.  For reasons of space, it was not possible to specify that I was praising the proposed Obama middle-class tax cut.  I do not, however, think it will do much (if anything) to end the current recession, although tax hikes could make things worse.

Larry Summers in the White House

Harvard University professor Lawrence Summers will join the Obama administration with a ready-made sales pitch for substantial economic stimulus and a chance that the role springboards him to the Federal Reserve.  Summers, 53, was Bill Clinton's last Treasury secretary. He will have a wide-ranging portfolio and help craft Obama's economic policies, a Democratic aide said...It also positions him to succeed Fed Chairman Ben S. Bernanke, whose term at the helm of the central bank expires in January 2010, said Vincent Reinhart, former director of the Fed's Division of Monetary Affairs.

Here is the story.

Good news, good news, bad news

The Dow is up 6.5 percent.  And Tim Geithner will be Treasury Secretary.  That's the two pieces of good news.  The bad news is that the market is up because of a political appointment.  That's really very bad news, especially since the other logical candidates for the post were extremely competent.

CEA rumors

From Megan McArdle.  Austan Goolsbee may be going elsewhere.  This could be either good or bad news; in any case the goal is to maximize his influence.  The name Cecilia Elena Rouse is being floated for the CEA position.

Addendum: Alex posted earlier this year about Rouse's important paper finding that education vouchers increase the quality of public schools.  Rouse was also an adviser for Kerry.  MR archives know all!

Economics positions: who Obama should appoint and why

Here is a run-down from Brad DeLong.  In addition to the analyses of particular names (I generally agree in the cases I can judge, though I would reappoint Bernanke, if only to limit market uncertainty), get this:

Trade Czar-nominee-designate-leekee. This will, I think, turn out to be a much more important job in the Obama-Biden administration than people recognize. Trade agreements are a principal way that we deploy our foreign policy soft power. And trade sanctions are, I think, going to be a principal tool in the construction of the system of global governance to fight global warming.

Facts about China

Exports constitute nearly 40 percent of China's GDP--far too high a figure. (By comparison, in the U.S., exports account for about 10 percent of GDP most years.) And the global financial slowdown is already taking a terrible toll. Some 10,000 factories in southern China's Pearl River Delta area had closed by the summer of 2008. Gordon Chang, a leading China analyst, estimates that 20,000 more will shutter by the end of this year. In the third quarter of 2008, Beijing also reported its fifth consecutive quarterly drop in growth, and several private research firms expect a sharper slowdown next year. Additionally, unemployment is skyrocketing; in Wenzhou, one of the main exporting cities, about 20 percent of workers have lost their jobs, Reuters recently reported.

Here is more.  By the way, here is an article on China's retreat from environmental concerns.

I thank Clifton Chadwick for the pointer.

Peter Orszag for OMB?

If reports are true and Barack Obama is really going to tap widely respected CBO Director Peter Orszag to head up the Office of Management and Budget (it’s like the CBO, but for the White House, so it makes sense) then I believe that would make him the highest-ranking blogger in the history of the United States of America.

Here is more.  Orszag, of course, is a very good economist.

The wisdom of Gordon Tullock, part II

The U.S. Navy said pirates commandeered a Saudi-owned supertanker bearing more than $100 million worth of crude a few hundred miles off the Kenyan coast, an attack that sharply increases the stakes in an effort by governments and militaries to protect the world's energy-supply lines.

U.S. Navy officials said the hijacking was unprecedented for its distance from shore and the size of its target -- a ship about the length of a U.S. aircraft carrier. The attack appears also to be the first significant disruption of crude shipments in the region by pirates.

Here is the story.  Here is Peter Leeson's paper on pirates.  I don't yet see it on Amazon, but stay tuned for Peter's forthcoming book The Invisible Hook. 

I thank Brad Williams for the pointer.

Addendum: From another article:

The pirates’ profits are set to reach a record $50 million in 2008, Somali officials say. Shipping firms are usually prepared to pay, because the sums are still low compared with the value of the ships.

The Obama transition: science and the arts

President-elect Barack Obama continues to name members of his transition team. Among the latest announcements are that the National Science Foundation agency review will be led by Jim Kohlenberger — who was senior domestic policy adviser to Vice President Al Gore, where he focused on science and technology — and Henry M. Rivera, a lawyer. For the arts and humanities transition team, Obama has selected Bill Ivey, director of the Curb Center for Art, Enterprise, and Public Policy at Vanderbilt University and former chairman of the National Endowment for the Arts; Anne Luzzatto, who served in the Clinton administration as a special assistant to the president and who has more recently been vice president for meetings and outreach at the Council on Foreign Relations; and Clement Price, the Board of Governors Distinguished Service Professor of History and director of the Institute on Ethnicity, Culture, and the Modern Experience at Rutgers University at Newark.

Here is the link.  Those names are not huge surprises and of course you will again see the imprint from the Clinton administration.

The wisdom of Bruce Bartlett

I think it would be a terrible mistake to simply write a check to the auto industry without demanding major, major restructuring of its labor contracts. Without that the money will simply go down a rat hole and the automakers will just be back again in a year or two asking for more money. Obama has a strong hand to play here and I hope he uses his leverage. With bankruptcy as the only alternative to federal aid, he can drive a very hard bargain with the auto workers. If he caves and just writes a blank check, everyone will know he can be rolled and he will pay a heavy political price for it. If Obama shows toughness on this issue, I think it will pay enormous dividends for him down the road.

Via Brad DeLong, Bruce is now blogging.  And if you want some provocation, here is Kevin Drum on the idea of a GM bailout. And Felix Salmon has some interesting ideas.

An update on the bailout

Gordon Tullock is a smart man:

When the government said it would spend $700 billion to rescue the nation’s financial industry, it seemed to be an ocean of money. But after one of the biggest lobbying free-for-alls in memory, it suddenly looks like a dwindling pool.

Many new supplicants are lining up for an infusion of capital as billions of dollars are channeled to other beneficiaries like the American International Group, and possibly soon American Express.

Of the initial $350 billion that Congress freed up, out of the $700 billion in bailout money contained in the law that passed last month, the Treasury Department has committed all but $60 billion. The shrinking pie — and the growing uncertainty over who qualifies — has thrown Washington’s legal and lobbying establishment into a mad scramble.

The Treasury Department is under siege by an army of hired guns for banks, savings and loan associations and insurers — as well as for improbable candidates like a Hispanic business group representing plumbing and home-heating specialists. That last group wants the Treasury to hire its members as contractors to take care of houses that the government may end up owning through buying distressed mortgages.

The real lesson here is about the massive fiscal stimulus on its way.  Beware, and don't be tricked by people simply postulating how the money "should" be spent.

The Chinese economic stimulus package

China on Sunday announced a huge economic stimulus package aimed at bolstering its weakening economy and perhaps helping fight the effects of a global economic slowdown.  In a sweeping move at a time when major projects are being put off around the world, Beijing said it would spend an estimated $586 billion by 2010 on wide array of national infrastructure and social welfare projects, including constructing new railways, subways, airports and rebuilding communities devastated by an earthquake in southwest China in May.

Here is the story.  Most of this money they would have spent anyway, so what is the net change in the stimulus?  And over how many years is this sum spent?  I think of this as mostly a public relations move.  China wants to tell other countries it is doing lots and it wants to tell its own citizens that it feels their pain and is pro-active.

Is there a gentle way to glide down from 10 to 5 percent growth?  I tend to doubt it.  Are you prepared for a China with negative economic growth for a few years (or more)?  I tend to doubt that too.

Matt Yglesias has interesting commentary; I guess now we'll see how much an economic surplus is worth when the core macro problem is something other than lack of aggregate nominal demand.

Addendum: Here is further comment.

AIG sentences to ponder

First came the bailout. Now comes talk of a bailout from the bailout.

Here is the article.  Felix Salmon offers related commentary.  This reminds me of problems in public utility theory.  To get optimal cooperation, the regulator allows the regulated firm to set price above marginal cost so that the regulated firm has some incentive to obey.  But what do you do when the regulated firm is essentially wiped out?

Iceland: what does the endgame look like?

Thrainn Eggertsson writes to the FT:

The government of Iceland has now been offered foreign loans that roughly equal the country's gross domestic product.  The annual interest payments, say 3-4 per cent, approximately correspond to the country's annual economic growth.  Additionally the loans must be paid up.

I believe Thrainn is being generous with that growth estimate.  Then he compares Iceland to Germany in 1919 and predicts similar consequences (I don't think he means that as a threat, however).  Instead, I wonder what it is like for a country to be truly, permanently bankrupt.  And a further difficulty lies on the horizon.  Circa 2000, fish accounted for 70 percent of the country's export earnings.  Here are many articles on dwindling cod stocks, the number one item sold by Icelandic fishermen.

I genuinely cannot imagine what the endgame looks like.

Department of Whatever

Dow up 889. 

Why the market has been down on the Euro and European banks

Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the International Monetary Fund.

Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The US figure is just 4pc. America is the staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn) to what was once the US backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.

Broadly speaking, the US and Japan sat out the emerging market credit boom. The lending spree has been a European play – often using dollar balance sheets, adding another ugly twist as global “deleveraging” causes the dollar to rocket. Nowhere has this been more extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss francs. A few dare-devil homeowners in Hungary and Latvia took out mortgages in Japanese yen. They have just suffered a 40pc rise in their debt since July. Nobody warned them what happens when the Japanese carry trade goes into brutal reverse, as it does when the cycle turns. . . .

Just in case you were wondering.  Here is the link.  By the way, this is further evidence that the driving force behind the earlier boom was the global savings glut, and sheer giddiness, not the excessively loose monetary policy of Greenspan's Fed.  The ECB has pursued a relatively tight monetary policy since its origin.  It also will be interesting to see what trouble arises in Spain, since Spanish banking regulation has been considered a model of how to keep these problems under control.

And here's Romania fact of the day:

Romania raised its overnight lending to 900pc to stem capital flight...

The credit crunch: I still cannot agree with Alex and Bryan

Alex is a very good truth-tracker but on credit I remain stubborn in my belief that there is a credit crunch.  Here is one report:

How is trade finance coping with the credit crunch

Badly. Steve Rodley, director of London-based shipping hedge-fund Global Maritime Investments, puts it bluntly: "The whole shipping market has crashed." The trouble is that credit is the lifeblood of commerce, but it is built entirely on trust. And that has evaporated. As such, many ship owners can't get banks to issue letters of credit, particularly on cargoes of price-volatile commodities that no longer look like adequate collateral. Even those who can get letters of credit are finding that their counterparties may no longer trust the credit rating of anything other than large, well-established banks, many of which are now charging big premiums. Letters now cost three times the going rate of a year ago, according to Lynn.

Here is another report.  Here are other reports.  Or read this account:

What's more, the dollar-denominated trade finance lines that exporter companies rely upon to do business are drying up in dramatic fashion amid the global credit crunch. In Brazil -- the world's top exporter of beef, iron ore, sugar and coffee and the No. 2 exporter of soy -- total outstanding trade lines have fallen by half this month to around $18 billion.

Here are simple and in my view decisive quantitative indicators of the current domestic credit crisis.  Or here is another report:

According to experts interviewed by Bloomberg, "letters of credit and the credit lines for trade currently are frozen," and as a result, "nothing is moving".

Or here is a recent survey of U.S. retailing CFOs:

Some 41 percent of US retailers are seeing tight credit as a result of the crisis in the banking sector, and many will cut staff and reduce buying as a result...

Many other surveys paint a similar picture.  I can only repeat my earlier words that immediate credit flows are demand-driven and they do not measure bad credit conditions concurrently because they stem from prior bank commitments.  To suggest, as commentator Tom does (and Alex endorses), that we have no credit crisis until lines of credit are exhausted, is in my view sheer logomachy (I like that word).  Nor is my view "convenient" or unfalsifiable as was suggested.  Here is Wikipedia on lagging indicators and yes it tells you that standard forms of credit fall into this category and this has been understood for some time.  Look instead at the currently informative pieces of the evidence and you will see that they point in a very consistent direction. 

It is true that many credit channels have not shut down.  But the ones that are shutting down are enough to cause a severe global recession.   

Addendum: I added this comment to the discussion: "People, financial markets and financial institutions around the world are falling apart. I'm not pulling this stuff out of a hat or from a few crazy journalists. There is massive disintermediation going on right now, much of it in the shadow banking system. I am trying not to be dogmatic but it is hard for me to see on what grounds anyone would deny this."

What did Alan Greenspan concede?

From all the hullabaloo I thought he had granted the death of capitalism but no.  Here are his prepared remarks.  Here is part of the Q&A.

He did admit that risk models had failed by selectively overweighting periods of euphoria and that the credit default swaps market had exploded in our face.  He also knows that there are hundreds of trillions of dollars in open positions in other derivative markets and most of them have worked relatively well in this crisis; his words indicated as such.  He also stressed that capitalism has had a string of forty years of numerous successes and that recent experience is an outlier.  He is still not sure what to make of the current failure.

Greenspan also said: “Whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets,” he said. “Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.”

His policy recommendation was the modest one of requiring banks to keep a share in any mortgage.

I don't agree with all of his detailed points (e.g., too much emphasis on subprime securitization), but I thought the overall ideological "flavor" of his remarks was essentially correct.  For differing, and yet not totally different, point of view, here is John Quiggin on Greenspan.  Here is the Ayn Rand Center on Greenspan.

Five weeks

Five weeks after the government launched an unprecedented bailout to save the private company from bankruptcy, AIG has so far burned through $90.3 billion of government credit.

How many weeks are in a year?  Fortunately crude extrapolation is not always the best way of making an estimate, but it still seems this problem is not yet under control.  The change in ownership has not brought superior results.

The article, by the way, details how Treasury may spend money on other insurance companies too.

How are Cayman Island banks faring?

A Friday article says this:

The worldwide financial crisis is proving a lot more damaging than was expected. Not in Cayman, yet, but we had better get ready for it to affect us severely sooner or later.

I've googled around and can't seem to find any reports worse than that one.  It's fair enough to argue those banks are doing OK because bailouts from abroad have limited systematic risk in the world as a whole.  But still Cayman Island banks don't seem to have gotten into trouble on their own, at least not so far. 

Cayman banking is not laissez-faire as is sometimes believed, but still it is relatively unregulated and measured in terms of liabilities it is the world's fifth largest banking center.  And it's doing OK.  As Arnold Kling has been pointing out, transparency isn't everything.

Panama, by the way, also does not seem to be having major banking problems.  The country has no central bank or lender of last resort, yet the banking system is highly liquid.

The point is not that the private client-based, tax haven, sometimes drug money, Panama and the Cayman Islands systems are automatic models for the U.S.  Rather many of the critics of deregulation are not trying hard to come up with the deepest possible explanation of the crisis.  A key principle of science is to consider the outliers or the points which might appear to refute your hypothesis.

It would be useful if someone would do a comparative international study of where the banking crisis has been most severe, least severe and why.

Addendum: Larry Ribstein comments.

The ice thaws in credit markets

Details here, and that is big news too; update here.  Here is The New Yorker on Bob Barr.  Kramnik just blew a superior position and now is probably doomed in the match with Anand.

Markets in everything, Jamaican edition

The disappearance was deemed so important that the Prime Minister, Bruce Golding, also took an interest in the theft and ordered a report into how 500 truckloads of sand was stolen, transported and presumably sold.

Here is the full story.

Scattered thoughts

Should the Fed burst bubbles?  Maybe in its role as regulator, if not monetary policy.  Anand draws first blood in an amazing game.  Robert Aliber's "pooling equilibrium" idea for reviving asset markets.  The splendid Alton Ellis, a giant of Jamaican music, just passed away.  Credit indicators are easing.  The demand for classic whiskey is robust.

Indian phone call of the day

For the past three years, [Bhumika] Chaturvedi has been a top collection agent at her call center, phoning hundreds of Americans a day and politely asking them to pay up. As the U.S. financial crisis plunges Americans into debt, her business is one of the fastest-growing sectors in Indian outsourcing. It is also one of the few sectors of outsourcing in India that is still hiring aggressively.

By the way:

India handles an estimated $16 billion -- or about 5 percent -- of delinquent U.S. accounts

The responses are numerous:

"My mortgage payments are just too high, honey. I just can't make the payment this month," a weeping woman with a Southern accent recently told her in response to a call for a $200 credit card payment. "I'm sure y'all heard about the credit crunch and gas prices. I'm flat broke."

I wonder what the Indian bill collector thinks in these moments.  Has anyone tried saying: "Pay up.  My aunt earns $1300 a year and pays 80 percent interest on her microcredit loans"?  Probably not.  In fact the strategy is the opposite:

Aparup Sengupta, global chief executive officer and managing director of Aegis, encourages his debt collectors to use a "hospitable Indian touch," meaning less arm-twisting and more emotional therapy.

"This business is a performing art," Sengupta said. "We are part therapists because the core of the issue is that every human being wants to be honorable in life. We don't just push someone into a bad situation. We try to create a real solution."

Decorating the office are dozens of yellow smiley faces with the words, "Happy People. Happy Customers. Happy Investors," along with other posters that read: "Connect and Collect."

If I owed money I would simply stop answering the phone. 

"The Icelandic Stock Exchange fell by 76% in early trading as it re-opened after closing for two days last week."

Elsewhere markets are generally up.

The Deal

Citigroup and JPMorgan Chase were told they would each get $25 billion; Bank of America and Wells Fargo, $20 billion; Goldman Sachs and Morgan Stanley, $10 billion each, with Bank of New York and State Street each receiving $2 to 3 billion. Wells Fargo will get an additional $5 billion, reflecting its acquisition of Wachovia, and Bank of America receives the same for amount for its purchase of Merrill Lynch.

...The government will purchase perpetual preferred shares in all the largest U.S. banking companies. The shares will not be dilutive to current shareholders, a concern to banking...executives, because perpetual preferred stock holders are paid a dividend, not a portion of earnings. The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.

Here is the story.  No matter what your point of view, you ought to be stunned by this development.

Addendum: Brad DeLong adds musical commentary.

Sept.23

“Some said we should just stick capital in the banks, take preferred stock in the banks. That’s what you do when you have failure,” Mr. Paulson told the Senate Banking Committee on Sept. 23. “This is about success.”

Here is the link.

Still more countercyclical assets

Pretty soon we'll get to the point where almost everything in this economy of ours is booming:

All over sunny San Diego, tough economic times have forced people to cut back on their $4 lattes and sushi dinners. But one new business is booming -- and ka-booming -- precisely because of frustration from the worst financial crisis to hit the United States in decades.  Welcome to Sarah's Smash Shack, where pent-up patrons can relieve stress by hurling dinnerware and bric-a-brac against a wall, as hard as they can, day and night, seven days a week.  San Diego entrepreneur Sarah Lavely charges her clients $10 and up to pulverize plates and glasses during 15-minute intervals. Music blares, clients dress in protective gear and a neon sign urges them to "Break More Stuff."(...)San Diego may boast surf and sunshine year round, but it also has its share of black economic clouds. Its real estate market has been hit hard by the high rate of foreclosures in California, the second highest in the nation, and its unemployment rate has risen to 6.4 percent from 4.8 percent in a year...

Here is the link and I thank John de Palma for the pointer.

Unintended consequences

...the financial benefit to Paulson of accepting the call of duty is surely greater than that enjoyed by any other public servant in U.S. history.  Goldman Sachs has long had a policy that all deferred compensation becomes payable promptly to any partner who accepts a senior position in the federal government.  Congress passed a law a quarter-century ago that people taking senior appointed federal position who convert their investments into either an index fund or a blidn trust can do so upon assuming office with zero taxable capital gain until such investments are later sold.  If Paulson took advantage of these provisions, they enabled him to sell his shares in Goldman Sachs without raising any public questions without tax and to diversity his large personal invetments in a single stroke.  For just over two years' service, the saings in Paulson's personal income taxes could have been as large as $200 million.  Paulson had no interest in diversifying his investments and had never sold a share of Goldman Sachs stock.

I wonder what the total benefits for Paulson have turned out to be.  Indeed, it is rare that taking a job in government is such a good business decision (please note: I am not suggesting any conspiracy or evil intentions here).

That passage is from Charles Ellis's The Partnership: The Making of Goldman Sachs.  This book gets better and better, as you keep on reading it.  Definitely recommended.

Libertarian perspectives on the bail-out

Veronique de Rugy and Philippe Lacoude.

Stan Liebowitz.

Please feel free to leave other references in the comments; there is a greater rush of material coming out than I can keep track of.

Addendum: Here is a (non-libertarian) dose of optimism.

Russian foreign aid, circa 2008

A E4bn loan from Russia might make financial sense – although Russians might think otherwise given Moscow’s shaky finances. But it would create strategic ructions. Iceland is a NATO member, but Russia would want something in return for a loan equal to almost a third of the tiny state’s GDP. The US would fret this could eventually mean a Russian military presence in the North Atlantic.

Here is the story.  It seems that Iceland may prefer Russia to the IMF, but Russia does not yet seem on board.  I can only wonder what Bobby Fischer would have said...

Bad news, but good news too

Banks are hoarding cash in expectation of pay-outs on up to $400bn of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and ­dealers.

This added pressure on the frozen financial system comes as authorities prepare to meet participants in the so-far unregulated $54,000bn credit derivatives market to speed up plans for the creation of a central clearing house.

Here is the story.  Here is my earlier post on derivatives and clearinghouses.

Are you Brian Donnelly?

The financial collapse of Iceland.

Economic topology, the video version.

Via Josh Hall, here is econjobrumors.com.

Abandoned house goes for $1.75 on eBay.

Economic experiments, using people with "personality disorders."

No, No, No!

Fannie Mae said it will set aside the loan of a woman who shot herself as sheriff's deputies tried to evict her from her foreclosed home....

"We're going to forgive whatever outstanding balance she had on the loan and give her the house," Faith said. "Given the circumstances, we think it's appropriate."

In other words, the taxpayers are now subsidizing self-injury.

The countercyclical asset, a continuing series

Nicer than tasers:

Mr. Borg, past president of the North American Securities Administrators Association, adds that in past market downturns he saw people turn to chinchillas, worm farms and super-breeds of rabbits. Emus, too, were big. "Eventually, people got tired of them and just let them go," he says. "To this day, you'll be in West Texas and a big emu running wild will just come up next to your car."

Here is the link and thanks to John De Palma for the pointer.  The National Alpaca Registry is doing well:

Peggy Parks, a 49-year-old auditor in Johnstown, Pa., turned to an unusual farm animal. "I've lost a fortune in stocks, and my 401(k) is falling through the floor. I feel comfortable in alpacas," she says. She invested $56,000 in a small herd that she believes has a better outlook than most mutual funds because of the animals' breeding potential.

Sentences to ponder

I think it's very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson's plan will increase the supply of, say, inventory loans.

Here is more, mostly on the commercial paper market, interesting throughout.

Is sanity on its way?

Maybe, just maybe:

The U.S. Senate may consider expanding the authority of the Federal Deposit Insurance Corporation as part of a package of legislation to reduce turmoil in the financial markets, Senate Banking Committee Chairman Christopher Dodd said today.

You'll note that the FDIC specializes in concentrating its actions on insolvent banks, which is exactly what we should be doing.  The FDIC also has experience in this area, believe it or not.

Bailout plan fails in the House

Seriously.  205-228.  They can still revote, by the way.  Maybe this is one of those "field experiments" I have read about...

Michael's bleg beg

He sounds like a very loyal MR reader to me:

Would you be willing to post a financial crisis topic bleg thread, where people can submit questions in comments and you occasionally pick from those questions?
I have so many questions as I try to get a handle on this stuff. I bet others do too, and that many questions are the same.

I make no promises but ask away...

And I haven't forgotten your earlier requests, I hope to return to many of them once we are out of the woods.

The Workhouse Test

The new Bailout plan has some interesting restrictions on CEO compensation and golden parachutes.  For example:

...a prohibition on the financial institution making any golden parachute payment to its senior executive officer during the period that the Secretary holds an equity or debt position in the financial institution.

This could either be a disaster or a saving grace.  If you think the situation is very dire and also that Wall Street is ruled by greed then it's a disaster as the captain may prefer to go down with his ship, rather than give up the golden parachute (life-jacket?).  Thus, those who think the situation is very dire must be gambling on CEO altruism!

On the other hand, if you think that there is still private capital out there ready to buy at the right price then this clause may mean a smaller public bailout than many are predicting.

It all reminds me of the workhouse test.   

Is a Potential Bailout Making Things Worse?

Ken Rogoff says yes.  Elizabeth Warren at Credit Slips summarizes Rogoff's discussion at a Harvard Roundtable (video):

Any liquidity crisis is caused by the promise of a government bailout. Ken said [Actually this was Greg Mankiw, AT] that his many friends in investment banking said that there is plenty of money to invest in financial services, but right now it is "sitting on the sidelines."  Why?  Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity).  As he put it, why do business with Warren Buffett who will negotiate a tough deal, if you believe that the government will ride in soon with cheaper cash? 

Ken [this is correct, AT] also talked about the need to shrink the financial services sector. He thinks it is good that the investment banking houses are failing and many people on Wall Street are losing their jobs because, in his view, we have an oversupply in that sector and our economy just can't support it.   

Ken's background with the IMF and on the Board of the Federal Reserve add a certain credibility to his assessment of conditions on Wall Street.  If he is right, the $700 bailout is saving some investment bankers' jobs in the short term, but overall it is just making the financial system worse.

In a related point Felix Salmon suggests that the Ted Spread may not be a valid measure of distress when the Fed is providing lots of liqudity.

...if you're a bank, you really neither want nor need three-month interbank funding right now. Global central banks, led by the Federal Reserve, have flooded the system with so much overnight liquidity that you can get as much cash as you need, at a much lower interest rate, directly from your central bank, overnight. The choice between that and locking in a high interest rate for three months is a no-brainer.

The WaMu Speed Bankruptcy

The Washington Mutual "speed bankruptcy" seems like a good model for the rest of the industry.  The FDIC took over the bank, wiped out the shareholders, and immediately auctioned it off to JP Morgan who paid $1.9 billion. Depositors are secure.

Notice that to do the deal, JP Morgan raised $10 billion in the equity markets and their shares rose.  Moreover, the issue was oversubscribed so they may go back for more.  All this illustrates that at least some of the substitute bridges from savers to investors that I have talked about continue to work (on the latter point see also Arnold Kling and Steve Landsburg). 

Hat tip to Garrett Jones.

Who should make this decision come January 20?

Israel gave serious thought this spring to launching a military strike on Iran's nuclear sites but was told by President George W Bush that he would not support it and did not expect to revise that view for the rest of his presidency, senior European diplomatic sources have told the Guardian.

Here is the story, from The Guardian.  I hope you all have given this matter some thought...

A Supply Side Approach to the Crisis

Yesterday I pointed out that credit is still robust.  Growth rates are declining, however, and many people say the real crunch is around the corner.  Thus, today I want to suggest a new approach to dealing with the crisis that will have benefits regardless of how the crisis unfolds.

I see the key issue as follows: Banks bridge the gap between savers and firms.  We want to keep capital flowing to firms even when some of the bridges collapse.  One approach tries to prop up the collapsed bridges, a second approach tries to route funds across substitute bridges.  A third approach is to increase the flow pressure - in other words, I suggest a temporary but large stimulus to savings.

I suggest that for the next 12 months contributions to an IRA account will never be taxed.  We can modify this in various ways to cap contributions at a certain level etc.  We can even make the proposal progressive - for the next 12 months contributions to an IRA account will never be taxed and the government will match $1 for every $10 saved for anyone with income below a certain threshold.  The main idea is to increase savings.

The increase in savings will help deal with our current problems by offsetting any credit crunch.  (Some of the savings will also help to recapitalize banks.)  In addition, the U.S. needs a higher savings rate regardless.  During the 1990s as measured savings rates declined to zero commentators argued that rising asset values compensated.  Well asset values are now falling so true savings are negative - thus we need to increased savings.

A big benefit of this proposal - lower taxes, higher savings and a savings bonus to those with lower incomes - is that it should appeal to both the right and the left.

Betting markets in everything

Will Congress approve a bail-out package for banks before September 30?  Right now the contract is selling at about 79, which usually translates roughly into a 79 percent chance of approval. 

Note however that the marginal utility of money here does differ across worldstates.  Assume that the marginal utility of money is higher (people are poorer) with no bail-out.  That makes some people want to bet against the bail-out as a form of insurance, thereby raising the price of the "no bail-out" contract.  (Addendum: that was bad phrasing -- no one has to intend insurance as long as the MUs of money differ across the world-states.)  In other words, the real implied chance of a bail-out is higher than 79 percent.

Economists Speak

An excellent Open Letter on the Bailout signed by many economists.  Hat tip to Justin Wolfers.

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses.  Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If  taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects.  If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity.  Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come. 

Ike Brannon, where is my talk?

My Wednesday evening, 6:30 p.m., Washington, D.C. talk on the financial crisis.  Both I and some MR readers would like to know, so please leave the answer in the comments.  If you know Ike, could you please forward this inquiry to him?  My email for him isn't working and tomorrow I am on the road.

And for those of you wondering about my Bloggingheads.TV with Robin Hanson, Robin had a cold and we will reschedule it.

Won't Get Fooled Again

International public goods? Public bads?

Among the potential sources of tension is the Treasury’s ultimate decision on whether it will buy troubled mortgage-backed securities from non-American banks. European banks, like UBS, invested heavily in such securities.

“If Paribas has bought a mortgage-backed security, why can’t they present it to Treasury?” Mr. Truman said. “If the government is going to do it for the American banks, they should do it for everyone.”

But that could provoke a strongly negative reaction from lawmakers on Capitol Hill, who already protested that other countries should chip in for the $85 billion rescue of the insurance giant American International Group, because it has operations in those countries or has insured their banks.

“Are the taxpayers in the United States going to bail out all the banks in the world?” said Allan H. Meltzer, a historian of the Federal Reserve. “I just don’t know how this works out.”

Here is the story.

Sentences to ponder

“It’s important to pay taxes if you want to live a normal life,” said ‘Lisa’, a prostitute who spoke with the newspaper.

That's from Sweden (no mention of patriotism), and apparently some social benefits are attracting more prostitutes to the taxed sector.  The record of income creates or enhances rights to sick-leave pay, parental leave benefits, and a pension.  Note that in Sweden it is illegal to buy sex but not to sell it.

Thanks to a loyal MR reader for the link.

Where we are at

Here is an excellent overview from Arnold Kling, read it.  Soon I will myself cover derivatives in greater detail.

The culture that is French, a continuing series

“I fear the government has passed the point of no return,” said Ron Chernow, a leading American financial historian. “We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have been doing in its wildest dreams.”

While they acknowledge the shock of the collapse of Lehman Brothers, the bailout package for A.I.G. on top of earlier government support for Bear Stearns, Fannie Mae, and Freddie Mac has stunned even European policy makers accustomed to government intervention in the economy.

“For opponents of free markets in Europe and elsewhere, this is a wonderful opportunity to invoke the American example,” said Mario Monti, the former antitrust chief at the European Commission. “They will say that even the standard-bearer of the market economy, the United States negates its fundamental principles in its behavior.”

In France, where the government has long supported the creation of national champions and worked actively to protect select companies from the threat of foreign takeover, politicians were quick to point out the paradox of what is essentially the nationalization of the largest American insurance company.

“Today the actions of American policy makers illustrate the need for economic patriotism,” said Bernard Carayon, a lawmaker of President Nicolas Sarkozy’s center-right governing party, UMP. “I congratulate them.”

Here is the story.  Since I am not a policy maker, I cannot claim that I am being congratulated personally.  Still, I believe I am receiving a kind of indirect congratulations.

The economic fallout from these events is dominating the headlines.  The intellectual and ideological fallout we are just beginning to contemplate.

The good news

There is some.  First, it seems (knock on wood) the Fed and Treasury may make money off the AIG deal, at least over a time horizon of one to two years.  Felix Salmon explains some detail.  The company has assets and if it needs to borrow money it is paying the Fed at Libor plus 850 (!). 

Second, the size of a guarantee does not represent the cost of the bailout.  I have been getting many emails about "the cost of the bailouts" and in truth we still don't know what those costs will be.  But think in terms of balance sheets to start on the problem, not numbers in headlines. 

Third, if the Fed needs to "print money" to make good on various guarantees (NB: this has not been the case), this need not be as disastrous or as inflationary as it sounds.  If it came to this, the Fed is creating money to protect against potentially deflationary events so the inflationary impact of that money creation is blunted.  (That said, you don't usually want to trade in bank-created higher monetary aggregates for an increase in borrowed reserves.)

You might wonder if AIG is (possibly) a money-making deal, why no one else wanted in on the action.  Think of it as a prisoner's dilemma among the lenders.  No one of them wants to put up money at non-exorbitant rates and so the company -- which has partially illiquid assets and profit-maximizing, weakly capitalized shareholders determined to take advantage of lenders -- fails.  But with the guarantee the company can borrow cheaply and the lending continues.  The company can continue and oversee an orderly liquidation.  That's not a pretty picture and it does mean that, in the bad world-states, losses continue to stack up precisely because the guarantee was extended.  But the good world-states are there too and the expected value of the guarantee and purchase may well be positive.  To give an example, Argentina in its crisis days had net positive value but no one wanted to lend to them either.

Recent events remind me of the arguments against free capital movements for developing countries and whether those capital movements boost economic stability and growth.  Well, we have free capital movements for investment banks and insurance companies and of course the losers get hit by whipsaw effects.

Did you notice that short-term Treasuries have been trading at rates close to zero?  That's not good news. 

In presenting all this "good news," I don't mean to communicate a pollyannish attitude.  The bad news is indeed very bad but let's understand it in its proper context.

I'd like to stress again that I remain worried about the rule of law in all these events.  First, the referee is on the playing field.  Second, while Dodd and others are on board, basically we have the executive branch of our government -- the Treasury -- operating without formal checks and balances.  (Does that sound familiar?  Would this administration do that?)  That's why it is all being done through the Fed.  Fortunately the Fed is also a competent technocracy (as is the current Treasury) but the broader implications here are very worrying, both for governance and for the future of the Fed itself.

Maybe there is no better alternative, but these developments are a sign of just how dysfunctional American government has become.

Is central bank independence gone?

It's another bail-out of sorts today, although you won't hear it described as such:

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

Here is the link.  How long will it take to win back Fed independence?  There used to be talk that "The Paulson Plan" would centralize various kinds of financial regulation in the Fed.  But, as it turns out, under the "beta" version of the plan, the Fed goes hat in hand to...Paulson.  I guess that's why they call it The Paulson Plan.

The sad saga of Almaz Moges

The National Bank of Ethiopia (NBE) has sacked Almaz Moges from her post as General Manager of the turbulent Nile Insurance.

Getahun Nana, Banking and Insurance Supervision Department head, wrote a letter to Nile on June 19, 2008, informing them that her deputy, Dawit G. Amanuel, would take over the post. It is alleged, however, that she refused to hand over the office to her successor. The central bank subsequently shut down the office on Thursday, June 26, 2008.

The letter came a week after the central bank declined to approve two of the seven newly elected members of the Board of Directors. Almaz had been advised by officials at the NBE that the insurance company needed better management. Currently, the company is in debt for more than 50 million Br following various business deals.

Yes the company had excess debt.  Here is the story.  Here is a picture of Almaz Moges.  Here, in black and white, is the authorized role of the bank in regulating insurance companies.  Here is Megan McArdle and here.  Read Felix Salmon.  Here are some cautionary words about strangers.  So can New York State now regulate the Fed?

There is more toast

Russia suspends trading with stocks down 17 percent.  There is a financial crisis and much of it is energy-related:

“The fundamental issue is oil. Russian oil companies are not producing more so their earnings are dependent on a rising oil price,” said Daniel Salter, analyst at ING. If the oil price falls, then earnings downgrades are in the pipeline for these stocks, he added.

State-backed bank VTB tumbled 33 per cent to Rbs0.03 and Volga Telecom sank 28 per cent to Rbs37.

Here is a recipe for Russian toast.  The price of oil was down to $91 a barrel last I looked.

Small thoughts, from the little people

It's a little scary that the world's largest insurance company hasn't planned for a rainy day.

Incentives matter

As it turn out, the really risks in the system were being created not by hedge funds but by boring old investment banks and insurance companies. Sure there have been hedge fund failures but none on the scale and with the repercussions of the recent failures of Bear Stearns, Lehman Brothers, and the government sponsored mortgage companies. Hedge funds might not have had all that many rules governing their behavior but their incentive pay structure seems to have regulated their risk far better.

Here is more.  On the other side of the governance fence:

The Wall Street Journal is reporting that the Federal Reserve has asked Goldman Sachs and J.P. Morgan Chase to help make $70-$75 billion in loans available to the AIG.

That's a lot of money to "ask" for.

The worst case scenario?

My take on the B of A buyout is that Hank is piling up all the **** into one huge **** on B of A's books so that when they go under it is clearly too big to fail and can be handled in one fell swoop.

That's from a comment at calculatedrisk.blogspot.com.  That view is an outlier, but it's always worth knowing the worst case scenario.  At least it explains why B of A is interested in such a hasty deal with a losing business partner.  Here is Paul Krugman's column.  Here is Felix Salmon on the unlucky Damien Hirst.  Arnold Kling outlines the best case scenario, which is right now a better forecast than the worst case scenario.  On another front, maybe Lehman bonuses will be clawed back.

I don't mean to overwhelm you with posts, but...

It's hard not to report this:

$$$ On CNBC they are saying that AIG has asked the Federal Reserve for some kind of emergency bridge loans. Can the Fed lend to an insurance company?

$$$ Federal Reserve is dramatically expanding its emergency lending program. It's now going to take all sorts of collateral, including equity.

$$$ "Take a very deep breath. It looks almost certain that this week will be the one where we see the financial implosion in U.S. banking and brokerage that many have been expecting for some time," Paul Kedrosky says.

$$$ With Merrill Lynch, Lehman Brothers and Bear Stearns gone, everyone is asking whether Morgan Stanley and Goldman Sachs will survive as independent investment banks.

Addendum: Here are Dow futures, at 10:21 p.m. down about 300 points.  All things considered that counts as good news.

Sentences to scare you

The government is looking for an agreement that would not involve public money.

That's about Lehman Brothers.

Customer relations

Treasury tried to head off such concerns by having David McCormick, the undersecretary for international affairs, call foreign central banks and other overseas buyers of the companies' securities or debt to reassure them of the instruments' creditworthiness. Over the weekend, Treasury officials called sovereign-wealth funds in Abu Dhabi and elsewhere in the Middle East, assuring them that they were working on financial issues involving Fannie and Freddie, says an individual apprised of the conversations.

Here is much more, interesting throughout.  Read this too.  But no, the buyers forced the hand of our government by essentially threatening, through inaction, to induce a massive run on the uninsured U.S. financial institutions.  One response is to insure all of those institutions, as the dominoes continue to fall.  Another response is to believe that runs on unprotected financial institutions are not very dangerous.  The third, correct response is...?

World's biggest bail-out: update

Arnold Kling wonders: what is the exit plan?  Brad DeLong and John Hempton think the Bush Administration showed some courage.  Brad thinks the preferred stock can do OK.  Here's what forced Paulson's hand.  All lobbying from the agencies has been eliminated.  WSJ reports: "House Financial Services Committee Chairman Barney Frank (D., Mass.) said in an interview that the near-term effects of the conservatorship will be to "strengthen the public mission of what they do" to prop up the housing market."  Preferred shareholders lose dividends.  CalculatedRisk has the clearest bottom line so far.

What if we didn't bail out the creditors?

"Could you clarify just how far on the hook I should be for someone else's frauds?"

That's MR commentator CK and the answer is "lots."  Here's more detail on the bail out, by the way.  Not good.

But let's say that the Treasury did not support the debt of the mortgage agencies.  The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless.  The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly.  The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value.  Most of the U.S. banking system would be insolvent.  Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot.  The rate of unemployment would climb into double digits and stay there.  Many Americans would not have access to their savings.  The future supply of foreign investment would be noticeably lower.  The Federal government would lose its AAA rating and we would pay much more in borrowing costs.  The deficit would skyrocket.

And I haven't even mentioned the credit default swaps market.  Well, I have now.

But for another point of view, try Jeff Rogers Hummel.

Department of Uh-Oh, The End of the Mortgage Agencies

Fannie and Freddie’s preferred shares have been considered so safe that banking regulators let banks count them in the capital required as a cushion against loan losses.

That should read "*had* been considered so safe."  Further background is here and here.  We also have an impossibility theorem.  I do not see how our government can let the value of this preferred stock fall much further, given the extent to which bank insolvency would increase.  I also do not see how our government can prop up the value of this preferred stock to a significant degree.  Silly me.  I guess that means I bet on the latter impossibility.

Here is yet further discussion of the end game.  It seems the common stock owners will end up suffering more dilution than they had been expecting.  The $340 billion in agency debt held by the Chinese central bank will be protected, as it must be.  Have a nice day.

And the newspapers were wondering why the Dow tanked 345 points.

Does this count as an event study?

...investors are also unnerved by the aftermath of the five-day war in early August.

Russian shares have lost about a third of their value since hitting record highs in May. Russian and West