The cost of ad hockery

You can think of our current economic problems as being caused by economic actors sitting on the sidelines instead of getting in the game. It has been apparent to many people for over a year now that risky assets are terribly underpriced in financial markets. There's a killing to be made buying mortgage backed securities, corporate debt, and the like at currently depressed prices and holding them until the crisis passes and their prices rise to reflect their true values. But where have the hedge funds and private equity funds with the cash to make these purchases been lo these many months? Sitting on the sidelines.

Last summer T. Boone Pickens announced he was going to invest in wind farms in Texas, potentially remaking the energy landscape. A few months later he decided to pull his project and sit on the sidelines instead. Meanwhile, people have stopped buying cars. Keep the old clunker for a few more years, sit on the sidelines.

What is everyone sitting on the sidelines for? Perhaps for the government to come up with a plan to sweeten the pot. The hedge fund managers who declined to buy risky assets a year ago made the right bet - they can buy them now for much better terms under the Geithner plan. T. Boone may have been waiting for just the right combination of subsidies for green technology in the stimulus bill or the 2010 budget. Potential car buyers would be forgiven if they held off a few months in the hopes that Congress will provide some more tax breaks for car purchases. I'd like to buy some new windows for my house and maybe a fuel efficient furnace, but I'm going to wait to see exactly what tax breaks I can get for these purchases. Likewise, I'd really like to refinance my mortgage, but why do it now when mortgage rates are 4.75 percent when I can wait a few months (maybe) and pay 4.25?

The problem with all this sittin' and waitin' is that our collective hesitance to buy is postponing the economic recovery. And the longer the recovery is postponed, the more pressure there is on policymakers to add more incentives to spend, the prospect of which gives us all the more incentive to postpone.

What do we do about this? One solution would be to simply abjure all potential remedies. A credible commitment by the Fed and Treasury not to subsidize the purchase of toxic (sorry, legacy) assets might just have forced the hedge funds' hands a year ago. A credible commitment not to introduce new subsidies or bailouts might get consumers and businesses off the sidelines. The problem is, failure to take the kinds of actions that the government has been taking would make the recession much more severe, in the short run at least. And for that reason, and because we live in a democracy, a commitment not to take remedial actions is inherently not credible.

The more sensible alternative, it seems to me, is a more predictable, systematic, automatic mechanism for economic stabilization. To use a concept from research on monetary policy, we need a fiscal policy based on rules rather than discretion. We have that to some extent in the form of automatic stabilizers: the income tax, unemployment compensation, means-tested income support programs. We should add to those institutions a public infrastructure bank from which funds are released in a countercyclical manner. Similar programs could be instituted for green technology and other types of investments the government would like to stimulate during economic downturns. We should design fiscal policy institutions so that, as much as is possible, consumers and businesses have a clear idea from the beginning of an economic downturn of the terms on which they will be able to spend in the ensuing months. Get them off the sidelines and into the game.

Employee Free Choice Act FAQs

From the Economic Policy Institute.

Geekiest proposal ever

The Chronicle reports:

[Peter] Leeson, an economics professor at George Mason University, bravely decided to pop the question to his girlfriend in the pages of his forthcoming book, The Invisible Hook: The Hidden Economics of Pirates (Princeton University Press).

"Ania, I love you; will you marry me?" reads the dedication. Mr. Leeson offers a light-hearted explanation in the book's preface: "If I've succeeded in hiding my plans from her since writing this, she should be very surprised. I hope she says 'yes.' If she doesn't, I might have to turn to sea banditry, which would be tough since I don't know how to sail (though I've tried to learn)."...

The big moment came during dinner on the first day of spring at the Washington, D.C., restaurant Citronelle. Instead of bringing dessert to Ms. Bulska, the waiter gave her a treasure chest, and Mr. Leeson handed her a key. Inside was the book, the dedication page marked, and a ring concealed beneath, in a compartment that one of Mr. Leeson's friends had crafted.

Perhaps I should have followed Leeson's lead rather than dedicating my dissertation to Brett Favre. My wife has never let me forget that dedication. Though a few weeks ago I sat her down to watch the rebroadcast of the 1992 Green Bay - Cincinnati game (Favre's first NFL start, in which he drove the team 90 yards in the final minute to pull out a miraculous victory, similar to the way in which I completed my dissertation that same year). I think she finally understood.

Extreme cliff diving

From the Flow of Funds 2008Q4. First the annual data:

Then quarterly:

A pessimistic view of the economic outlook

Wolfgang Munchau writes in the Financial Times:

I am more worried now than I was a month ago. The main problem is that the feedback loops between the real economy and the banking sector are truly scary. Remember that all the public and private sector forecasters are still busy adjusting their 2009 economic projections downwards. The latest downward revision for Germany came from Commerzbank last week, which now projects 2009 growth at a negative 6-7 per cent for this year.

At this rate of contraction, the number of private and corporate defaults is likely to increase massively beyond some of the stress-test assumptions made by the banks themselves. After the crisis caused by toxic securitised assets, the financial industry is now hit by another crisis of potentially similar magnitude. This looks to be one of the worst credit cycles in living memory.
Economists and policymakers who wonder how much it will take to recapitalise the banking sector are discovering that rescuing the banks is a much more dynamic exercise than they thought. Whatever you think it costs – and there have been widely different estimates – it is likely to end up costing you a lot more for that precise reason. The economy is trapped in a vicious circle where credit crunch and recession mutually reinforce each other.

By the end of December, global banks had written off about $1,000bn (€752bn, £699bn) in bad assets, approximately half of that in the US. Since the onset of the crisis, the writedown of assets in the US has exceeded the provision of new capital. Even the Geithner public-private partnership plan is not going to reverse the expected deterioration of capital ratios at sufficient speed and on sufficient scale. In Europe, new capital exceeded writedowns by a small amount, but on the recent projections I have seen, this trend could reverse sharply this year, unless governments introduce new recapitalisation plans.

In the absence of such plans, the banking sector will continue to contract its balance sheet by cutting lending. This is a totally rational response by the banks. To unfreeze the global financial market therefore requires significant increases in bank capitalisation, not just to the status quo ante, and not just to account for the toxic securitised assets themselves, but to adjust for the stuff that is getting toxic right now and tomorrow... This is the main reason why the Geithner plan is not an optimal policy response... For all its technical ingenuity, this plan is at best insufficient – and more likely an expensive distraction that delays the inevitable policy response of a government-led recapitalisation programme.

Europeans think they have less of a problem because they already put bank rescue packages in place last October. This is one of the many misjudgments of European officials in respect of this crisis. The current rescue packages are not doing the job. They were emergency measures only. But we have moved beyond the immediate emergency, and need a strategic response. Europe, too, will have to start to address the problem, by forcing banks to write down their assets in exchange for new capital. And not all the banks should survive. We must allow the sector to shrink while we recapitalise. This means many painful and unpopular decisions have yet to be taken.

I have no hope that this week’s Group of 20 summit will provide a solution to this problem. In fact, the old Group of Seven would be a much more appropriate group to discuss a co-ordinated approach about crisis resolution, as most of the world’s most important financial centres are located in these countries.

But it matters less who does it than what is being done. The Europeans need a new plan. And the US needs a better plan.

But I still hold out hope that the combination of the Geithner plan, ridiculously low mortgage rates, and fiscal stimulus will set off a positive feedback loop that sparks recovery this year.

I hate to quarrel with Paul Krugman, but...

I hate to take the opposite side of an argument with Paul Krugman and Jeffrey Sachs, but I think that their argument that Treasury Secretary Geithner’s PPPIC plan amounts to a giant subsidy to the banking industry is just plain wrong. There is a subsidy, but it is a rather small and state-contingent one.

Let’s take the example in Sachs’ piece in yesterday’s Financial Times. Krugman’s example is similar.

Consider a simple example: a toxic asset with face value of $1m pays off fully with probability of 20 per cent and pays off $200,000 with probability of 80 per cent. A risk-neutral investor would pay $360,000 for this asset.

Along comes the government and says it will finance 90 per cent of the investor’s purchase and, moreover, do so as a non-recourse loan… Now the investor is prepared to bid $714,000 (with rounding) for the same asset. The investor uses $71,000 of his/her own money and $643,000 of the government loan. If the asset pays off in full, the investor repays the loan, with a profit of $357,000. This happens 20 per cent of the time, so brings an expected profit of $71,000. The other 80 per cent of the time the investor defaults on the loan, and the government ends up with $200,000. The investor just breaks even by bidding $714,000, as we would expect in a competitive auction.

Of course, the investor has systematically overpaid by $354,000 (the bid price of $714,000 minus the market value of $360,000), reflecting the investor’s right to default on the loan in the event of a poor pay-out of the toxic asset. The overpayment equals the expected loss of the government loan. After all, 80 per cent of the time (in this example) the government loses $443,000 (the $643,000 loan minus the $200,000 repayment). The expected loss is 80 per cent of $443,000, equal to $354,000.

The problem with this example is that it assumes that each loan guaranteed by the FDIC is used to buy a single asset that either defaults or pays in full. In the scenario described by Sachs and Krugman, a PPPIC that bought several assets with FDIC financing would default on the loans used to finance the failing assets and repay the loans used to finance the assets that pay off. But in fact the Treasury’s plan, as I understand it, is for PPPICs to bid for pools of loans/securities held by banks. The FDIC loan guarantee will apply to the pool rather than the original loan. The PPPIC will only default on the loan if the value of the pool turns out to be considerably less than the purchase price (specifically, less by the amount of the firm’s capital investment).

Let’s revisit Sachs’ example. The asset for sale is a pool of 1000 loans each with a face value of $1000, for a total price of $1 million. Each loan pays off fully with a probability of 20 percent and pays $200 with a probability of 80 percent. If defaults are completely uncorrelated, the value of the pool is $360,000. A PPPIC plans on putting up ten percent of the purchase price of the pool and borrowing the other 90 percent. The PPPIC will only default if the pool as a whole returns less than the size of the loan (90 percent of the purchase price). Let P be the price of the pool and X the ultimate payoff. If investors are risk-neutral and competitive bidding drives the rate of return to zero as in Sachs’ example, the price of the pool will be slightly greater than the expected value of the loan's payoff, reflecting the fact that the buyer's liability is capped at zero in the unlikely event that the loan pool pays less than 90 percent of the purchase price. I'll figure out the math later - the key point is that the probability that the pool as a whole pays off less than 90 percent of its purchase price is much lower than the probability that any one loan fails, so that the subsidy is much smaller than Krugman and Sachs suppose.

If investors are risk-averse the price will be lower.The effect of the loan guarantee will be to drive the price above what it would be without the guarantee, but the price will not exceed the true expected value. The FDIC ends up transferring money to the banks only if the value of the pool turns out to be lower than the amount of the loans. The existence of the guarantee drives up the price of the loans and therefore makes such a payoff more likely, but this is a much smaller subsidy on average than the subsidy described by Sachs and Krugman.

The results will be different when returns on the assets in a given pool are correlated. If they are perfectly correlated the example is identical to the case that Sachs and Krugman describe (since the pool is essentially a single asset). So to minimize the subsidy, the task of the Treasury is to ensure that banks are selling diversified pools, and to restrict the amount of leverage allowed to the extent that asset returns within the pools are correlated.

[Note: I've removed a stupid math error from an earlier version of this post.]

Am not!

Commenter #1 says my post is very interesting, keep on doing what I'm doing - and by the way, check out the great offers on my website. Commenter #2 says "you are an uneducated idiot." Not true - I've got 24 years of formal education under my belt!

Good reads on the Fed-Treasury plan

Treasury Department: The plan.
Brad DeLong: The plan makes sense, might work.
Paul Krugman: The plan is a disaster, we're all doomed.
Mark Thoma: Toxic cars.
James Kwak: Treasury should let regular folks buy into its hedge fund.
The NY Times: Asks four economists what they think, including three of the above.
Chris Carroll: The plan is part of a sound overall package.

For what it's worth, here are my scattered thoughts. All along we knew (I knew anyway) that the solution to our financial sector's woes was for some big hedge funds with piles of cash to swoop into the banking sector and buy up their toxic assets. The banks have to sell because the market for these assets doesn't exist, so under mark-to-market accounting rules they're in deep do-do. The hedge funds stand to make a pile of money because the assets are undervalued (I think they are; Krugman disagrees). The price of these assets is bid up, banks are recapitalized and can start lending again; yields on risky assets in general fall and businesses and households start borrowing and spending again.

That was the theory, anyway. But for some reason the hedge funds didn't bite. Too much risk. So look around - who's got the biggest appetite for risk, the longest financial planning horizon in the economy? The government, of course. It makes sense for the government to essentially organize itself as a giant hedge fund, buy up the assets, hold them to maturity, and make a tidy profit (maybe). That was the Paulson plan, but it was going to prove impractical because there was a very strong chance that the government would overpay for these assets. So the Geithner plan takes an indirect route: provide cut-rate financing to private investors like hedge funds to get into the market.

This seems like it just might work. But here's a question: why would banks sell their toxic assets at much less than face value? They know that if their balance sheets continue to weaken because of their toxic asset holdings, the government will come to their rescue. So it would pay them to sit and wait for an outrageously high price. The government, it seems to me, is going to have to strong-arm banks to participate. Chris Carroll, above, fears banks will sell off only the weakest assets - the adverse selection problem - and it may be necessary for the government to force banks to sell all their suspect assets if they sell any. In the end, the threat of nationalization rather than more bailouts if this plan doesn't work may serve as an incentive to cooperate.

Chris Carroll is right that we need to look at this plan as part of a package rather than as a standalone solution. Paul Krugman was complaining a few weeks ago that the stimulus package was too small - it would fill only a quarter or so of the projected output gap. Brad DeLong (above) says the latest Fed-Treasury plan is too small - it will buy up only a quarter or so of the suspect assets that need to move off bank balance sheets. Critics complained that Obama's mortgage plan was too small - it wouldn't catch all houses in the process of foreclosure. But put them all together - and add the huge stimulus to come from next year's $1 trillion plus budget deficit - and the total package that is taking shape could well be enough to get the economy growing again in the near future.

Is Keynesian economics dead? No.

Brad DeLong pokes holes in John Cochrane's argument about the effects of stimulus and the irrelevance of Keynesian economics. Cochrane says:

The basic Keynesian analysis... is simply wrong. Professional economists abandoned it 30 years ago when Bob Lucas, Tom Sargent and Ed Prescott pointed out its logical inconsistencies.... Robert Barro's Ricardian equivalence theorem was one nail in the coffin. This theorem says that [fiscal] stimulus cannot work because people know their taxes must rise in the future...

How can borrowing money from A and giving it to B do anything? Every dollar that B spends is a dollar that A does not spend.... Neither fiscal stimulus nor conventional monetary policy (exchanging government debt for more cash) diagnoses or addresses the central problem: frozen credit markets...

DeLong correctly points out that (1) the Ricardian Equivalence theorem says nothing about the effect of government spending; (2)

"Frozen credit markets" means that private intermediaries cannot borrow money from A and give it to B. And if Cochrane is right that "[e]very dollar that B spends is a dollar that A does not spend," then every dollar that B does not spend is a dollar that A spends. So if government deficit spending cannot do any good to boost employment, frozen credit markets cannot do any harm to reduce employment either.

And unfreezing credit markets couldn't have any more stimulative effect than fiscal policy. I would add (3) Lucas, Sargent et al. did not point out any "logical inconsistencies" of Keynesian economics. They pointed out empirical failures (the failure of Keynesian models to predict high inflation in the 1970s) and methodological flaws in the construction of quantitative Keynesian models (the feature built into these models that the people in the models did not update their expectations to reflect changes in policy rules). Both of these critiques were important developments in macroeconomics. They did not cause all economists to "abandon" Keynesian economics - they caused Keynesian economists to think more clearly about the assumptions that underlay their models and to develop Keynesian models that responded to the methodological criticisms of Lucas and Sargent. Neither critique refutes the underlying logic of Keynesianism: that recessions occur when desired spending falls short of productive capacity, and that recessions can be cured or made less severe by government programs that stimulate spending.

Cost Containment Update

As a rule, memos that contain the words "Our people are our most valuable resource" do not contain good news.

Stamped money

Greg Mankiw brags about his grad student who discovered the idea of taxing money to allow the Fed to reduce interest rates below zero. As I'm reading his post I'm saying to myself, well duh, Silvio Gesell thought up that idea about a hundred years ago. Then Mankiw updates his post saying that Alan Taylor has informed him about Gesell's stamped money proposal. Keynes discusses Gesell's proposal in the General Theory. Is it possible that one of the founders of New Keynesian Economics has not read the General Theory?

Some perspective, please

No one called for Tim Geithner's, Hank Paulson's, or anyone else's resignation when the decision was made to let Lehman Brothers go bankrupt, causing trillions of dollars of wealth to evaporate and sending the world economy into a death spiral. No one has resigned or been asked to resign for any of the monumental mistakes that were made before that. Let's not now go asking for Tim Geithner's head over a few million dollars of bonuses to people at AIG.

New course approval

The Academic Policy and Program Committee requires the following format for the course description when submitting a proposal for a new course:

The maximum length should be 80 words, including the title. Please begin the first sentence with a noun, or one modified by an adjective; the first sentence should be a fragment. Keep to the present tense; avoid the future tense. Avoid first person pronouns as well. Do not include the reading list.

Rather, I shall begin my description with a verb, followed by the second person pronoun. I get testy late in the semester.

Exactly right

The defining feature of the current recession is the extraordinary rise in yields on private-sector bonds relative to the interest rate that the Federal Reserve controls. As the economy fell into recession in 2007-2008, the Fed reduced its key interest rate, the federal funds rate, from 5.25 percent to near zero. In times past, such a gigantic drop in the federal funds rate would have brought all of the economy's key interest rates - rates on corporate bonds, mortgages, etc. - down with it, stimulating spending and generating a recovery. This time, of course, chaos in the financial markets kept these rates high: the yield on Baa-rated corporate bonds is still above 8 percent and mortgages have fluctuated between 5 and 6 percent. Until those rates come down, the economy's downward spiral will continue.

We have known all along that the key to recovery is getting these "risky" interest rates down (I'm calling interest rates on things like corporate bonds "risky" because the bonds are subject to default risk, as opposed to "risk free" Treasury securities which for all practical purposes are not). By we I mean most but not all economists. Bob Barbera and I have written a couple of papers on the importance of risky rates for monetary policy. Bob has written a great book on the broader implications of the issue for economic policy. Ben Bernanke has announced that one element of the Fed's response to the recession is a policy of "credit easing," by which he means an attempt by the Fed to lower risky interest rates by buying or financing the purchase of risky securities. But as Chris Carroll points out in a piece to which I linked below, a lot of economists out there still seem to have a blind spot on the subject.

So after a few months of hemming and hawing, the Fed has at last girded its loins and plunged headfirst into the fray. It's going to buy $300 billion in long-term government bonds and $1.45 trillion of bonds issued by Freddie Mac and Fannie Mae. The government bond purchases are intended to reduce long-term interest rates in general, while the purchases of the agency bonds will work directly on mortgage rates. This is in addition to TALF, a program the Fed created in November and has expanded in recent months to finance the purchase of a wide range of securities backed by things like credit card debt, student loans, and so on. The one thing that seems to be missing is support for the corporate bond market, but perhaps that's coming.

The Fed's plan has earned positive reviews in general, but there are questions as to why the Fed didn't do this much sooner. Perhaps the Fed has seen signs of a deterioration in economic activity that somehow have eluded the rest of the world. Perhaps the Fed's move is timed to coincide with Treasury's roll-out of moves to stabilize the banking sector. Maybe the Fed waited until the Obama Administration signalled that it was ready to support such an action. My bet is that the Fed waited until there was a glimmer of optimism in financial markets (the recent uptick in stock markets) so that its intervention would have maximum psychological effect - but this is pure speculation. Whatever the reason for the timing of this action, it's very good news for the economy.

But - we are far from out of the woods. The economy is going to continue to deteriorate for several months at least. Financial markets are going to be spooked by the prospect of the U.S. government and Federal Reserve's taking on huge amounts of debt. There will be concerns, maybe panic, about the value of the dollar. I imagine that the mood at the Fed these days is similar to what it was in 1979. Then, the problem was that inflation was out of control, and after years of temporizing the Fed under Paul Volcker finally realized that it had to take bold action to stabilize the economy and restore its reputation. There followed two years of white-knuckle meetings at the FOMC at which members saw the worst recession since the Great Depression unfold before their eyes, but maintained high interest rates knowing that this was the last chance they had to put the dagger through the heart of inflation. There were tremendous risks then as now. Hopefully policymakers at today's Fed are as courageous as their predecessors thirty years ago.

An easy solution

In the wake of AIG, David Leonhardt asks how the government can control excessive executive compensation. Towards the bottom he hits on what I think is the most direct, least complicated solution:

If no such ideas proved workable, there is still one more option. Today’s tax code makes no distinction between income above $373,000 and income above, say, $5 million. Both are taxed at 35 percent.

That is a legacy of the tax changes of the early 1990s, when far less of the nation’s income went to millionaires. Today, you can make a good argument for a new, higher tax bracket on the very largest incomes. In the past, the economist Thomas Piketty says, higher marginal tax rates tended to hold down salaries and bonuses, because executives had less incentive to angle for multimillion-dollar pay.

How about a 100% tax on incomes above $5 million? "A lot of people have done a lot of good making their first $5 million. Nobody has ever done any good making his second $5 million."

Do we have to pay out those bonuses at AIG?

That's what Andrew Sorkin asks in today's NY Times. He says yes. His argument:

1. If we start abrogating contracts, all hell will break loose.

As much as we might want to void those A.I.G. pay contracts, Pearl Meyer, a compensation consultant at Steven Hall & Partners, says it would put American business on a worse slippery slope than it already is. Business agreements of other companies that have taken taxpayer money might fall into question. Even companies that have not turned to Washington might seize the opportunity to break inconvenient contracts... (The auto industry unions are facing a similar issue — but the big difference is that there is a negotiation; no one is unilaterally tearing up contracts.)

2. AIG broke it, they're the only ones who know how to fix it.

Here is the second, perhaps more sobering thought: A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it.

3. AIG is blackmailing us.

If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it.

Somehow, Andrew Sorkin is not making me feel any better about those bonuses. Let's consider these arguments.

Sanctity of contracts: Sure, but this is what bankruptcy is for, right? If needs be, the government could declare AIG bankrupt, abrogate all contracts, and assure AIG's counterparties that they would be made whole or nearly whole. The argument against this is that the uncertainty generated would cause turmoil in stock markets. But this is why God invented the long weekend. Announce the bankruptcy after markets close on Maundy Thursday and patch everything up before markets reopen on Monday (or is it Tuesday).

Seems to me the analogy with the automakers is exactly on point. The UAW is negotiating its salary concessions in the same way a mugging victim negotiates handing over his wallet.

They know how to fix this thing: All right, I'm out of my field of expertise here. I don't know what's involved with managing these contracts. But my gut tells me that the talent is in designing and selling the contracts; at this point, AIG just needs someone to cut checks. Hire some temps.

They're blackmailing us: If the government guarantees the counterparties and/or settles with them definitively over Easter weekend, how do you "bet against AIG's book?" The book is gone by the time the markets reopen.

Memo to self: when it comes time to reform the financial system, let's require that anyone who is going to make large transactions in financial markets with someone else's money be licensed. In a case like this, the AIG miscreants lose their licenses and have to find honest work.

Cause for optimism?

Would it be crazy to be optimistic that the economy will begin to recover this year? Perhaps, but let's take this thought out for a spin.

First, ignore the stock market. The stock market has rebounded strongly in the last week. But these are the same guys who a year ago were pushing the market to record highs. At this point in time I place zero confidence in the predictive ability of players in the financial markets.

Let's look at the banking system, however. It appears that at its core banking in the U.S. is profitable. It couldn't be otherwise - banks can borrow at 1-2 percent and lend at 5-8 percent. The problem the banks have is the dead weight of toxic assets on their balance sheets. The market for the banks assets - mostly those tied to mortgage-backed securities - has disappeared, so the market price of these assets is low, so bank capital is low, so banks need to reign in lending to ward off the little guy in It's a Wonderful Life who visits George on Christmas Eve (the bank examiner, not Clarence Oddbody). In an interview with CNBC, Warren Buffett says that the solution is to stop forcing banks to mark asset prices to market. Give the banks time, Buffett says, and they will work their way out of their difficulties by borrowing cheap, lending dear, and using the profits to beef up their capital. Sure enough, the American Banker reports that the FASB is going to propose that the mark-to-market regulation be suspended for assets the markets for which have evaporated (from Calculated Risk).

Mark-to-Market. The proposal for estimating market values will take into consideration whether there is an active market (such as the number of recent transactions, whether price quotes are based on current information, whether price quotes vary substantially, etc.). If there is not an active market, then the quoted price is a distressed transaction unless certain other conditions exist. For distressed transaction prices, “Level 3” techniques (such as present values of future cash flows) are used instead of the distressed prices and should reflect an orderly transaction between market participants, including a reasonable profit margin for uncertainty in a non-distressed situation.

Other-Than-Temporary-Impairment. FASB will also propose that the full market loss continue to be reported through earnings (and capital) only if the entity intends to sell or will be required to sell the security prior to its recovery. For all other OTTI, the amount of market loss will be split between the credit portion of the loss, which will be reported in earnings, and the remainder of the loss, which will be reported in “other comprehensive income.”

Upshot: it may, just may be possible to restore health to the banking system without a massive government intervention.

Now consider fiscal policy. The pessimistic view is that the $790 billion stimulus package was too small to fill the recessionary gap we're facing and that in this environment the multiplier effect of spending and tax cuts is likely to be smaller than normal because of the problems in the banking system. Richard Clarida:

Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001, the economy was in recession, but households took advantage of zero-rate financing promotions – as well as ready access to home equity withdrawal from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts and income earned from government spending on goods and services will not be leveraged by the financial system to nearly such an extent, resulting in (much) smaller multipliers.

There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates. Just in 2008 alone, I estimate that the net worth of US households fell by some 10 trillion dollars, with much of this concentrated in older demographic groups who, in our defined contribution world, must now be focused on building back up their wealth to finance retirement, which is not that far away. This means more saving, less consumption, and smaller multipliers.

But the amount of stimulus in the budget, even without the stimulus package, is huge. The CBO reports that the budget deficit for just the first four months of FY 2009 (that's October 2008 - January 2009) was $355 billion. That's before the stimulus package and is based on a conservative accounting of spending for TARP. Even before the stimulus package was passed the CBO was projecting a deficit for FY 2009 of 8.3 percent of GDP. That is really an enormous amount of stimulus.

How 'bout them multipliers? Well, it seems to me that Clarida's argument could work both ways. Suppose the deficits stimulate some spending, increasing corporate profits, boosting stock prices, improving credit ratings, raising asset values held by banks thereby increasing bank capital,... The multiplier could in fact be stronger than usual due to the "financial accelerator." The huge stimulus with big multipliers and a recovering banking system could give us a significantly stronger recovery in 2009 than we'd all been expecting.

I know, there's an awful lot of bad news out there as well, most of it indicating extraordinary weakness through the end of the year at least. But a boy can dream, can't he?

The Fed should target the risky interest rate

This is the line of argument Bob Barbera and I have taken in a couple of papers. Here Chris Carroll makes the case:

Given the Fed’s pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed’s balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

Neoliberalism and Higher Education

Stanley Fish in the NY Times. Short version: Neoliberalism is the ideology that places primacy on markets and market valuation in place of ethics. The rise of neoliberalism has led to a withdrawal of public support for universities, forcing universities to behave more like for-profit, market-based organizations. Administration and faculties alike are co-opted by the market as they pay more attention to the bottom line and seek funding from corporations. Fish's critics say that his admonition to academics to "stick to their knitting" rather than take on the mission of transforming society makes him a tool of the neoliberals. Interesting reading.

See, here's where a rational Republican party would have come in handy

The Los Angeles County Metropolitan Transit Authority gets a chunk of money under the stimulus law which it must distribute in chunks of $500,000 or more to each city in the county. Irwindale, California gets $500,000, but it doesn't have transportation projects to undertake. Instead, it has a general fund deficit and would like to use the money to pay salaries and avoid layoffs. So it wants to swap its $500,000 stimulus money with Westlake Village, which has some transportation projects in mind, for $310,000 cash. It's a Pareto-improving exchange! Unfortunately, the Transit Authority says this kind of swap is not allowed under the stimulus law - Irwindale has to find a way to spend the $500,000 on transportation and find some other way to fill its budget deficit.

Maybe there's a good reason for the inflexibility in the stimulus law. Maybe the Obama Administration is concerned that if it just gave the LAMTA or the state of California a block grant the money would not be spent in a sufficiently stimulative manner. Or maybe the inflexibility is due to some dirigiste impulse coded into the DNA of the Democratic party. At any rate, there seems to be an inefficiency here. In the fantasy world of my fevered imagination, there is a Republican Party and a group of moderate Democrats in Washington that serve as a useful counterweight to the liberal Democrats. The Republicans and their moderate Democratic sometime-allies say to the Obama Administration, look, we agree with the goal of your stimulus package. But you're trying to exert too much command and control here. Let's tweak the law some, in the spirit of federalism, to give us more bang for the buck. You do this for us (and make some other adjustments) and we'll give you the votes to pass this with a truly bipartisan majority.

Sadly, we don't have that kind of Republican party or Democratic moderate wing. The Republicans covered their eyes and stuck their fingers in their ears and took the position that government spending of any kind would do more harm than good. The moderate Democrats (and three moderate Senate Republicans) made the bill worse by first larding it with the AMT fix, then squawking about the price tag and forcing cuts in the useful components of the bill.

During the election it was often remarked that we needed Republican control of at least one of the three political organs - Congress, Senate, Presidency - in Washington in order to counter the excesses of the Democrats. I said no, what we need is Democratic control of all three but something short of a 60-vote majority in the Senate so that the moderates in both parties could temper the liberals (who are, in the main, right on most of the issues). But if the moderates aren't going to do their jobs, who needs 'em?

I like my homeless children in squalor

James Taranto of the WSJ takes issue with the National Center on Family Homelessness's report that in 2005-06 one of every 50 children in the U.S. experienced homelessness. He quibbles with the Center's definition of homelessness:

The AP link above includes a graphic that breaks down the "living conditions of homeless children." Fifty-six percent of them are "doubled-up," defined as "sharing housing with other persons due to economic hardship." By this definition, the Meathead on "All in the Family" was "homeless."

Another 7% are listed as living in hotels--a category that, in the report itself, also includes motels, trailer parks and camping grounds. We'll give them campgrounds, but when you think of the homeless, are residents of hotels and trailer parks what come to mind?

It's not clear what percentage of "homeless" children are in emergency vs. transitional shelters, but the report does say that "Nationally, there are 29,949 units (i.e., housing for one family) of emergency shelter [and] 35,799 units of transitional housing." In any case, a substantial number of the "homeless" who are in "shelters" are actually in facilities the center itself calls "housing" and are on track to finding permanent homes.

The remaining "homeless" children are either "unsheltered" (3%) or "unknown/other" (10%). Among these are children "abandoned in hospitals," "using a primary nighttime residence that is a public or private place not designed for, or ordinarily used as, a regular sleeping accommodation for human beings," and "living in cars, parks, public spaces, abandoned buildings, substandard housing, bus or train stations."

People in most of these categories are plainly homeless--but note how the center slips "substandard housing" in there between abandoned buildings and bus stations. A child should not have to live in substandard housing, and maybe one who does deserves help at the taxpayer's expense. But a lousy home doesn't make you homeless any more than a lousy marriage makes you single.

To satisfy Taranto's definition of homelessness, you must dress in rags and live in a cardboard box. Look, if Mom loses her job, we can't make the rent, and we have to live with my aunt for a month, I'm homeless. I may not be sleeping outside in the rain, but if my friend at school asks me where I live, I'm not going to say "in a nice house on Walnut Street," I'm going to say "with my Aunt." There's a difference. Also, the children living in hotels are not Eloise at the Plaza. They are being put up in cheap hotels at taxpayer expense because they have nowhere else to go.

Who are the idiots buying credit default protection on US debt?

Paul Krugman alerts us to Marketwatch, which reports that the spread on credit default swaps for US government debt have hit 97 basis points:

The spreads on credit-default swaps for U.S. government debt jumped to 97 basis points Tuesday, nearly seven times higher than a year ago and 60% higher than the end of last year, to a level roughly in line with those of France, according to data supplied by Markit. The spreads also hit a record last week...

Higher spreads on credit-defaults swaps indicate sellers have raised the price of guaranteeing protection because they perceive the likelihood of a default as higher. A spread of 97 means it would cost about $97,000 to buy protection on $10 million in U.S. government debt...

The chance that a seller of CDS won't be able to make good on its commitment to cover an underlying entity's debt default, or what's known as counterparty risk, prompted "Black Swan" author and investor Nassim Taleb to describe CDS purchases as tantamount to buying insurance on the Titanic from someone on the Titanic.

I take it a CDS is not something available to the ordinary citizen. The purchasers of these things have to be banks, hedge funds, private equity funds, people with gobs of money. These titans of finance are supposed to be rationally allocating society's scarce savings to the most productive uses; they're supposed to be optimally diversifying risk. Yet they don't seem to understand that in a world where the U.S. government defaults, we're all cowering in our bomb shelters eating beanie weenies from a can, and you will not be able to locate the guy who sold you that CDS.

And they're making this mistake while we're suffering the consequences of the same identical mistake that people made when they bought credit default swaps on mortgage backed securities. Kind of unbelievable.

We've been here before

But not often. The last time the real interest rate on Baa-rated corporate bonds was this high was the recession of 1981-83. Before that, it was the Great Depression (twice).

Oops

Gretchen Morgenson informs us that amid all the swirl of paper floating around Wall Street in the heady days of the housing boom, someone forgot to keep track of who actually holds the lien on my house:

Stated simply, the notes that underlie mortgages placed in securitization trusts must be assigned to those trusts soon after the firms create them. And any transfers of these notes must also be recorded.
But this seems not to have been a priority with many big banks. The result is that bankruptcy judges are finding that institutions claiming to hold the notes that back specific mortgages often cannot prove it.

On Feb. 11, a circuit court judge in Miami-Dade County in Florida set aside a judgment against Ana L. Fernandez, a borrower whose home had been foreclosed and repurchased on Jan. 21 by Chevy Chase Bank, the institution claiming to hold the note. But the bank had been unable to produce evidence that the original lender had assigned the note, which was in the amount of $225,000, to Chevy Chase.

With the sale set aside, Ms. Fernandez remains in the home. “We believe this loan was never assigned,” said Ray Garcia, the lawyer in Miami who represented the borrower. Now, he said, it is up to whoever can produce the underlying note to litigate the case. The statute of limitations on such a matter runs for five years, he said...

Bookkeeping is such a bore, especially when there are billions to be made shoveling loans into trusts like coal into the Titanic’s boilers. You can imagine the thought process: Assigning notes takes time and costs money, why bother? Who’s going to ask for proof of ownership of these notes anyhow?...

“My guess is it’s because in the secondary mortgage market they have been sloppy,” Judge Bufford added. “The people who put the deals together get paid for the deals, but they don’t get paid for the paperwork.”

I'm going to stop making my mortgage payments for a couple of months and see if anyone shows up at my door with the proper paperwork.

Why does Obama want to eliminate deductions for charitable contributions?

Short answer: he doesn't, he wants to limit deductions for people at the top of the income distribution. Still, this provision of the 2010 budget raised my eyebrows along with those of many commentators. Here's Peter Orszag's explanation of the President's proposal:

First, the proposed tax change would not be imposed during a recession... Instead, it would begin in 2011 – at which point we expect the economy to be recovering.

Second, the money raised from the limits on itemized deductions would be used as part of the historic $634 billion reserve fund to fund health care reform. Reforming health care is essential to the long-term fiscal health of the country. Indeed, bending the curve on health costs is the single most important thing we can do to get our country back on a sustainable long-term fiscal path.

Third, there’s a question of fairness... If you’re a teacher making $50,000 a year and decide to donate $1,000 to the Red Cross or United Way, you enjoy a tax break of $150. If you are Warren Buffet or Bill Gates and you make that same donation, you get a $350 deduction – more than twice the break as the teacher.

This proposal walks that difference back some of the way – it would limit the tax benefit for Buffet or Gates to $280. In other words, we are not eliminating the deduction – just reducing it to 28 percent... for the 5 percent of families at the very top of the income distribution. That is the same tax benefit that they would have enjoyed at the end of the Reagan Administration.

Will this hurt charities?

The evidence suggests that many factors affect charitable contributions, including the desire to help the charity and overall economic conditions. (The most recent example with changing the tax code illustrates that point. Between 2002 and 2003, the top income tax deduction for charitable contributions was reduced from 38.6 percent to 35 percent – and yet individual charitable contributions rose, presumably because other factors were a more important influence on giving than the change in the income tax.) Furthermore, about 75 percent of overall contributions would not even be affected by the proposed income tax change – because the contributions come from individuals who would not be affected or from corporations or foundations not subject to the individual income tax. Finally, even to the extent that charitable contributions are affected by tax considerations, the budget contains other proposed changes (including retaining an estate tax) which will create stronger incentives for giving. Above all, though, the best way to boost charitable giving is to jumpstart the economy and raise incomes – and the purpose of the Recovery Act enacted earlier this month was to do precisely that.

If fairness was really the Administration's top concern it would replace the deduction with a tax credit - if you contribute $1000 to charity your taxes are reduced by $1000 (or some fraction thereof) regardless of income. So I'm not buying that point. But his last paragraph is convincing. If our choice is between full charitable deduction without an estate tax (perhaps the Republican preference) versus capped deduction plus estate tax (Obama's plan), it's a good bet that Obama's plan gives a greater incentive to make charitable contributions.