Eats shoots, and leaves

So much for the "green shoots" of recovery - today's GDP report ate 'em. I'm not used to seeing numbers of this magnitude: residential and nonresidential fixed investment each down 37.9 percent on an annualized basis; equipment and software investment down 33.8 percent, structures down 44.2 percent. Exports down 30 percent, imports down 34 percent. Real gross private domestic investment is lower than it's been in any quarter since 1997Q1. The percentage decline in real exports of goods and services is bigger than in any quarter since 1965Q1. The bright spot: personal consumption spending rose 2.2% after two consecutive quarters of decline. Whether the economy recovers at all this year hinges on that number holding up.

Perspective

The current world recession is indeed the worst since the Great Depression. The World Bank predicts that world GDP will fall in 2009. Misery and chaos is our immediate future. This is all true. Still, consider the big picture for a moment. World GDP has more than tripled since 1969; per capita GDP rose by almost 80 percent. From 2000-2008 world GDP grew by almost 25 percent; per capita GDP rose by almost 15 percent. A two percent decline in 2009 brings us back roughly to where we were in 2008. Even in the depths of the recession, the world will be producing vastly more per person than it did a generation ago.

Since we're reforming higher education...

Here are my suggestions:

1. Cut back interdisciplinary programs. Let's face it, human societies are like ant colonies: each ant is a simple-minded creature focusing on her own tasks. No ant understands how her actions contribute to the functioning of the whole, but contribute they do, and the collective is a masterpiece of social engineering. Likewise the knowledge generated by our society and required to keep it running is too vast and particular to be understood in its entirety by any single scholar. The best each of us can do is to become an expert in our narrow field, and have faith that the collective body of knowledge is wondrous, beautiful, and useful. A master of a particular discipline can attempt to gain a smattering of knowledge from other fields, but we should not flatter ourselves that anyone can gain a complete understanding of the totality of human knowledge. [Again with the ants. Yes, I'm reading a great book on ants, a subject well outside my own field of expertise. Very interesting stuff, but I'm not going to pretend that having read the book I am now qualified to teach a course on it.]

Every student in my college (I won't speak for other colleges and universities) should have a major in an established discipline and a minor or another major in an interdisciplinary subject. One should not be allowed to major only in "International Relations" or "Environmental Studies." One needs expertise in a scholarly discipline.

2. Reduce government subsidies to higher education. It's basic supply and demand, people: when supply is relatively inelastic (as it is in education), subsidize tuition and you mostly increase price rather than quantity. And what is the effect of increasing price - or, to put it another way, of relieving colleges' and universities' budget constraints? You allow these institutions to offer more luxury goods to students and faculty: magnificent athletic centers, beautifully manicured quads, luxurious faculty dining halls, state of the art dorms, ... College becomes a glorified sleep-away camp for the privileged, subsidized by the taxpayer. Get rid of the subsidies, cut tuition, put the students back in quonset huts, and turn off my air conditioning (wait, Gettysburg College is way ahead of me - I'm sweltering over here!).

There must be a better way to assure equal opportunity for people with lower incomes. Here's an idea: every child in America receives $2000 when he/she is born, the money placed in an interest-bearing account. Every year the government puts $2000 into that account. When the child graduates from high school the money becomes available for certain activities: tuition, downpayment on a home, retirement account, business startup funds. (By my calculation, with 4% annual interest you'd have about $55,000 at 18.) Yes, you can only get the money if you graduate from high school or get a GED. Government spending on a bunch of stuff (aid for tuition, small business loans, mortgage interest deduction, etc.) can be reduced by an equivalent amount to pay for this.

3. Don't let 18 year olds go to college. They're too young. Make your high school graduate live on his/her own for a year before college - get a job, travel, whatever. Studies show that three-quarters of a freshman's energy and attention is spent on learning to live like a quasi-independent adult rather than on academics. That's a waste of money. (Ok, I made that study up.)

4. Colleges should do far less for students. We organize all sorts of activities for them, provide them with dining halls, convenience stores, coffee shops, etc. In each case, students are customers rather than participants. Put students in charge of life on campus. You want a coffee shop on campus? Let the students open one up, funded by the college but staffed and managed by the students. Faculty and administrators (and parents - God, the parents!) need to take some steps back and let the students grow up a bit on their own.

5. Abolish tenure. Why? Because my senior colleagues are assholes.

Q: How to destroy higher education

A: Follow Mark Taylor's advice in today's New York Times:

GRADUATE education is the Detroit of higher learning. Most graduate programs in American universities produce a product for which there is no market (candidates for teaching positions that do not exist) and develop skills for which there is diminishing demand (research in subfields within subfields and publication in journals read by no one other than a few like-minded colleagues), all at a rapidly rising cost (sometimes well over $100,000 in student loans)...

But our graduate system has been in crisis for decades, and the seeds of this crisis go as far back as the formation of modern universities. Kant, in his 1798 work “The Conflict of the Faculties,” wrote that universities should “handle the entire content of learning by mass production, so to speak, by a division of labor, so that for every branch of the sciences there would be a public teacher or professor appointed as its trustee”...

If American higher education is to thrive in the 21st century, colleges and universities, like Wall Street and Detroit, must be rigorously regulated and completely restructured. The long process to make higher learning more agile, adaptive and imaginative can begin with six major steps:

1. Restructure the curriculum, beginning with graduate programs and proceeding as quickly as possible to undergraduate programs. The division-of-labor model of separate departments is obsolete and must be replaced with a curriculum structured like a web or complex adaptive network. Responsible teaching and scholarship must become cross-disciplinary and cross-cultural...

2. Abolish permanent departments, even for undergraduate education, and create problem-focused programs... It is possible to imagine a broad range of topics around which such zones of inquiry could be organized: Mind, Body, Law, Information, Networks, Language, Space, Time, Media, Money, Life and Water...

4. Transform the traditional dissertation... For many years, I have taught undergraduate courses in which students do not write traditional papers but develop analytic treatments in formats from hypertext and Web sites to films and video games. Graduate students should likewise be encouraged to produce “theses” in alternative formats...

6. Impose mandatory retirement and abolish tenure.

This must be a joke, no? Let's see if I have this right. There is one sector of the US economy that is more productive than any of its competitors. U.S. higher education does a better job educating undergraduates, producing Ph.D level scholars, and advancing knowledge than the higher education system of any other country in the world. Taylor says this system is in crisis, and has been in crisis since 1798. Merely counting on prospective grad students to wise up and forego the Ph.D because of a lack of jobs is not sufficient - higher education must be regulated and restructured (presumably by the brilliant minds in the U.S. Congress). What should be the nature of this restructuring? Why, we must stop pursuing all of the types of research that Mark Taylor does not understand. How silly that we spend our time analyzing obscure chemical reactions or trying to understand the evolution of a particular subspecies of tropical ant - we should be talking about Water! Water from a chemical perspective, but also a religious perspective, water as it is discussed in great works of literature, water in film. But let's not get too technical, lest the generalists among us (and we will all be generalists) get bored. Then, let's publish our findings in the form of video games. The ephemeral nature of this type of outlet is of no concern, because when we stop thinking about Water and start thinking about something else (Space), we will not need to retain any of this old useless knowledge anyway. Finally, abolish tenure. Why? Because my senior colleagues are assholes.

Someone tell me this man is not serious!

Jon Faust on TARP

Also on Real-Time Economics, Jon Faust argues that the common view that the Treasury is vastly overpaying for assets under the TARP program is incorrect. The Warren Panel report on TARP says the Treasury is buying assets worth only 66 cents on every dollar spent. Faust says this is nonsense:

The report’s valuation is based on the view that market prices “provide the best indications of economic value.” Usually, perhaps, but the very essence of the crisis is that markets for key assets have broken down. By the time of the report, many experts were calling for changes in accounting rules precisely because market prices were not reliable signals of value; the Financial Accounting Standards Board recently adopted such changes. The valuation report acknowledges this problem, and “to mitigate the concern” the analysts checked several market prices. Of course, the one thing markets do nearly flawlessly is to price equivalent assets the same way. Thus, checking multiple prices is little better than reading several copies of the same newspaper to mitigate concerns that there is an error in one of them.

Faust doesn't mention PPIP, but the same argument holds here as well. Krugman and other critics of Treasury's PPIP plan argue that the point of the plan is to subsidize the banking industry by overpaying for the assets it buys. But the assets subject to sale under the plan are in all probability vastly underpriced in current financial markets. As I've argued before, under the plan the price investors pay for the assets will probably be only slightly greater than their true ("fundamental") values, the difference equal to the value of a put option on the asset pools.

Tracking the Fed's balance sheet

Real-time Economics has a cool interactive Fed balance sheet tracker.

Conservative brains v. liberal brains

From Nature, 2007

Neurocognitive correlates of liberalism and conservatism
David M Amodio, John T Jost, Sarah L Master & Cindy M Yee
[Abstract] Political scientists and psychologists have noted that, on average, conservatives show more structured and persistent cognitive styles, whereas liberals are more responsive to informational complexity, ambiguity and novelty. We tested the hypothesis that these profiles relate to differences in general neurocognitive functioning using event-related potentials, and found that greater liberalism was associated with stronger conflict-related anterior cingulate activity, suggesting greater neurocognitive sensitivity to cues for altering a habitual response pattern.

It was explained to me thusly: Have a liberal and a conservative repeatedly cross a busy road where cars tend to crawl along at 20 mph. Both will tend to cross lackadasically, understanding that motorists have plenty of time to slow down to let them cross. Now introduce an occasional car speeding along at 50 mph. The liberal recognizes the increased risk of crossing. He crosses less frequently, exercising more caution. The conservative does not react in this way. Unless he actually sees someone get hit by the speeding car (or gets hit himself), he does not change his behavior. He shuts out the risk of events with which he has no experience, falling back on established patterns or dogma.

Hypothesis: this explains
- Why conservatives are less likely to support policies to fight global warming
- Why conservatives fight social change like gay marriage
- Why conservatives are more likely to believe in a literal interpretation of the Bible and strict construction of the Constitution
- Why liberals are more prevalent in academia.

Galbraith on the economic recovery

James Galbraith walks through the possibilities for recovery from a Keynesian perspective:

First, the optimistic scenario:

Today, though, we have heard (from the bank economists) a Keynesian case for an imminent turnaround and relatively rapid expansion - the Obamaboom, as Warren Mosler has named it. The case has four major elements:

- The fact that recessions are self-limiting through the inventory cycle. In the slump, production always falls much more than consumption, so that inventories are liquidated, and as this process is completed, production must be restarted. To this, we can add the fact that sharply falling commodity prices have helped restore real purchasing power.

- The fact that services are more stable than either manufacturing or agriculture and that they are a much larger part of the total economy than they were eight decades back.

- Even more important, the fact that rock-stable government is much larger, in proportion to the economy, than in 1929. To this we can add that falling income taxes and rising unemployment insurance provide massively for automatic stabilization as unemployment rises. It's ugly but it works.

- Finally, the fact that the fiscal expansion package (including the recent increase in social security benefits) is the largest on the post-war record, and also the longest-lasting, with expenditures expected to surge for two years rather than the norm of one.

Next, the pessimistic view:

- [The recovery] will surely be very slow to restore employment. At present writing jobs are being lost at the rate of over 600,000 per month. To reverse this in six months would require a swing to job creation of the same amount, or a net swing of 1.2 million jobs a month for half a year. This is not going to happen - not even close. Among many reasons, homebuilding is likely to be depressed for a long time, while elsewhere production gains will be backed by productivity increases. As a result, we can expect the human wreckage of this slump to persist and to deepen as the period of unemployment lengthens. Without direct employment measures, many of the people most hurt will not again find decent jobs.

- As a result of the administration's determination to save the big banks, we will emerge from this slump with an unreformed financial sector in the hands of the same people who produced the disaster in the first place. While some bad assets will recover value, many will not, and losses will either go unrecognized or they will be transferred, via the public-private partnerships, first off the balance sheets of the banks and then to the taxpayer, when the mortgages default, via the non-recourse feature of the FDIC's loans. We could assess the likelihood of this happening, if we chose, by the simple step of auditing the loan tapes underlying a fair sample of sub-prime securities, to determine the prevalence of missing documentation, misrepresentation and prima facie fraud. Such a study would constitute minimum due diligence and that fact that one is not underway is a very bad sign.

- In the expansion the early easy buck, especially for speculators, may well be in commodities, especially oil. A rapid increase in imported energy costs would reverse the effective stimulus now being given by low oil prices. It will also generate CPI inflation, perhaps inducing the Federal Reserve to slam on the brakes. There is little reason to hope that the recovery will be allowed to march us all the way back to full employment unless we overcome our vulnerability to volatile oil prices, and nothing in the plans so far suggests we have faced up to that elementary necessity.

- A turnaround could bring the deficit hawks back out of the woodwork, arguing vociferously that "now is the time" for tax increases and entitlement cuts. Should they prevail, the process could be thrown into reverse, in a recapitulation of Roosevelt's balance-the-budget recession of 1937-38.

Finally, some policy initiatives that could increase the likelihood of the optimistic outcome:

- Treasury should change its bank plan, recognize that too-big-to-fail is also too-big-to- regulate, and too-big-to-regulate is also too-big-to-manage. A financial institution that cannot be controlled by its own top leadership is an intrinsically dangerous thing. Since the financial sector must and will shrink in any event in the post-crisis economy, the strategic choice facing policy is how to do it. That choice is between preserving vast rogue companies whose major functions are tax and regulatory arbitrage, or allowing the smaller banks that have largely played by the rules to grow into the legitimate market niches the big players may vacate. Apart from the vast political power of the big banks, this is not a difficult choice.

- The unmet human disaster of this slump remains urgent, and the way to meet it is to strengthen, not weaken, the social safety net. Given the triple hit to the elderly as a group - in home values, stock values and interest on cash holdings - Social Security benefits should be increased, not cut. Medicare eligibility should be reduced to age 55 as an emergency measure. The payroll tax should be placed on holiday, and measures to mitigate foreclosures or otherwise keep people in their homes taken urgently. Fiscal assistance to states and localities should be made open-ended, putting an end to job cuts in those vital public sectors, indeed permitting them to grow and add employment.

- For the long term, we should build institutions now, including a National Infrastructure Fund and a cabinet Department for Energy and Climate, capable of planning and funding the reconstruction of the country. The point of this is to build expectations for a sustained expansion and also to give it a direction, charting the course that private investments will follow when they eventually return.

- Finally, we should recognize that we are fortunate in this country to have the governing institutions established for us in the New Deal and Great Society, including a central bank with unlimited lending powers, a national government that can borrow and spend at will, and the global reserve currency. These institutions have -- despite flaws and mistakes -- served us well. But we should recognize that the rest of the world is not so favored. In particular, Europe lacks the mechanisms and the inclination to take action as we can, and all the pathologies of structural adjustment that we avoid here are routinely imposed everywhere else.

Jane Mayer on the torture program

I'm a big Jane Mayer fan since reading her book "The Dark Side." Here she writes about the Levin Report on CIA interrogations:

Jane Mayer: Thoughts on the Levin Report

President Obama has thrown a kind of protective, legal “invisibility cloak” over C.I.A. officers who may have participated in torture or other war crimes, but whose actions were authorized by lawyers in the Bush Administration. The reasoning goes that, if they were acting in good faith on the orders of superiors, it’s unfair to hold them to a different standard. But the unclassified report (pdf) from the Senate Armed Services Committee, released tonight by Chairman Carl Levin, raises questions about whether the C.I.A. was always operating with legal authorization.
Take. for instance, the torment of Al Qaeda suspect Abu Zubaydah, the guinea pig for the C.I.A.’s most abusive interrogation techniques, who was critically injured in a gunfight and captured on March 28, 2002. The Justice Department’s Office of Legal Counsel authorized harrowing tactics for interrogating Zubaydah in the infamous “Bybee Torture Memo” of August 1, 2002, which Obama released publicly last week. So, presumably, whatever happened to Zubaydah after August is indemnified by the Obama invisibility cloak. But what about what happened to Zubaydah in the four months before?

The Levin report provides some new details. On April 16, 2002—a couple weeks after Zubaydah’s capture, and three and a half months before the Bybee memo—a military psychologist named Dr. Bruce Jessen was already circulating a blueprint for cruelly coercive interrogations based on torture methods used by Chinese Communist forces during the Korean War. The report describes Jessen’s blueprint as a “draft exploitation plan” for U.S.-held captives. (I wrote about Dr. Jessen’s partner, James Mitchell, in the July 11, 2005, issue of The New Yorker.)

By June 2002—again, months before the Department of Justice gave the legal green light for interrogations—an F.B.I. special agent on the scene of the interrogation of Abu Zubaydah refused to participate in what he called “borderline torture,” according to a D.O.J. investigation cited in the Levin report. Soon after, F.B.I. Director Robert Mueller commanded his personnel to stay away from the C.I.A.’s coercive interrogations.

What did the F.B.I. see in the spring of 2002? And exactly who was involved? How high up was this activity authorized? Is it off-limits for criminal investigation?

There are plenty of new names and details in the Armed Services Committee report, including a scene of two military men teaching the C.I.A. how to use Chinese torture techniques. One of the instructors, Joseph Witsch, played the “beater,” while the other, Gary Percival, became the “beatee.” By the mid-summer of 2002, beating was no longer just an academic exercise. Precisely when these tactics were used on live captives, and at what point top Bush officials endorsed them, may be a matter of serious interest to Attorney General Eric Holder.

Put that Levin report on the summer reading list!

Slippery slope

I'll add Shadow Government to my standard sources of information and analysis. Philip Zelikow, former deputy to Secretary of State Condoleeza Rice, recounts his involvement in the torture memo controversy:

At the time, in 2005, I circulated an opposing view of the legal reasoning. My bureaucratic position, as counselor to the secretary of state, didn't entitle me to offer a legal opinion. But I felt obliged to put an alternative view in front of my colleagues at other agencies, warning them that other lawyers (and judges) might find the OLC views unsustainable. My colleagues were entitled to ignore my views. They did more than that: The White House attempted to collect and destroy all copies of my memo. I expect that one or two are still at least in the State Department's archives.

Stated in a shorthand way, mainly for the benefit of other specialists who work these issues, my main concerns were:

- the case law on the "shocks the conscience" standard for interrogations would proscribe the CIA's methods;

- the OLC memo basically ignored standard 8th Amendment "conditions of confinement" analysis (long incorporated into the 5th amendment as a matter of substantive due process and thus applicable to detentions like these). That case law would regard the conditions of confinement in the CIA facilities as unlawful.

- the use of a balancing test to measure constitutional validity (national security gain vs. harm to individuals) is lawful for some techniques, but other kinds of cruel treatment should be barred categorically under U.S. law -- whatever the alleged gain.

And he warns of a slippery slope:

The underlying absurdity of the administration's position can be summarized this way. Once you get to a substantive compliance analysis for "cruel, inhuman, and degrading" you get the position that the substantive standard is the same as it is in analogous U.S. constitutional law. So the OLC must argue, in effect, that the methods and the conditions of confinement in the CIA program could constitutionally be inflicted on American citizens in a county jail.

In other words, Americans in any town of this country could constitutionally be hung from the ceiling naked, sleep deprived, water-boarded, and all the rest -- if the alleged national security justification was compelling. I did not believe our federal courts could reasonably be expected to agree with such a reading of the Constitution.

Torture

Substantively the release of the torture memos doesn't tell us a lot that we didn't know already. It's mostly about filling in the details:

You have described the specific techniques at issue as follows...

4. Walling... The individual is placed with his heels touching the flexible wall. The interrogator pulls the individual forward and then quickly and firmly pushes the individual into the wall. It is the individual's shoulder blades that hit the wall. During this motion, the head and neck are supported with a rolled hood or towel that provides a C-collar effect to help prevent whiplash... [T]he repetitive use of the walling techique is intended to contribute to the shock and drama of the experience, to dispel a detainee's expectations that interrogators will not use increasing levels of force,a dn to wear down his resistance...

8. Cramped confinement. This technique involves placing the individual in a confined space, the dimensions of which restrict the individual's movement. The confined space is usually dark... For the larger confined space, the individual can stand up or sit down; the smaller space is large enough for the subject to sit down. Confinement in the larger space may last no more than 8 hours at a time for no more than 18 hours a day; for the smaller space, confinement may last no more than two hours...

10. Stress positions... The three stress positions are (1) sitting on the floor with legs extended straight out in front and arms raised above the head, (2) kneeling on the floor while leaning back at a 45 degree angle, and (3) leaning against a wall generally about three feet away from the detainee's feet, with only the detainee's head touching the wall, while his wrists are handcuffed in front of him or behind his back, and while an interrogator stands next to him to prevent injury if he loses his balance...

11. Water dousing. Cold water is poured on the detainee either from a container or from a hose without a nozzle. This technique is intended to weaken the detainee's resistance and persuade him to cooperate with interrogators...

12. Sleep deprivation (more than 48 hours)... the detainee is standing and is handcuffed, and teh handcuffs are attached by a length of chain to the ceiling. The detainee's hands are shackled in front of his body, so that the detainee has approximately a two- to three-foot diameter of movement. The detainee's feet are shackled to a bolt in the floor.. [T]he detainee's hands may be raised above the level of his head, but only for a period of up to two hours...

13. The "waterboard" ...

The most unnerving aspect of the memos is the creepy, dispassioned, methodical, clinical description of the torture techniques. I would expect to find the same tone in documents from the archives of Nazi Germany or Pinochet's Chile, albeit with fewer expressed reservations about damage to the long-term health of the prisoner. We are not in Jack Bauer territory here, with a bomb about to explode and the interrogator grabbing at the nearest sharp implement he can find with which to threaten the prisoner. This is an exquisitely constructed, institutionalized program carried out over weeks or months, intended to disorient and dehumanize the prisoner until he coughs up useful information.

Dick Cheney says the Obama Administration should declassify reports on the intelligence gleaned by these techniques. By all means let's do that. But whether or not these reports show that valuable intelligence was attained using these methods is irrelevant. If the result of the various inquiries is the formation of a body of opinion that torture is acceptable when it yields valuable information, we will have lost a good chunk of our national soul. Perhaps we have already.

Accountants lift Citigroup profits

Citigroup announced first quarter profits of $1.6 billion, the first positive profits in over a year. But wait:

The earnings were helped by an accounting change that allowed the bank to post a one-time gain of $2.5 billion. Under the rule, companies are allowed to record any declines in the market value of their debt as an unrealized gain.

That's a nifty trick! I run my company into the ground. Bond traders believe there's a good chance that I will be forced to default on my debt, so the market price of the bonds I've issued falls from $100 to $90. The accounting rule allows me to treat the $10 loss per bond as income - presto, I'm in the black again!

I need to learn more about this.

Coase in the home

Our local Easter Bunny makes sure that each child in the house gets the same number of jelly beans and chocolate eggs. Yet within minutes of their finding their baskets, my daughter has all the jelly beans and my (older) son has all the chocolate eggs. I'm fairly certain that if I put nothing but chocolate eggs in my daughter's basket and nothing but jelly beans in my son's, the final distribution would be exactly the same.

Paul Krugman is on board

Krugman says "It’s now looking like a reasonable bet that growth will turn positive later this year," but warns that as in 2002, the return to growth may be accompanied by another year of rising unemployment. True, and that's a problem. But for months Krugman has been warning that the economy may be plunging into the depths of depression. He has assailed the Obama administration for failing to act aggressively enough - the stimulus is too small, the banks should be nationalized. Now he's apparently recognizing that whatever the deficiencies of the Administration's policies, they have done enough to make it a "reasonable bet" that the dire scenario will be avoided. I call that a positive development.

Skirting the issue

In today's NY Times, Andrew Rosenfield proposes an alternative to PPPIP which is essentially the good bank - bad bank solution: the government takes the banks and their toxic assets, puts the toxic assets in the basement, recapitalizes the banks, and sells them off. A plausible proposal, but like most commentators he skirts the main issue: if the government makes the banks' creditors whole, it is providing a giant taxpayer-financed subsidy, just as we are doing now. And if it doesn't make creditors whole, it risks economic armageddon (or so many believe), in which case look for another round of massive bailouts of various failing companies. No matter how people slice and dice it, getting out of this recession is going to require a subsidy to someone.

Gaussian Copulas don't kill financial markets, people do

The most unpopular mathematical formula today is the Gaussian Copula used to value mortgage backed securities and similar financial instruments (and incidentally is the formula I'd have to use to prove my point that Krugman et al. exaggerate the amount of government subsidies under the Geithner plan).

The formula turned out to give misleading estimates of the value of mortgage-related securities, in the end leading to huge losses for banks and plunging the financial system into crisis. But of course the problem was not the formula itself or the decision of banks to rely on it to price the securities; the problem was that banks overleveraged themselves so that the losses they suffered were unmanageable. The SEC's decision in 2004 to lift the 12:1 leverage restriction on investment banks (after which banks like Bear Stearns and Lehman Brothers increased their leverage to 40:1 or more - meaning they were borrowing 40+ times their capital) has to go down as one of the biggest blunders in economic history.

The inviolability of bank debt

A commenter points me to Willem Buiter's column in the Financial Times. Buiter describes the Woodward-Hall-Bulow "good bank - bad bank" proposal in which troubled banks are split in two, a good bank that has deposits and good loans and a bad bank that has bank debt and bad loans. The plan promises to restore health to the banking system because good banks will have sufficient capital that they can resume lending, without cost to the taxpayer. The way the plan avoids cost to the taxpayer is by forcing bank creditors to convert their debt to equity (as is normally done in bankruptcy proceedings), taking a "haircut" along the way.

In a perfect world, this is exactly what would happen. Those idiots who lent money to overleveraged banks would be made to feel the pain, just as the banks' stockholders have. I'm sympathetic to this idea. However, my friend/co-author Bob Barbera, who knows much much more about this from his perch advising Wall Street clients, tells me this is the road to insanity. If you touch the creditors of banks like Citigroup, all bank debt is now perceived to be in play and panic engulfs world financial markets. I asked him plaintively the other day - "Do you mean to tell me that if Citigroup's creditors are told they only get 90 cents on the dollar, tomorrow Wells Fargo doesn't get any loans? Is that the kind of crazy world we live in?" Answer: "Yes."

I'm not totally convinced that the world would end if bondholders were forced to suffer along with the rest of us. Buiter makes some good arguments on this. However, it seems that right now we have weathered the financial crisis of fall 2008, we have a multi-pronged recovery plan in place, and the last thing we need is another Lehman Brothers - style panic. I'm guessing we'll have positive GDP growth in the U.S. starting this summer, and unemployment will peak at 10 percent or so next year before heading down. I say we stay Obama's course and think of ways to spread the pain when we're out of the woods.

Iowa Court Overturns Gay Marriage Ban

More on Krugman's critique of the Geithner plan

The mistake that Krugman and others make in their analysis of the Geithner plan is very important. Krugman believes that the Geithner plan amounts to a large subsidy to the banks that hold toxic (sorry, legacy) assets. The subsidy arises because buyers default on the loans backing the purchase of each individual asset that turns out to be worthless (and lots of assets are sure to do that). The loan is then paid off by the FDIC. The ability to selectively default on their loans gives the buyers the incentive to overpay for the toxic assets, so in effect the FDIC is transferring large amounts of money to the banks.

But this simply isn't true. The FDIC guarantees loans on whole pools of assets; the buyer must either pay off the whole loan or default on the whole loan. The buyer only defaults if the whole pool returns less than the value of the loan, i.e. its value turns out to be more than 12 percent less than the purchase price (under the maximum leverage scenario).

So what does this imply about the price buyers are willing to pay for pools of toxic assets? It turns out that the math is hard. Not too hard - there are plenty of finance people who do this all the time - but hard enough that I don't want to spend the time working through it when I have courses to teach, students to advise, fellow faculty members to boss around. So how about an intuitive approach:

Suppose you want to buy an asset that you think (and suppose you're right) has a true expected payoff of $50 (say, a 50% discount on a $100 face value). If you're risk neutral and you're paying in cash, the price you will pay is $50. Any time you can leverage your purchase of an asset at an attractive rate of interest, the potential return is higher; but at the same time there is a possibility of larger losses. The expected value is the same, so you should still pay $50. The deal the Geithner plan offers you is, if you buy at $50 but the pool turns out to pay less than $44, you lose your capital investment ($3) as does the Treasury ($3), but you default on your loan and the FDIC picks up the rest of the loss. So if the pool pays $30 instead of the expected $50, the FDIC is on the hook for $14 net.

This deal is equivalent to the government's offering you a straight "recourse" loan (that is, if you default the FDIC can seize your business, house, everything you have) plus a put option with a strike price of $44. So if the pool pays $30 but you owe $44, you exercise your option to sell the pool for $44 and use the proceeds to pay off the loan. As the seller of the put option, the FDIC is paying $44 for an asset worth $30, so is on the hook for $14 again.

How much is this recourse loan + put option worth to the buyer? Something more than $50, but not much more: the put option is "out of the money" and the true expected value of the pool is $50. Let's say the value of the put is $5, so you buy the pool for $55. Some of that extra $5 is not paid to the bank but paid as a fee to the FDIC for the loan guarantee, so the amount that goes to the bank is somewhere between $50 and $55. This is a subsidy to the bank, but a small one. Since the price of the pool is slightly higher than it would be otherwise, the probability that a pool will return less than 88% of the purchase price is also slightly higher, so there will be more loan defaults which the FDIC will cover. Presumably the FDIC is setting fees at a rate that covers its expected costs, so the subsidy to the banks actually comes, ultimately, if everything works out as planned, from the pool buyers.

Finally, it is important to acknowledge the externality associated with the Geithner plan. If the plan is successful and it returns the banking system to health and the economy starts to recover as a result, the assets that the PPPIPs buy will rise in value and there will be very few defaults indeed; the government will be a net winner by virtue of the capital investment that the Treasury makes.

Oh, one more thing. Krugman is skeptical that the toxic assets are currently underpriced. For the life of me, I can't understand where that skepticism comes from. I'm guessing (and I actually have it on good authority from financial industry sources) that while subprime loan/security pools are not horribly underpriced currently, prime mortgage loans/securities and other relatively sound assets are selling at absurd discounts. Just look at the yields on Baa corporate bonds. What justifies a risk premium of 5 percent compared to the historical average of 1-2%? The market for these things is pricing in unrealistically high probabilities of default. No, the reason risky yields are so high (prices of risky assets are so low) is a general panic / liquidity crisis. It makes sense for the government to come up with a plan that allows banks to sell these things at prices that reflect reality.