Monthly Archives: November 2008

Krugman refutes Friedman and Schwartz…

…or so he thinks. Our friend David Beckworth points Krugman to Christina Romer’s excellent work on the Great Depression (which I have mentioned here and here).

My thoughts on Krugman’s take are in the comments on Beckworth’s site.

Quote of the Day

“Some who promoted the first stimulus package have reacted to its failure by saying that we must now switch to large increases in government spending to stimulate demand. But government spending does not address the causes of the weak economy, which has been pulled down by a housing slump, a financial crisis and a bout of high energy prices, and where expectations of future income and employment growth are low.”

John Taylor

Big Players and Uncertainty

There has been a great deal of discussion lately with regards to the ever-changing role of the Troubled Assets Relief Program (TARP).  Initially, the program was designed to purchase the troubled assets of financial institutions in an attempt to cleanse their balance sheets and get them lending again.  I have previously come out against this plan as it fails to take into account the limitations and dispersal of knowledge within markets.  Perhaps this and other objections were heeded by the Treasury Department, which inexplicably abandoned this stated goal in favor of direct equity injections in troubled financial institutions.  In the aftermath of this decision, little has been done to instill confidence in the financial markets and the capital infusions have done little to increase the lending by the recipient institutions.  Given that many noted economists preferred capital infusions to the purchase of troubled financial assets, recent events beg the question as to why this change in policy has been unsuccessful.

The answer can be found in Fairleigh Dickinson economist Roger Koppl’s theory of Big Players.  Koppl defines a Big Player as a market participant that is substantially large, immune to profit and loss mechanisms, and yields ample discretionary power to have an impact on the market as a whole.  Central banks are perhaps the clearest example of a Big Player and this theory indeed might explain much about the artificial boom that preceded the current mess.  However, the theory is perhaps more applicable in the aftermath of the boom.  Since the onset of the crisis, the Federal Reserve and the Treasury department have acted as Big Players.  They continue to wield significant discretionary power and often take unprecedented action – and at times unexpected restraint.  In other words, to use a tired saying, they are flying by the seat of their pants.  One need not look beyond the TARP for an understanding of the discretionary power of these entities.

The effect of this discretionary power is to increase uncertainty within the financial markets.  Firms that receive capital infusions refuse to increase lending precisely because the rules are changing on a daily basis.  The same goes for investors who must not only predict what the market is going to do, but also the behavior of the Big Players.  Of course, the ability to predict what the Treasury and the Fed are going to do next is substantially difficult.  The result is the herd-like behavior that has been prevalent in the stock market for the last few months.  When there is a high level of uncertainty in markets, participants start relying more on what they believe that others believe than the prospective yield of a particular investment.  The empirical evidence presented by Koppl and his colleagues confirms these claims.  Uncertainty breeds uncertainty.

Nevertheless, some pundits continue to press on.  The same individuals who advocated using capital infusions and who were surprised to find the institutions unwilling to lend are now advocating forcing the financial companies to lend. Markets function well when the surrounding institutional framework is sound.  If the government really wants to help, they can start by setting the rules now and following through on their promises.  So long as they continue to change the rules on a daily basis, uncertainty will prevail, the stock market will remain volatile, and the credit markets will remain frozen.  

Selgin on Free Banking

Our friend George Selgin discusses free banking on EconTalk.

Restraining the Fed

Gerald O’Driscoll writes:

Mr. Obama’s task is made all the more difficult because there has been a perfect storm of bad policies and practices. Laudable goals, such as fostering more homeownership, went terribly awry. Financial services regulation has failed at its most basic task, protecting the soundness of the system. And a dysfunctional compensation system has given corporate managers incentives to take excessive risks with investors’ money.

None of the policies and practices that are now widely criticized suddenly appeared in the past decade. But they were kindling for a financial firestorm that needed only an accelerant and a spark. Both were provided by a policy of easy money that came in response to the bursting of the dot-com bubble in 2000-01, the ensuing recession, and the Sept. 11 attacks.

At first Fed easing was in order. The central bank needed to counter the “irrational exuberance” of the dot-com bubble. And by May of 2000 the Fed had done that by raising the fed-funds target to 6.5%. That needed to come down when the bubble burst. Aggressive cutting brought it to 2% in November 2001.

The problem is the rate remained at 2% or less for three years (for a year it was at 1%). During most of this period, the real (inflation-adjusted) fed-funds rate was negative. People were being paid to borrow and they responded by often borrowing irresponsibly.


The subprime saga follows a familiar pattern. Easy credit begets a boom and then the inevitable tightening of credit bursts the bubble. What is not familiar is the scale of the devastation wrought in this boom-bust cycle.

Never before had financial markets evolved such a complex superstructure of interlinked securities, derivatives of all kinds, and special-purpose investment vehicles. Professor Gary Gorton of the Yale School of Management has best described that complexity in his paper “The Panic of 2007,” published by the National Bureau of Economic Research. He makes clear that as this system evolved there was not a sufficient guard against systemic risk.


The point is not to deflate asset bubbles, but to avoid them in the first place. Imposing a commodity standard is a practical response to the repeated failures of central banks to maintain sound money and financial stability. What would be impractical is to believe that the next time central banks will get it right on their own.

Read the whole thing.

Keynesian Policies and the Depression

Paul Krugman writes:

Now, you might say that the incomplete recovery shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump. Here’s the Cary Brown estimates, from Brad DeLong…Net stimulus of around 3 percent of GDP — not much, when you’ve got a 42 percent output gap.

Alex Tabarrok responds:

Now there is actually a lot of truth to this but the way in which Krugman, Rauchway, DeLong and others present this point is esoteric and likely to mislead even many economists. What Krugman seems to be saying is that the government didn’t spend enough during the thirties (Rauchway, who also cites Cary Brown, says directly “there was never enough spending to achieve the desired effect.”) Yet federal spending during this time increased tremendously. So what is really going on? The answer is actually quite simple.

During the Great Depression federal expenditures increased tremendously but so did taxes. Thus, the reason spending was not stimulative was not that spending wasn’t tried it’s that taxes were also raised to prohibitive levels.

This may seem a bit strange, but both Krugman and Tabarrok are correct here. Much of the increased spending was offset by tax increases as Tabarrok notes. However, I would also point out that one of the main problems with New Deal policies was that they were decidedly NOT Keynesian in that they did not attempt to stimulate demand, but rather attempted to stimulate prices. Many of the New Deal policies were aimed at restricting supply (namely in the agricultural sector) in order to raise prices. Keynes himself in an open letter to Franklin Roosevelt argued against such policies:

Now there are indications that two technical fallacies may have affected the policy of your administration. The first relates to the part played in recovery by rising prices. Rising prices are to be welcomed because they are usually a symptom of rising output and employment. When more purchasing power is spent, one expects rising output at rising prices. Since there cannot be rising output without rising prices, it is essential to ensure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turn-over. But there is much less to be said in favour of rising prices, if they are brought about at the expense of rising output. Some debtors may be helped, but the national recovery as a whole will be retarded. Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.


But too much emphasis on the remedial value of a higher price-level as an object in itself may lead to serious misapprehension as to the part which prices can play in the technique of recovery. The stimulation of output by increasing aggregate purchasing power is the right way to get prices up; and not the other way round. [Emphasis added.]

Rosser’s Path Forward

The always thoughtful Barkley Rosser has been discussing the path forward from the current crisis over at Econospeak. Below are some highlights of two of his recent posts.

First, on regulation:

So, my first remark will be to urge that there be no new regulatory bodies or other bureaucracies created. What is needed are better rules and better people in the relevant positions. There may be (and already have been) changes in the powers of particular bodies, but any effort to create some new, grand oversight body will be just a waste of time and effort.

Second, on mark-to-market accounting:

In any case, banks must revalue their assets according to current market conditions, which in itself is not such a bad thing. However, the minimum capitalization rules in conjunction with this method of accounting aggravate downward spirals. If a bank’s assets decline in value, it may be forced to sell some to raise its capitalization, which has a clearly negative multiplier effect on the markets in general.

The SEC has reportedly been considering some variation of this rule. I would suport a change that has been reported to have been adopted in Germany. Banks that declare a willingness to hold onto an asset to maturity, may value it at its original face value. Thus, promises to hold certain assets to maturity takes them out of being subject to the mark to marketing rule and stabilizes their capitalization, and hopefully, the financial markets more broadly.

Selgin on Greenspan and the Crisis

George Selgin on Greenspan, monetary disequilibrium, the productivity norm, and the current crisis. Read the whole thing.

Income Taxes

Vince Farrell on taxes:

If you are lucky or hard-working enough to have earned $364,657 in 2006, the last year for which data is fully available, you are in the top 1% of earners. That group earned 22% of all income and paid 40.4% of all taxes levied on individuals. The top 1% paid almost as much as the lower 95%! The percent of taxes paid by the top 1% has increased from 19% of all tax to the current 40% over the last 25 years.

$145,283 in earnings landed you in the top 5% of earners, and the top 5% paid 60% of all taxes. $103,912 was needed to qualify for the top 10%, and that group paid 70% of all taxes. The top 25% of incomes (over $62,066) paid 86% of taxes. It’s estimated that, in 2009, well over 40% of American earners will pay no Federal tax.

The campaign promise was that 95% of Americans would get a tax break of some kind. The 5% that won’t get a tax reduction now pay 60% of all tax. The campaign slogan was it’s “all about fairness.” I don’t quibble with that concept nor do I think we should have anything but a graduated tax system. I need to be told the definition of “fair.” Is it fair for the top 1% to earn 22% of income and pay more than 40% of taxes? Is it fair for the top 5% to pay 60% of taxes but not share in a tax reduction program? Maybe it is fair, but what I believe is needed is not what was a very effective campaign argument but a thoughtful discussion and explanation of what our tax program should be.

HT: Barry Ritholtz

Economic Advisors

Frequent readers know that I try to keep political commentary around here to a minimum, but this is simply too good to pass up:

President-elect Barack Obama has just named Michigan governor Jennifer Granholm to his 17-member economic advisory panel.

Granholm carries respect in the Obama administration thanks to her alternative energy “vision” — that is, heavy subsidies for alternative-fuel plants such as ethanol and renewable-power mandates on utilities.

But Granholm has presided over the worst state economy in the United States since her election in 2003. Just last year, in the teeth of a gaping budget deficit and galloping unemployment now at 8.7 percent, she raised personal income taxes 17 percent.