Skeptonomics

Both McCain and Obama are effectively running against Bush, but neither is able to frame his argument in a coherent way. That is, we have criticisms of this policy or that one, but no general position that ties them together and makes them look like anything more than random corrections. McCain’s problem is obvious—he’s really running against his party (the “maverick” trope)—but what about Obama?

Republicans have put forward different frames over recent years, but two are central to actual policy: free-market economics and the unrestricted, hegemonic use of police and military power (“standing tall”, “keeping us safe”). You could say that the current financial crisis blows away the first and that Iraq discredited the second. So this is an opportunity for the Democrats to engage in a little frame replacement to their own advantage. Instead, what do we get?

Obama talks about the Iraq disaster in an apolitical fashion, as a simple error in judgment. As one who saw through the bs from the beginning, he claims to have superior judgment compared to someone like McCain. What’s missing, however, is how his rejection of Bush’s war reflects a broader position on military and foreign policy. No doubt he is afraid of being labeled “soft”, and this explains his reckless belligerence regarding Pakistan. Yet it would not be very difficult to construct a politically saleable alternative to the shoot’em up philosophy of Bush/McCain.

You’d think he would do better on the economic side. The lessons of the financial mess are straightforward and lend themselves to a reframing of the public role in directing the economy. Still, Obama goes only halfway. He talks repeatedly of the “failed philosophy of the last eight years”, but he says nothing about what the new philosophy should be.

A failure to frame is politically disabling on multiple levels. It cedes too much of the political turf from the outset, and does nothing to predispose the voters to support you. It means that every policy initiative has to start from zero, with no ideological headstart. Above all, it represents an abandonment of the leadership role of politics, the struggle to change the political center of gravity. If one side hammers relentlessly on its frames and the other talks about competence and judgment—well, we know what you get.

There is no evidence at this point that the Democrats are prepared to conduct a political fight in broad daylight to change the direction of this country.

I’ve been thinking mostly about the global portion of the loop—how the dollars we send abroad on the current account (and now, just a bit, on net private capital outflows) are returned to us—and its operation under the Paulson plan. The Fed/Treasury team is proposing to allow this recycling to proceed under an asset cleansing program: the Fed removes the bad assets from our creditors’ portfolios while the Treasury replaces them with nice, reliable T-bills. (Metaphor: TARP as a giant mollusk in the sea of finance.) So far so good.

But this is only part of the picture. The other part is the domestic sector. Our current account deficit says that, as a country, we consume about 6% more than we produce, where “consume” in this context means total demand and not just the household piece of it. So the recycling process has to actually get the money into the hands of those who will spend it. This means credit expansion of some form. To be more specific, capital spending is very weak at present, and households are now holding up the tent. They have been borrowing against largely fictitious real estate equity and, to a lesser extent, running up credit cards and drawing down savings. If the popping of the housing bubble and the retrenchment of consumer credit mean that these channels are no longer available, how do we keep the engines running?

Basically, there are two channels still open: fiscal deficits and further drawdowns of savings. In the case of the former, it is important to be able to identify how the deficits will enter the spending stream. I worry that much of the eleven-figure disbursement will simply keep financial institutions, now highly risk-averse, afloat. This maintains existing wealth for the small minority that holds most of it, but it doesn’t translate into effective demand. And eating up savings can go only so far. Say what you want, the asset bubble(s) promulgated by earlier rounds of recycling at least propped up domestic spending. I worry that, even if the bailout keeps the global loop in operation, it will not be able to reconnect it to the domestic loop. The result will be a monster recession.

In the last several days there has been an emerging consensus among well-informed analysts (like this and this) regarding the Fed/Treasury plan to bail out financial markets. It goes something this: the US financial sector faces a liquidity crisis on top of a solvency crisis. The liquidity part is that financial intermediaries (only some of them banks) are increasingly unable to meet their obligations to depositors and counterparties because they have no access to credit. Highly leveraged, they do not have the resources at hand to carry on their business. If this were the entire problem, the Fed could solve it by offering to buy mortgage-backed securities and similar assets at their actual market value. In that case there would be no bailout, just an infusion of liquidity to tide the markets over.

But there is an underlying solvency crisis: as housing values have declined, assets tied to them are no longer worth the financial obligations institutions have incurred in acquiring them. A large portion of the financial system (no one knows at this point how large this is) has negative net worth. This is why Bernanke has spoken of purchasing assets at their face rather than market value.

There are two gigantic problems with the bailout scheme, in addition to all the smaller ones. First, overpaying banks, investment funds and other financial players to the tune of hundreds of billions of dollars is an ethical and moral hazard nightmare. These people have made obscene fortunes in wild speculation; now that their bets have gone sour is it the public’s duty to cover their losses? Second, it is not even clear that the strategy will work. We don’t know how much it will take to bring the financial sector back to life, partly due to the lack of transparency that helped get us into this mess in the first place, and also to the understandable reluctance of firms to mark down all the paper that has declined in value. It may well be that between one and two trillion dollars will be needed to get the markets back on their feet, and this may exceed the financial and political resources of the federal government.

A big improvement (championed by Paul Krugman) would a buyout of the firms rather than the assets, even as an option as formulated in the Dodd proposal. Still, and especially in light of the difficulty in disentangling viable portfolios from moribund ones, the cost may be too great. It would be nice to have something completely different on the table. So read on: here is a Plan B, an alternative to bailouts that might restore a functioning credit mechanism to the US economy.

The concept: The existing approach tries to bring existing institutions out of insolvency and credit gridlock. Plan B allows these institutions to go belly up but rapidly creates a parallel financial mechanism to rescue sound assets from the rubble while offering credit to new borrowers. Rather than providing a public prop, it provides a public alternative.

The plan: Create a new publicly-financed, publicly-run enterprise; for the purposes of this description we can call it Fund US. Its initial capitalization would be provided by a Treasury issue. The amount could well be much less than the $700B (or $1.4 trillion in borrowing authority) that headlines the existing plan. This is because the fund would be permitted to leverage up to some reasonable ceiling—say six-to-one. So give it $300B as an initial allocation.

One initial function of Fund US would be to open a window for the purchase of existing financial assets at fair market value. This is not necessarily the same as the value of the moment, since, by its size relative to the markets as a whole, Fund US would be a price-maker. One possibility would be to honor prices as of September 15, before any general public plan was broached. Another, specifically for MBS’s, would be to use an algorithm based on a decline of the Case-Schiller Index to long run trend. Either way, this would protect the genuine value of financial wealth tied to housing from the cascade of defaults likely to sweep through the private sector.

The other main function would be to serve as an all-purpose financial intermediary to the US economy and to foreign interests that do business here. It would underwrite existing loans or other contracts, originate new credit and assemble a portfolio of financial assets in a manner consistent with prudent management. On the liability side, it would accept deposits and sell instruments like mutual funds and secondary debt. In other words, it would do what the current system does, subject to greater constraint.

What could assure this constraint? Here are some ideas: (1) The limit on leverage would be statutory. (2) Full transparency could be written into the legislation authorizing Fund US. All assets and liabilities would be publicly reported and all terms made explicit. (Small borrowers and lenders could have their individual identities protected for privacy purposes.) (3) There could be systems of oversight and undersight. The first would be provided by an outside board of disinterested specialists, primarily academics in the fields of accounting and finance. For the second, we might have front-line employees, who analyze and perform individual transactions, constitute themselves into a review body. This entity could give frequent public assessments of the quality of the Fund’s activities and their adherence to overall policy objectives—institutionalized, routinized whistle-blowing capacity. (4) All employees of the Fund, top to bottom, should be paid fixed salaries—no commissions or bonuses. (5) The Fund’s goals should be to maintain the value of public equity, minimize aggregate risk and have the capacity to supply credit sufficient to meet the needs of the economy. Profit maximization, returns in excess of what is necessary to supply a net worth buffer, would not be a goal.

Of course, one paragraph cannot possible provide sufficient detail to demonstrate that such an institution is feasible. On the other hand, how many paragraphs do we have at this point for the mega-bailout?

Two additional elements of Plan B are required to complete this brief sketch. First, Fund US would not be a chartered monopoly. Any financial institutions that survive the ongoing shakeout can compete against it, as can startups. Indeed, because of its lack of incentive for aggressive marketing on both sides of the ledger, it may eventually evolve toward being a financial intermediary of last resort. This would be fine. Second, for competition in this market to be constructive, new regulation must be extended to all players along the lines currently being discussed. In particular, limits on leverage and transparency requirements should apply to all intermediaries, whatever their institutional morphology.

I will not make any great claims for Plan B. Its details require much more working out. There is also a valid concern that it may not be possible to get a massive new institution up and running before existing credit channels freeze up. It would have been much better to have developed a public fund slowly and carefully during the pre-crisis phase, but who was thinking this far ahead? I am less bothered by the ideological objection to a public institution taking on the functions of private firms and competing with them. To take one example, more than half of all the assets in the German banking system are in public and cooperative banks. Germany isn’t utopia (and one of its state banks was mauled because it indulged in dubious US assets), but it is, along with China, the world’s leading industrial exporter. It runs a huge trade surplus with the US, largely due to the strength of its small and medium-size enterprises. Small firms in Germany are global players because they have the same access to capital as big ones, something that can’t be said for the US. This is not to say that we should copy the German template, just that there is no reason to assume that public financial institutions can’t support a successful modern economy.

Plan B is offered to you as a stimulus to creative thinking about the current imbroglio. I would be interested to find out if it can withstand scrutiny.

According to today’s New York Times, it’s the beleaguered US taxpayer. In fact, the word “taxpayer” appears five times in their report on Fed/Treasury actions, always in connection with where the burden will fall. But this is flatly wrong.

In case my previous post was too oblique, let me say it bluntly: Taxpayers are not and will not be the ones to finance the bailout of the financial sector. There will be no tax increase to pay for it, nor will there be drastic (eleven-figure) cuts in other federal spending. It will be financed by substantially greater public borrowing from sovereign creditors, especially the People’s Bank of China and the various entities of the Gulf Cooperation Council. (Russia is an uncertainty in light of its own financial crisis.) The feasibility of the bailout depends entirely on the continued willingness of these deeply authoritarian countries to continue recycling their mountainous piles of dollars into dollar-denominated assets—formerly including private sector debt but now public debt exclusively.

In the absence of this external support, no bailout plan is remotely possible.

A question I sometimes ask my intro macro students is, could the Fed, if it wished, conduct open market operations by buying (and later perhaps selling) famous paintings, rock memorabilia, etc.? This tests their understanding of the concept: any asset can be used to inject or absorb liquidity. Little did I suspect that the asset in question might be vast swaths of suburban tract housing. But the recent announcement that the Fed’s acquisition of junk mortgages would be partly financed by $100B in new Treasury issues indicates that the bailout is being insulated as far as possible from monetary policy.

But this is interesting from the standpoint of global capital flows too. Many of the investments of the last few years, like Chinese purchases of Fannie and Freddie stuff and Gulf capitalizations of US banks and shadow banks, aren’t looking very good right now. All indications, in fact, are that sovereign funds are rebalancing as fast as they can away from anything that bears the slightest whiff of the US housing market. But where can they go and still stay in dollars? Answer: the Fed can buy up the tainted assets our creditors no longer want to hold, financed by new Treasury bonds, financed by these same creditors. The creditors are happy (or at least placated) by being able to shift away from risk, the capital inflows needed to finance the US external deficit keep flowing, and enough domestic credit market players are refloated to keep the debt game going a while longer. In theory the Fed/Treasury risk laundering scheme could be extended to new classes of debt, like consumer credit and corporate paper, as their quality deteriorates. The longer it continues, the longer US employment and income can be buoyed up by borrowing, giving the macroeconomy a semblance of stability. I’m getting the feeling, however, that this is an endgame scenario, not a new financial equilibrium.

Reports out of Minneapolis, combined with memories of New York during the 2004 Republican convention, make it clear that police across the country are adopting a new tactic to suppress demonstrations: they conduct mass arrests of as many demonstrators as they can, remove them from the action, then drop the charges. No doubt they are acting on studies that show that this is a cost-effective way of limiting protest activity, but it is also a clear violation of civil rights. A quick and dirty economic analysis suggests a possible solution.

False arrest has always been a problem, but an important countervailing factor has been the sheer cost of imprisonment and trial. The individual cop does not bear this cost, but the political jurisdiction does, and this gives them at least some incentive to reign in the most egregious miscreants on the police force. It would be far too optimistic to say that this incentive is strong enough to enforce a respect for civil liberties all on its own, but it probably leads to less infringement than we would otherwise have. The great Wobbly free speech fights of the pre-WWI era, in which an army of activists would descend on a town in order to get themselves arrested for the horrible crime of speaking freely in public places, were based on this cost. A town would find that granting freedom of speech, compared to the cost of confining and trying dozens or hundreds of IWW activists, was the “lesser evil”.

No such incentive operates against the tactic of mass arrest, followed by dismissal of charges. For the hundreds, including several journalists, herded onto a bridge in Minneapolis by riot police, handcuffed, led away, held and then released (too late for them to participate in the planned demonstration timed to coincide with McCain’s acceptance speech), the only incremental cost to the city was the plastic hand-ties. Next time they could go green and make them out of potato starch so they can be composted.

The point is that there needs to be a real cost. And in human terms, of course, there is a cost, the inconvenience and denial of rights experienced by those who are rounded up. Hence my proposal: those who care about this issue should promote a policy of financial compensation for any citizen who is arrested and then released without charges being filed. It is government’s way of saying, sorry for hassle—we made a mistake and will reimburse you for it. Suppose the amount were $100. This would have an insignificant effect on local budgets as long as the false arrests were occasional, honest mistakes. But if the police deliberately detain 500 citizens without cause they are exposing the taxpayers to an extra $50,000 payout. This might be enough to nip this tactic in the bud; if not there is always the possibility of giving the compensation an upward nudge.

This is an entirely feasible reform, as far as I can see. It has an obvious fairness value in situations where individuals are unfairly detained. And it would have minimal effect on local finances unless the tactic of mass false arrest is being contemplated.

My institution, beloved Evergreen with its moss-covered halls, is eager to be greener than green. Like many of its ilk, it especially wants to be able to say that its operations are carbon neutral. Since there is no way that its footprint (either production or consumption based) can go to zero, this means offsets. In preparation for a meeting on this topic, I’ve been thinking about what it means for an enterprise to achieve neutrality, and I’d like to float some of these ruminations.

1. Evergreen is different from most other colleges or companies in that it maintains a large forest. Each year our trees get bigger and more organic matter gets built into the soil, so that represents a big plus in the carbon ledger. From a simple accounting standpoint there can be no dispute. Nevertheless, what does it mean for an entity (like Evergreen) to operate two divisions, so to speak, a working college and an intact forest? Does this mean that we have a license to spew more carbon in our educational operations than we would if we deeded the forest to a land trust? Perhaps the problem lies in the rather arbitrary goal of carbon neutrality. If you will be fixing a certain amount of carbon in one branch of your operations, it may mean that your proper goal overall is a corresponding degree of carbon negativity.

2. And even in the absence of a forest, what is the magic of neutrality? From an economic point of view, the goal should be to maximize the value added (broadly defined) per unit of carbon. This involves reducing the footprint for a given level of services, maybe more services for a given footprint, maybe a better mix of services from a carbon standpoint that will do both. But looking only at the footprint side misses the point. (1) Some services are worth having even if they are relatively, and unavoidably, carbon-intensive. (2) In an ideal world, some institutions would end up having higher footprints than others, with the goal of equalizing net social benefits per ton of carbon. Specifically, it may be (and as an academic I am dogmatically convinced that) a college does more good than almost any other type of organization in society. In that case, it may well be wrong for a college to crimp its services in the pursuit of carbon savings; other savings elsewhere (like hedge funds) are more crimpable. Even more specifically (and with even more self-interest on my part), what about faculty travel to conferences? Very bad, carbonically, but think of the immense social benefit that comes from the networks we geniuses establish among ourselves. Better that, oh, sales reps for academic software companies stay at home and do their pitching via remote teleconferencing.

3. Then there is vexing issue of buying carbon offsets. I’m on record as saying that, in a voluntary environment like the one we have now, offsets are OK, but once we have a mandatory carbon cap they should be seen as a hole in the bucket. I will stand by that, but what happens when you adopt the goal of carbon neutrality? The fact is, if an organization takes neutrality as its mission, it really does trade off its own emission reductions against the purchase of offsets. Since offsets are unreliable (additivity problems, principle-agent problems), how should they be discounted in carbon calculations? I still think that, all else equal, it is peachy to purchase an offset, but if the price includes not taking some other beneficial action that was available, all else is not equal and all bets are off. So, if you can reduce air travel but you don’t because you’ve bought some offsets instead, if the offsets don’t do what they promise you don’t meet your goals. Once again, I think the root problem is the assumption that neutrality is a magic point on the carbon meter, and that reductions above or below that level (as opposed to getting to it) are of second-order significance. If you drop that and view all reductions as intrinsically good (leaving aside costs), the notion of a tradeoff between reducing your own emissions and buying offsets vanishes. And that’s how it should be. The goal should be calibrated to what an institution can accomplish. If you have the possibility to significantly cut your carbon footprint you should try to do that. If you have a good financial mechanism for purchasing offsets, do that too. Good is good.

4. We are (or maybe only I am) getting tied into knots over nothing. At the moment we are in a strange situation: most of the public recognizes the necessity of combating climate change and there is near-consensus at institutions like Evergreen that we have to begin taking action now. Meanwhile, the federal government is in the hands of what can only be described as a hydrocarbon cult, determined to thwart any threat to their beloved industry. This can’t continue much longer, and I’m convinced it won’t. Not only do both major presidential candidates back a mandatory carbon cap, the corporate sector seems to be on board too. (They will do whatever it takes to minimize their own financial exposure, but that’s a different story.) Chances are, in a year we will have legislation that puts a limit on greenhouse gas emissions and drives the price of carbon fuels way up. Then the big challenge facing everyone will be how to cope with it. Places like Evergreen won’t need a carbon neutrality task force; they will be forced to dramatically curtail their footprint just like everyone else. Students who now commute by car won’t be able to afford it any more, so you have to find other commuting and housing options for them or you lose your students. Heating bills will explode, so you have to find ways to use less fuel for heating. And yes, faculty travel to distant conferences will become a lot more expensive, so solutions will have to be found there too. Repeat: instead of wracking our brains about how to calculate our carbon footprint, we will be struggling to control costs. This will lead us to reduce our footprint whether we want to or not, which is the point of the legislation. Maybe, just maybe the institutions that take action today to reduce carbon emissions will be better positioned to survive the coming cap, but that will be because they have taken action on their own operations, not because they bought a thick portfolio of offsets.

So the bottom line is that, in voluntary carbon policy, as in most other aspects of this issue, we are losing valuable time by asking the wrong questions. There are ultimately only two questions that make sense for us individually and collectively: how can we get a fair, effective, rational climate policy pronto, and how can we cope with it once we have it? If Evergreen has a few grand to invest in offsets, I’d rather see it put the money into political action for better policy. And rather than pulling me into a task force to measure our carbon footprint operation by operation, I’d like them to enlist me and anyone else they can corral into an effort to forecast the impact that national policy will have on us so we can start preparing today.

My apologies for going middlebrow, but that’s my take on the new Woody Allen movie, “Vicky Christina Barcelona”. PC almost pulls it out. Since this is an economics blog, I’d like to ask, has anyone else noticed that the money just seems to be there in Woodyland? People have jobs mainly as a source of identity, but in fact they just pass Go every now and then, and their bank accounts are recharged so they can enjoy the comfortable life without worrying about how much it costs. Only in this magical world would a woman’s choice between a young Wall St. go-getter and a “bohemian” artist have no financial implications.

In general, I’m not reassured that the Republicans have put a Christian fundamentalist on their national ticket. Sarah Palin holds beliefs about such matters as creationism and God’s will (Jesus pays close attention to natural gas pipelines) that make me cringe. But I would suppress all that if she would make the connection between biblical teachings (Leviticus, chapter 25, various verses) and disorder in financial markets.

The passages I’m thinking of describe a jubilee which is to take place on the fiftieth year; all debts are foregiven, property (particularly in humans, as was common back then) redistributed, and liberty proclaimed. From a narrow economic point of view, periodic dissolution of debt claims has the virtue of avoiding the sort of overly leveraged, and therefore highly fragile, financial structure that is a recurrent threat to prosperity. This is the one “thou shalt” that we really should.

Incidentally, I think that in this, as in other matters, we should prefer a loose reading of scripture. If the jubilee were entirely predictable in its fifty year rotation, the credit mechanism would collapse as the big event approached: who would lend if there were a certain date on which a universal default was scheduled? But maybe Einstein was wrong and God really does throw dice. In that case, we could interpret Leviticus as advising us to establish a stochastic jubilee, such that in each year there would be a 2% chance of its occurrence. This could be done by picking an envelope out of a drum on nationwide TV. (Imagine the ratings: you could take in a lot of revenue just by selling the advertising.) The downside is that an extra 2% risk premium would be attached to all loans, but we could learn to live with it.

So why is it that those who proclaim their belief in every word of the bible conveniently forget its most far-reaching economic proposal?