Keynesian "Depression Economics" Does Not Apply to the Eurozone

I'm swamped with real work, but I have more posts on austerity politics planned. Anyway, to keep the lights on around here I thought I'd ask a simple question with (I think) a simple answer. First the set-up, then a factual observation, then the question:

The standard Keynesian case appears to be that policy blunders around the world are the result of a mistaken belief in expansionary austerity. The eurozone crisis is often provided as the exemplary case, which it would have to be because the rest of the world economy is doing more or less okay. The Keynesian case against fiscal consolidation is that it is contractionary, not expansionary, when monetary policy is at the zero lower bound (meaning interest rates are zero). That's when you get the liquidity trap, paradox of thrift, and all the rest of it. If you're not at the zero lower bound then the whole case evaporates, and what drives macroeconomic outcomes is monetary policy, not fiscal policy. If you're not at the zero lower bound then fiscal consolidation is "appropriate" (neutral actually) since it can be offset by monetary policy, although there will be distributional consequences. 

But the European Central Bank is not at the zero lower bound. In nominal terms it literally is not. Interest rates are not at zero. In fact, the ECB raised rates as the euro crisis worsened, and have since then held them steady. Quantitative easing programs have been "sterilized" by the ECB, which has taken pride in so doing. (I quote them on it in a forthcoming paper, about which more later.) All of the evidence which supports being in a liquidity trap -- sovereign yield at zero or even negative real rates, etc. -- at best only asymmetrically applies to the eurozone.

None of this is news, but so much eurozone commentary doesn't start from the position that the story is monetary rather than fiscal. So all this commentary ignores the fact that the entire Keynesian "depression economics" structure, which takes as a precondition the presence of a liquidity trap, does not apply to the eurozone crisis. Not one bit. The entire problem is monetary rather than fiscal, according to Keynesian economics. Belief or non-belief in expansionary austerity is a total non-issue.

So here's the question: why aren't we all talking about the distributional monetary politics within the eurozone rather than debating this or that fiscal policy?

Time to Update the Priors: Not All Policies Matter for All Outcomes

In response to my previous post Mark Thoma and I had a bit of a roundabout on Twitter. His first point is that he wasn't addressing our article in his blog post. I mentioned in my post that that was obviously the case, even though he quoted Farrell's summary of it before launching his discussion on unrelated topics. But through the Twitter discussion several interesting topics were raised. Thoma asked me two main questions:

1. Is it your argument that peripheral crises can never lead to systemic crises?

2. Is your answer to #1 completely independent of crisis response policies?

My response to #1 is that the likelihood is exceedingly low. I base that on the fact that not a single peripheral crisis* from 1970-present (using the IMF's database) has turned into a systemic crisis. Obviously crisis management policies have varied quite a lot, but the global (i.e. systemic) outcome has not.

That leads me to believe that policy considerations are not very important from the perspective of preventing systemic contagion from peripheral crises. In peripheral crises, policy matters a lot locally -- i.e. for the peripheral country experiencing the crisis and maybe one or two others connected to it -- but not systemically. In systemic crises, policy in the core matters a lot globally; policy in the periphery matters less**.

Thoma disagreed. Obviously that's fine, but I'd like to explain why I think he's wrong. Since I've heard others make it in plenty of other contexts, I thought I'd make the point here. These Tweets of his seems to sum up his view, which I believe is a common view:

@whinecough @dandrezner So if ridiculous policy enacted, you wouldn't worry (see first proposal)? Glad policymakers didn't share that view.
— Mark Thoma (@MarkThoma) March 26, 2013

@whinecough @dandrezner You're right. I can't prove what would have happened under an alternative policy. But not willing to risk it.
— Mark Thoma (@MarkThoma) March 26, 2013

@whinecough @dandrezner Again, this is a very simple question.Either policy in Cyprus could have mattered, or not. We disagree on the answer
— Mark Thoma (@MarkThoma) March 26, 2013

We went around like that for awhile. So here's my position: if policy mattered for global outcomes things would likely be much more worse right now than they are. Why? Because the Cyprus deal is basically the worst possible policy from the perspective of preventing contagion. Cyprus has been hacked off from the global financial system. Capital controls are in force. Its entire banking system has been closed for two weeks, its second-largest bank will be closed permanently, and its largest bank will be forcibly restructured. Foreign depositors, bondholders, and shareholders are being gutted.

If you were trying to start a systemic crisis, this is the way you would do it: repudiate a huge chunk of claims, and close the capital account. And yet markets around the world are up today. Even in Russia.

Or take the examples of Iceland and Ireland. Iceland repudiated the debt of its banks, imposed capital controls, and told international investors to take a hike. Once again, this is a recipe for contagion yet systemic crisis did not result. Ireland did the opposite: it guaranteed the debt of its banks, did not institute capital controls, and paid off international investors. Systemic crisis also did not result. The opposite local policy response produced the same global outcome. Only the local outcome varied.

Contrast those cases (and all the other eurozone cases, and Argentina, and E Asia, and etc.) with the US in the Fall of 2008. A couple days of dithering -- of the sort that the eurozone has made its speciality -- lead to an immediate and profound downturn in global markets, including the largest single-day evaporation of wealth in absolute terms in history. The US tried to kick the can down the road, but couldn't because it is the core node; the EU has been able to repeatedly kick the can down the road because those crises are in the periphery.

I conclude from this that policy always matters locally, but it only matters systemically when the crisis is in a core node. No matter what the policy response to peripheral crises is, systemic contagion is exceedingly unlikely. I am prepared to hear arguments counter to this, but they must go beyond assertion or "I'd rather not chance it". Evidence is preferable, but I'd even countenance an evidence-free logical argument with a clear causal mechanism. These are every bit as rare as the claim that systemic outcomes depend upon local policies is common.

*Note that we're making it hard on ourselves by calling essentially every country but the US and UK "peripheral". This is not a common view (or was not prior to the crisis). Many thought that Iceland, Ireland, Cyprus, and other tax havens were significant global financial centers (or rapidly becoming so).  We're not talking about Somalia here... we're talking about OECD countries. Yes, we realize this is a bold claim. We think we have evidence and argument to support it.

**Remember that Spain was winning awards for prudential regulation a couple of years before the crisis. Ireland was held up as a model too. In the end that didn't help them.

All Networks Are Not Equal (and Financial Crises Are Not Viruses)

Many thanks to Henry Farrell for discussing some research co-written by a decent chunk of this blog's contributors, which was just released (and is currently ungated, thanks!) by Perspectives on Politics as part of an issue on inequality and the global financial crisis. It's been kicked around the internet a bit already, and already I've come across a major misinterpretation* of the central argument from Mark Thoma:

Are highly interconnected networks better at dispersing risk? It depends upon the type of risk. Suppose a toxin hits a network. If diluting the toxin across the network also dilutes its effects to practically nothing, then we want the network to be as large and interconnected as possible. When shocks hit they will be quickly diluted and rendered relatively harmless. But for toxins that are deadly in minute doses, toxins that kill whatever they touch even when they are highly diluted, we want the infected node on the network to be isolated as much as possible.

This is, we believe, the dominant view of financial contagion in the social sciences and in particular in international economics. In the paper we cite several different formulations of this view in the academic and policy literatures. If we reiterated this view it would not be noteworthy, and it probably would not be publishable. We think our article is noteworthy (and was published) because it argues that this conceptualization of risk in networks is fundamentally misguided: it places undue focus on the strength of the shock and the density of the network, rather than the location of the shock and the topology of the network.

To see the difference consider two shocks of equal strength which hit two networks of equal density. The only difference in the two networks is in the distribution of that density: in one of the networks the connections are distributed more or less equally -- most nodes in the network have about the same number of connections to other nodes -- but in the other network the connections are distributed very unequally -- a few nodes have a lot of connections, while most nodes have few.

We believe that we should expect very different outcomes from the same shock and the same overall density because of different distributions of connections. All networks are not equal. Outcomes do not just depend on the strength of the toxin, but whom it contaminates.

We show empirically that different crises have have different impacts on the global system: crises originating in the US have adverse consequences throughout the entire network, while crises that hit other places do not. We show empirically that the global financial network is highly unequal: it is centered around the US (as Farrell notes in the bit Thoma quotes). And we argue that it is this variation in the distribution of connections, which we call "topology",  which made the subprime crisis so severe from a global (i.e. "systemic") perspective. Or, as Farrell put it in his useful discussion:

Oatley et al. argue that you get two kinds of financial crisis in this kind of world. First, you get financial crises in the periphery, which tend to be limited to a particular region because few other countries are directly exposed to the countries undergoing crisis, and to fizzle out. Here, US dominance serves as a dampener – since it is large enough to absorb shocks itself, it can prevent financial contagion from spreading. In contrast, when a crisis occurs within the US, it tends to spread everywhere, since every other country is heavily linked to the US. When US mortgage markets sneeze, everyone catches cold.

I'd say that when the US sneezes everyone catches pneumonia. So in our view the question isn't whether the toxin is "diluted"*. Nor is it whether a denser network might be more or less capable of absorbing a shock. In our view the performance of the system in the face of a shock depends on the structural properties of the system, such as its topology, and the location of the shock within that structure: if it hits the periphery, the impact is narrow and remains in the periphery; if it hits the core, the impact is broad and emanates throughout the system.

This may seem obvious. We believe it is obvious, after you've read the article. Before you've read it (as Thoma obviously has not) you may end up writing things like this (as Thoma has):

We have been told that problems in places like Cyprus have been walled off -- nodes in the network have been isolated -- but so long as a few isolated connections still exist that are difficult to cut, highly toxic shocks can pollute the rest of the network. In addition, as we saw today when "Jeroen Dijsselbloem, the current head of the Eurogroup, held a formal, on-the-record joint interview with Reuters and the FT today, saying that the messy and chaotic Cyprus solution is a model for future bailouts" and financial markets reacted negatively (the statement is being walked back), some connections -- those involving expectations -- cannot be severed in any case.

Highly interconnected networks are highly desirable so long as (1) we can quickly identify trouble, and (2) nodes can be quickly and effectively isolated. But when those conditions are not present, the occasional highly toxic shock will cause quite a bit of damage.

Despite being the conventional view (here's another example, also from yesterday) we think this is totally wrong. We think that the ongoing collapse in Cyprus is unlikely to have a major effect on the global economy, just as the collapses in Iceland and Ireland did not have a major effect on the global economy: the effects were devastating for those economies, and had some impact on the few countries which were strongly tied to them (mostly regional partners), but did not advance outside of that. Indeed, as the eurozone crisis has deepened over the past few years, the world economy has gone from recession to growth and global financial markets have posted strong gains (esp in the West; less in the "Rest").

We don't think this is a coincidence. We don't think we have just gotten lucky. We don't think that we were saved by wise and prudential crisis management (does anyone?). We think crises in peripheral nodes are very unlikely to spread to the core of the system because of the structural properties of complex networks. We think, in other words, that the global financial network is not some abstract quantity, but something that can be modeled and understood.

Thoma says that markets "reacted negatively" yesterday. The S&P was off 0.33% yesterday -- a totally normal fluctuation -- after increasing by 4.3% over the past month, during which time the botched Italian election and worsening situation in Cyprus were supposed to send financial markets into turmoil. As I write this, European markets are up today.

So financial turmoil from Cyprus hasn't happened yet, just as it didn't happen last summer when the Greek crisis flared up. We wrote about that too, and said the same thing then as we're saying now, just as many economists and pundits argued then that we may be on the brink of doom just as they are now. We were right then and we're right now. Greece has defaulted at least twice since last May, yet the global economy hardly even notices. The Cypriot financial sector has essentially disappeared overnight (from a network perspective the links connecting that node have been effectively severed) and financial markets are up.

I'm being pedantic about this because the message doesn't seem to get across. The belief that a crisis anywhere can lead to a crisis everywhere is so ingrained that very intelligent people don't even recognize contradictory arguments with supporting evidence when they are quite literally staring them directly in the face, as Farrell's precis of our research (and link to the article) was peering through the monitor right into Thoma's cornea.

So I'm afraid I might have to be boring on this point until folks start internalizing it: all networks are not equal.

*Thoma doesn't explicitly assign this view to us, but he quotes part of Farrell's summary of our article -- which says something different from what Thoma says -- and then goes on to the bit I quite as if we were making the a similar case.

**In fact, we refrain from discussing viral contagion at all, as we believe it is not an appropriate analogy for financial contagion. We spent a bit of time discussing this in a previous draft, but as it was somewhat tangential to our main argument we eliminated it in the final version for reasons of space. The general point is that a virus can infect anyone it comes into contact with regardless of who that person is: a king is no less vulnerable than a peasant. Our argument is that not all financial crises are capable of infecting all nodes with which they come into contact. Most crises are not contagious at all, in fact. Our theory provides an explanation for that. But the virus language was referenced by both Farrell and Thoma, so I'll run with it for the purposes of this post.

Against the "Evil Rapacious Bankers Wut Did It" View of Financial Crises

Gillian Tett:

For if you look at the personal financial decisions of the bankers involved in securitisation in that period – at the very heart of the credit bubble – it seems many believed their own hype. Many of them not only bought large quantities of housing stock at the worst possible moment (ie in 2005 and 2006), but also did so in some of the most “bubbly” markets, such as southern California. They then failed to sell those properties in time – and thus were left nursing losses after 2007. Or to put it another way, the bankers who were repackaging housing loans not only lived by the mortgage sword, but suffered under it too. ...

[The researchers] started by combing through the published lists of bankers who attended the 2006 American Securitisation Forum’s annual conference in Las Vegas and randomly selected 400 mid-level securitisation bankers from organisations such as Citigroup, Lehman Brothers and Wells Fargo. They then cross-referenced the names against publicly available data – extensive in the US – on subsequent real estate transactions and mortgages, and analysed whether those people had been trading properties, and whether they made or lost money.

Next, the three economists repeated a similar exercise for a randomly selected group of 400 lawyers and 400 Wall Street equity analysts who were not involved in housing analysis. The aim was to see whether patterns among those real estate transactions were unique to the housing experts – or just reflected something that all wealthy professionals tended to do.

The results were striking. Before conducting the research, the economists had expected that securitisation experts would be good at judging when to sell properties and how to avoid housing market losses; after all, they were close to the front line of the mortgage industry and supposed to know all about real estate. But in reality, the number-crunching showed “little evidence of securitisation agents’ awareness of a housing bubble and impending crash in their own home transactions”, as the paper says. The supposed experts “neither managed to time the market nor exhibited cautiousness in their home transactions”. Furthermore, they actually suffered bigger losses on housing than the random “control” group of lawyers who were not “experts” on housing at all.

Here is the underlying research. The question I have is whether the top-level executives behaved differently from the mid-level folks. I doubt it, but it's certainly possible.

Austerity Politics: Materialism vs. Ideationalism in the Eurozone

In a series of videos, Mark Blyth discusses the intellectual history of austerity -- the basis for his forthcoming Oxford UP book. Annoyingly, the video is organized as a playlist, so the video switches every ten minutes or so rather than playing through. The talk is well worth an hour's watching nevertheless, and I look forward to reading the book when it comes out in April.

I don't want to take too much away from him, but I have a few problems with in Blyth's analysis of current events. When he talks about the eurozone crisis he diagnosis it correctly: in a currency union, if everyone devalues internally then recession will continue; in a currency union, devaluation externally is impossible; the only other option is default. Where Blyth goes wrong is when he says that austerity is a choice, even under these conditions. Here I disagree for reasons I outlined in a previous post (see also the follow-up: "There Will Be Austerity"). Any of default, internal devaluation, and external devaluation is a form of austerity. What form is chosen is a political question. Each of these imposes costs on a different groups of people, so the political battle is of a distributional nature. Blyth insists (sometimes) that this is not the case, that austerity is the result of a cognitive or ideological blunder, and expresses a preference for a policy which is not politically feasible, nor normatively desirable (at least for much of the eurozone): turn the ECB into a "bad bank", and load it up with all of the underperforming assets being carried by eurozone banks.* While this would be great for some eurozone countries, it would be horrible for others. Which is why I think this political question is ultimately of a distributional, rather than ideational, nature.

In a another, somewhat similar way I think Blyth contradicts himself about the causes of the eurozone mess. On the one hand, he maintains that the root cause is profligacy on the part of the eurozone banks: they loaded up on too much sovereign debt from the europeriphery, as evidenced by declining interest rate spreads among the eurozone members. On the other hand, Blyth argues that the sovereigns themselves were not profligate; with the exception of Greece, they were all fiscally sound before the crisis and bailouts. But both cannot be true. If the euro sovereigns did not issue massive quantities of bonds, then there would not be massive quantities of sovereign bonds for banks to buy, in which case the banks would not be in any trouble at all.

This is an important point for him, because he claims that the eurozone crisis (and the US crisis) is the "greatest bait-and-switch in human history". Specifically, he claims that private obligations -- incurred by banks -- became public obligations -- via bailouts -- and now governments are the ones being chastised for fiscal profligacy and the public is having to pay through austerity policies. While not entirely false, this account needs more than he gives it. The story he's telling goes like this: Sovereign debt becomes bank assets, which then become sovereign liabilities again once the sovereigns begin to have trouble servicing they debt, which pushes the banks into insolvency, thus necessitating a bail out. But if this is not the fault of sovereigns then there must be a missing step somewhere. Otherwise I'm not sure where the "bait-and-switch" comes in. I think he can fairly easily square this circle by reference to capital inflows from the eurocore to the europeriphery which fed real estate booms, as well as European appetite for U.S. asset-backed securities. But then he can't explain the convergence in European sovereign borrowing costs so simply.

In the Q&A someone asks Blyth how he defines "austerity". I perked up at this point, because I've written about the slipperiness of definitions of austerity before. His answer, I think, leaves something to be desired. Blyth answers that to him "austerity" is not a combination of any particular policies, but rather a belief in the supposed expansionary properties of fiscal consolidation. Krugman also talks about the problems with "expansionary austerity" a lot, but it seems to me that this contradicts Blyth's own narrative about the ideological history of austerity. As Blyth tells it, austerity has traditionally been viewed (by Schumpeter and others) as the "purge" which must follow the "binge". It is the necessary hangover after the party. Well, such analogies provide no indication that austerity will be expansionary; quite the opposite. It is called "austerity" after all, not "luxury".

At times, Blyth conflates the "expansionary austerity" argument with the "Treasury View" (and earlier versions such as Ricardian equivalence). This is incorrect. The Treasury View -- which largely prompted Keynes' General Theory, as a retort -- is that government spending would "crowd out" spending in the private sector, so the effect of public spending would be neutral (or negligible), not expansionary.

Later, Blyth tries to make the case that shift from Schumpeterian "hangover" austerity to "expansionary" austerity occurred in the Bocconi school of economics in Milan, and was given full voice by Alberto Alesina.** So far as I can tell, this entire school of thought consists of a mere handful of academic papers authored by an even smaller number of economists (see lit review in this paper), the most significant of which (Alesina's) was published in 2010, well after austerity politics had begun in Europe and the U.S. Does Blyth seriously think that the German Finance Ministry, or U.S. Federal Reserve Board of Governors, are primarily influenced by these somewhat-marginal Italian economists rather than more traditional, distributional, political economy concerns? If so, he needs to do more to make case. Perhaps it's in the book, but as I've written before claims of expansionary austerity are mostly attacking a straw man.

These qualms aside, as intellectual history Blyth's talk is excellent and I expect his book will be outstanding as well. I've been waiting for it for what seems like years now, and I'll be happy to get my hands on a copy.

*Note that I think this is possible, and perhaps normatively desirable, but only if the legal standing and conceptual nature of the ECB changes in fundamental ways. As many have noted, this would transform the ECB into a quasi-dictatorial body with nearly no democratic oversight. Perhaps this is itself desirable to some, but there are major downsides to such a policy choice even assuming that the ECB chooses to behave as Blyth seems to think it will. As such, I see no clear sign that it will happen the way Blyth wants it to happen in the near term. Also note that Blyth says that the U.S.'s TARP was an analogous policy. It wasn't. TARP was administered by the Treasury, not the central bank, and was therefore the sort of private-obligation-into-public-obligation program that Blyth decries as a "bait and switch". The TALF program, which was administered by the Fed, supported new issuance of asset-backed securities (with the securities as collateral) as a means of unfreezing credit markets during the winter of 2008-9. The Fed bought some "toxic assets" as part of PPIP, but these later turned into billions in profit. The Fed is not now, nor has it ever been, a "bad bank".

**Alesina did do his undergraduate degree in economics at Bocconi, but he did his PhD at Harvard and has been on Harvard's faculty for almost his entire career. At one point he was the department chair. I.e., Alesina's saltwater credentials are intact. For the record, here are Alesina's current views on the effects of austerity on growth. The short answer? It depends. The longer answer? Austerity via tax increases harms economic growth, while austerity via spending cuts has a neutral effect. Nowhere does he say that austerity of any sort will be expansionary. So it is probably better to put Alesina in the "Treasury View" camp, at least as it relates to spending cuts, rather than the "expansionary austerity" camp. In which case, Blyth may need a better definition.

Who, Exactly, Is Getting Away With What, Exactly? And Why?

In an recent article in the NY Review of Books, Paul Krugman and Robin Wells review three recent books that attempt to diagnose just how American political economy got so screwed up after 2008*. Noam Scheiber blames Obama's choices of economic advisors, and in particular the reliance on acolytes of the Rubin-Summers faction of Clinton administration vets who have a predilection towards getting into bed with Wall Street. Next comes Thomas Frank, demonstrating yet again that he understands nothing about American politics or political history (and in particular the politics and political history of the American right wing). Frank claims to have observed "something unique in the history of American social movements: a mass conversion to free-market theory as a response to hard times" that is buttressed by hermitically-sealed stupidity. If this is indeed a first then what exactly was "morning in America" all about? And how to explain the rise of right-wing parties throughout the industrialized (and industrializing) world since 2008, much less the landslide victory of Obama in the 2008 election? Thomas Edsal's thesis -- which Krugman and Wells reject as incorrect on its face -- is that America does not have enough resources to accommodate conflicting social goals, which has led to in uptick in partisanship.

So we have three theories: Scheiber's leadership failure cum rent-capture critique, Frank's vast right-wing conspiracy cum ignorance critique, and Edsall's scarcity leads to nasty politics critique. While showing signs of sympathy for all three, particularly the first two, Krugman and Wells end up with their own conclusion:

But ultimately the deep problem isn’t about personalities or individual leadership, it’s about the nation as a whole. Something has gone very wrong with America, not just its economy, but its ability to function as a democratic nation. And it’s hard to see when or how that wrongness will get fixed.

Let's leave (mostly) aside that this political narrative is opposite in emphasis of the tale Krugman was telling a year ago (cf) -- then it was about personalities and leadership -- and note the defeated tone. While some of Krugman's friends believe that the only way the wrongness will get fixed is through the destruction of the Republican Party (eg), that isn't going to happen so there must be some other way out of the malaise. The problem is that Krugman and Wells seem to have few answers on that score. I believe that is because they don't have a clear conception of politics.

Each of these three concluding sentences contains a distinct phrase of dissatisfaction. The first asserts that there is a "deep problem" in American politics; the second identifies that problem as the lack of an "ability to function"; the third summarizes these first two components as culminating in "wrongness". These are vague, even non-descript, but let's try to parse each of them.

Given the context of this essay within their other writings, the "deep problem" would seem to be persistently high unemployment and growing inequality. How do I know that Krugman and Wells think this is the problem? Mostly from the context of their other writings, but in this essay the refer to parallels between today and the 1930s, a period of high unemployment that followed a rise in inequality and significant financial crisis. The cause of these problems would seemingly be both ideational -- capture of elites in government (Congress, the Fed) and the commentariat, as well as much of the public, by right-wing laissez-faire orthodoxy -- and material -- capture of the government  (the Obama administration, the Fed) by Wall Street. Both of these phenomena have been discussed in the political economy literature, of which Krugman and Wells are completely unfamiliar**.  

The next sentence indicates that this problem is not limited to economic outcomes: there is also a political problem, the "(in)ability to function as a democratic nation". It is not at all clear what he means by this. I think he means that democratic nations are supposed to always and everywhere and at all times generate egalitarian outcomes, and pursue policies that maximize some deduced social welfare function that just so happens to map onto Krugman's ideological preferences more or less perfectly. Other than vague intimations that bankers control the country through their puppets in the Obama administration, it's not clear why Krugman thinks that the U.S. doesn't function as a democracy. Because it hasn't generated a particular set of outcomes in a given time and place? What a priori reason do we have to think that this should happen? Why should we think that the U.S.'s version of democracy is somehow superior to other democracies that have similarly depressed economies, e.g. Europe?

The fact is that "democracy" is a catch-all word that describes a host of political institutions which are similar only in that they aggregate the preferences of their citizens through some type of electoral process which is guided (and constrained) by previously established law. "Democracy" is decidedly not
a description of a set of particular outcomes favored by the technocratic center-left, a group of which Krugman is a member. It is even less a description of a political system dedicated to pursuing an Old Keynesian version of technocracy. Given that, it is not completely clear to me that the U.S. has lost its ability to function; conflicting interests, partisanship, gamesmanship, interest group lobbying, rent capture, and vituperative campaigns are all par for this course, not evidence that things have gone horribly awry.

Which leads us to the very end. This "wrongness" -- essentially the existence of distributive interest group politics -- is only a "wrongness" if you expect particular (and exceptional) moments of national unity (such as the bipartisan passage of the Social Security Act that Krugman and Wells reference at the top of the piece) to be the norm. But they are not the norm, and we should not expect them to be. Democratic politics is generally messy, generally contentious, and generally fought along lines demarcated by interests and ideology. Any particular individual -- and in fact all particular individuals -- will be upset with roughly 50% of the political decisions made. This is just how it works. There is no sense in bemoaning this, as it is a fact of life. It is not a "coup", it is not a systemic collapse of everything we hold dear.

It's not clear to me why the NY Review of Books would ask non-political economists to write about political economy. Had they not they not done so, they might have been able to publish an article with a better ending then "We don't like this but we don't know how to fix it."

*By "screwed up" the authors seem to all mean something along the lines of "President Obama only getting to fulfill most of his campaign promises". These being provision of universal health care, no tax increases on those making under $250k/year, an aggressively militaristic anti-terrorism policy, re-regulation of the financial sector at both the domestic and international levels, the repeal of DADT, and increased investment in green technologies. Or by "screwed up" maybe they mean the continuing existence of an opposition party, or the fact that Obama was always insufficiently left. Anyway, Krugman and Wells just take it for granted that something is screwed up, and the impression they leave of the books they review is that the other authors do the same thing. I haven't read any of those books so I can't be sure whether that's a fair characterization or not.


**I can be quite sure of this, having read them both extensively over the years. The closest thing to a political economist to whom Krugman gives credence is Larry Bartels, an American politics scholar who has studied some politics of inequality.  

Agreeing and Disagreeing with Kindleberger (and Delong and Eichengreen)

This post is basically to point to the new preface by Brad DeLong and Barry Eichengreen to Kindleberger's The World In Depression 1929-1939. I'm glad the book is being reprinted, and I am in agreement with all of DeLong & Eichengreen's intro. Except this part:

Kindleberger’s second key lesson, closely related, is the power of contagion. At the centre of The World in Depression is the 1931 financial crisis, arguably the event that turned an already serious recession into the most severe downturn and economic catastrophe of the 20th century. The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial centre, Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver consequences, to London and New York. This is the 20th century’s most dramatic reminder of quickly how financial crises can metastasise almost instantaneously.

I don't think this is "arguable". First things first... Creditanstalt was decidedly not a "relatively minor" institution; as Ben Bernanke has noted it was one of the largest (and most well-connected) banks in Europe. Moreover, it wasn't the first major bank to fail. To give just one example, the Bank of the United States (a private bank located in New York) failed in December, 1930 -- one of the largest bank failures in U.S. history, which occurred months before the collapse of Creditanstalt. Indeed, in his monetary history of the U.S. Milton Friedman considered the collapse of the Bank of the U.S. as the pivotal moment that tipped the U.S. from recession into depression. In general, financial instability in the U.S. seemed to precede financial instability in Europe from 1929 on.

The U.S. and much of Europe was already in depression before the collapse of Creditanstalt. Indeed, chronology suggests that Delong & Eichengreen have causality reversed: the Depression (combined with the fallout from losing WWI, including reparations) caused the collapse of Creditanstalt, not the other way around. U.S. industrial production had fallen by nearly 25% before Creditanstalt's collapse. Farms prices were down by 40%. The financial system was decimated. Trade was collapsing. The signal events occurred in 1929, not 1931. By the latter date we are talking about knock-on effects, not first causes.

My view is not particularly controversial. The collapse of Creditanstalt exacerbated a pre-existing panic, but it did not generate one sui generis.

Contagion is powerful, but it tends to operate from the center outward rather than from the periphery inward.* The best read of the collapse of Creditanstalt is that it was evidence of contagion rather than the epicenter of it.

That said, Kindleberger's book is very good in general, as is the new Delong/Eichengreen intro.

*We've blogged about this before, and we have a piece that will hopefully be forthcoming soon that makes this case explicitly. For a simplistic precis see this Foreign Policy piece that Thomas and I recently placed.

P.S. While thinking about this I stumbled across this piece from a 1952 issue of Time which gets nearly every detail wrong in its first paragraph. For starters: Creditanstalt collapsed in 1931, not 1929; it was not controlled by the Rothschilds until after that collapse; Hitler persecuted the bank during Anschluss for that reason, so it not quite fair to say that the bank "served" Hitler. The rest of the article is blocked to nonsubscribers so I (mercifully) can't read it.

A Financial Story IPE Folks Should Love

Because it reinforces our priors:

Its membership in the euro currency union hanging in the balance, Greece continues to receive billions of euros in emergency assistance from a so-called troika of lenders overseeing its bailout.

But almost none of the money is going to the Greek government to pay for vital public services. Instead, it is flowing directly back into the troika’s pockets. ...

If that seems to make little sense economically, it has a certain logic in the politics of euro-finance. After all, the money dispensed by the troika — the European Central Bank, the International Monetary Fund and the European Commission — comes from European taxpayers, many of whom are increasingly wary of the political disarray that has afflicted Athens and clouded the future of the euro zone.

More here. I have said for awhile now that the story in the eurozone is that the north would keep the south liquid until the north's banks were sufficiently capitalized to handle a default, at which point the money would stop flowing. I thought that would be sometime in 2013 (I think I wrote a post saying that, but can't find it now), but now I think it could be this year.

Why should IPE folks like this story? Because this is the type of tale we tell all the time: "bailout" funds are used to bail out the donor, not the recipient. Just like "aid" funds to the developing world are often tied to certain types of disbursement and are thus a form of subsidy for corporations in the developed world.

There are parallels here (of course) to the Latin American debt crises of the 1980s, where much of the debt was owed to commercial banks in the U.S. The U.S. Treasury pushed for IMF intervention, mostly so U.S. banks could get their money back without the federal government having to officially bail them out. (The story is even more nuanced -- Congress understood what was happening and demanded new regulations of the banking sector, which led to the creation of the first Basel accord -- as Thomas argues here.)

Annals of Silly(?) Policymaking: Procyclical Financial Regulations During a Bank Run Edition

This (via @dandrezer) does not seem smart:

Banks must raise their core tier one capital ratios to 9pc by the end of this month or face the risk of partial nationalisation. The global Basel III rules are also pressuring banks to retrench.  

The International Monetary Fund said banks will have to slash their balance sheets by $2 trillion (£1.6 trillion) by the end of next year even in a "best-case scenario".

That is only within the European Union, and it came about due to panic over Greece last month. Basically, this means that EU banks have to increase their capital cushions by over 200% by the end of this month. What does that mean?

The Bank for International Settlements (BIS) said cross-border loans fell by $799bn (£520bn) in the fourth quarter of 2011, led by a broad retreat from Italy, Spain and the eurozone periphery.

Note that this just in Europe. But it made me wonder (on Twitter): why do this now? After all, it was Germany that insisted on a longer phase-in period for Basel III during negotiations, while the US/UK/Switzerland wanted that stricter capital requirements. Now the EU is doing a rapid phase-in and tougher capital limits years before they are required to by Basel. And they're doing it in the middle of a bank run during a continent-wide recession. What gives? A few things.

1. Banks do have to get to 9% tier 1 capital by the end of the month, but they don't have to come fully into compliance yet. That is, a lot of junk capital that is prohibited by Basel III -- but was allowed under Basels I and II -- will still be allowed. (ht to @Procyclicality for this point)

2. Nevertheless, this is still a big boost to minimum capital standards. So how will banks come into compliance? Two quick and easy ways are to:

a. Hold more cash.

b. Buy more sovereign debt.

The first of these is contractionary -- it's basically hoarding more cash rather than lending it out -- although the ECB can facilitate it if they want to pump eurozone banks full of cash. Non-euro EU central banks, such as the Bank of England, can do the same thing if they want and the US Federal Reserve has injected a bunch of liquidity into foreign banks when needed in the past as well. As a zero-risk instrument, cash has a zero risk weight, so adding more of it to your portfolio brings your overall capital ratio up.

The second of these is expansionary. OECD sovereign debt also carries a zero risk weight under Basel III, as it did under Basels I and II. This might seem bizarre at first, but remember who's making these rules: OECD governments. And OECD governments want to pay low interest on their debt. To do that, they rig the regulatory rules to make it more attractive for financial institutions to buy that debt. Hence, a zero risk weight in Basel.

So what does that mean? If banks need to boost their capital stock, there are two ways to do it: by raising more capital (e.g. by selling equity) or by shifting their risk portfolio. The former latter will be often preferred to the latter former, so banks are essentially being encouraged to buy sovereign debt (and other zero risk weight instruments) in order to come into regulatory compliance.

Was this the point of this policy? I don't know. Probably it was mostly a freak-out after runs started on Greece and then Spain. But I imagine it was part of the calculus, or at least has become so since. In practice this will likely be a transfer of private funding for public funding. Given that the ECB cannot provide liquidity directly to eurozone governments, but can accept sovereign debt as collateral when lending to banks, this could be part of a stealth bailout program that began when Mario Draghi took over as ECB chief from Jean-Claude Trichet last year. Call it "bailout by regulatory arbitrage".

Will it work? I don't know.

More on Cowen on Europe

In his op-ed, Tyler Cowen raises a concern about a euro-collapse that I haven't much seen previously:

We thus face the danger that the euro, the world’s No. 2 reserve currency, could implode. Such an event wouldn’t be just another depreciation or collapse of a currency peg; instead, it would mean that one of the world’s major economic units doesn’t work as currently constituted.

There are a lot of claims -- some implicit -- in here. I'll take them in turn.

1. Does an exit of several peripheral countries from the eurozone constitue an implosion of a reserve currency? I don't think so. The status of the euro as a reserve currency does not depend on Greece's membership, it depends on Germany's management of it. If the alternatives are to jettison Greece -- or even several of the GIPSIs -- or to devalue the currency to keep them in, the euro's status as a reserve currency might actually be improved by a smaller membership of weak countries.

2. How important is the euro as a reserve currency? Roughly as important as the German mark was pre-euro, perhaps in combination with the the franc. The euro has not advanced much above the mark+franc status as a global reserve currency, if any at all, since its introduction in 1999. So the global economy as a whole does not appear to be very dependent on the euro; it is dependent on the US and, to a lesser extent, Germany, Britain, and Japan.

3. Would a euro-exit be more severe than a collapse of a currency peg? It conceivably could, but again: what matters most is Germany, and markets' belief in Germany's credibility to maintain a valuable currency. Germany's economy is not on the verge of collapse, nor does it depend on Greece, and German policymakers have repeatedly chosen to maintain policy credibility over possibly saving peripheral members. How much do markets care about Greece? I'll return to that below.

4. Would a euro-exit signal that one of the world's major economic units doesn't work? No. Greece is not one of the world's major economic units. A euro-exit would signal that one of the world's major political units doesn't work, but I'm not sure that this is new information nor am I sure that markets care all that much. The the extent that markets prefer stability over instability any resolution may be preferable to continued uncertainty.

Let's look at some data. Has the euro has significantly weakened as the crisis has grown more severe?

A bit. But if we zoom out and look at a longer time series we see that the euro is now trading at historical levels:

If Greece leaves will the value of the euro hold? Considering that Greece is by far its weakest link I would think so. Indeed, the fewer non-German members in the euro the more credibility it has! Germany does not need to devalue.

Anyway, just how important is the euro? At the end of last year global dollar holdings were nearly 250% higher than euro holdings. Or consider the exchange market. The introduction of the euro did nothing to reduce the world's reliance on the dollar, as I discuss (and graph) here. The euro is used in roughly the same percentage of the world's Forex as was the mark + franc. The global economy survived the end of those currencies.

There is only one truly important global currency -- the dollar.

Perhaps most distressingly, Cowen seemingly misunderstands the arguments of Kindleberger that he references in the paragraph immediately following the quoted one above:

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences. For historical reasons, Germany isn’t up to playing the role formerly held by Britain and, to some extent, still held today by the United States. (But when it comes to the euro zone, the United States is on the sidelines.)

I said a bit about that in my post yesterday, and I'll say more about it in another post (this is plenty long already), but if the hegemon is most important than we should really only be concerned about the US (the global hegemon) and Germany (the regional hegemon), not Europe's southern periphery. And the role of the hegemon is to stabilize the system, not necessarily to guarantee good outcomes for every constituent within it.

Think about it this way: if Germany left the euro and re-issued the mark, do you think it would be stronger or weaker than the Germany-less euro? Do you think the new mark would be used more as a reserve currency than the euro or less?

So why should we think that a Greek exit would be much worse than "another depreciation or collapse of a currency peg"?

Being Relatively Unconcerned About Concerning Things

Blogging has been non-existent the past few days because more pressing work has taken precedence. One such thing was an essay (with Thomas) for ForeignPolicy.com on why we should all be more blase about the Greek situation. It's very counter to the sort of convention wisdom that you can find here (other examples cited in our article).You can read it here. Our central claim:

Further economic and financial deterioration in Greece would certainly have negative impacts there and might adversely affect Greece's southern European neighbors, who are facing similar circumstances. But financial weakness in Greece is unlikely to spark a global crisis analogous to the one triggered by Lehman Brothers' collapse in September 2008 -- even if economic woes eventually force Greece to exit the monetary union. Instead, the global consequences of southern Europe's debt crisis are more likely to resemble the Latin American sovereign debt crises of the early 1980s, the East Asian crises of 1997-1998, and Argentina's crisis at the turn of the millennium. Each of these had significant local effects -- widespread bank failures, sharp increases in unemployment, large exchange-rate devaluations, deep recessions -- that were not transmitted globally. Indeed, in each of these cases the global economy continued to grow, major world equity markets held their value, and world trade expanded. None had the dramatic global consequences sparked by Lehman's collapse.

We're already getting some pushback -- as we have from the underlying research that informed this piece -- such as this from Dan Drezner:

I think you understated the global impact of the 1997 East Asian crisis. I'd rather avoid another one of those.

On the one hand, I agree: I'd rather avoid another one of those, although I don't know how that's possible. On the other, I don't think we understate the global impact of the E. Asia crisis. I think many people dramatically overstate it. The period during which the E. Asian crisis occurred -- the late 1990s -- is associated with one of the largest periods of global economic growth ever. These days we look back on it with nostalgia, and wonder how we can do it again. The E. Asian crisis was a crisis for E. Asia, but not so much for everyone else. I think it's likely that the S. European crisis will be the same. Actually, given the slow-motion nature of the thing, I think it's likely that the S. European crisis will be even less of an event.

We may soon see. I hope we don't. 

Austerity v. Drudgery

I recently posted on Twitter something to the effect of "what does 'austerity' mean when every country practicing it is running massive deficits?" It was meant to be provocative -- I know full well that deficits can come from a decrease in revenue as well as an increase in spending -- and led to an interesting but brief exchange with @dandrezner. My point is that different countries face different constraints, have different institutions, and have responded to the crisis in different ways. Describing them all as practicing austerity therefore doesn't seem appropriate. My takeaway from the exchange was that we don't have a good definition of what austerity is. We used to associate it with Washington Consensus policies enacted under duress in the midst of financial crises in exchange for emergency finance. That definition works alright for Europeriphery countries today, but not the U.S. and U.K. which were a) already following most of the Washington Consensus principles; b) not subject to external pressures from financiers; c) not really significantly altering fiscal policies in a contractionary way at all at least to this point.*

But people still use the term, often to denote something to the effect of "not enough Keynesian/monetarist stimulus". It seems to me that that is a different thing from austerity, and implies a different political interaction. As Steve Waldman notes, we're choosing our depression, and we're doing it in a way that prolongs the recovery but does not choke it off. This is being done for political reasons, but the reasons are very different than those that currently obtain in Greece, e.g. Greece is practicing true austerity -- or at least something closer to it... they keep agreeing to austerity but then missing their targets -- under duress; the U.S. is simply choosing to accept the risk of a slow recovery over the risk of higher inflation.

So why do we use the same work to refer to these two different things. I suspect there is an ideological component to it in many cases, but that's not satisfying enough. This sort of thing from Krugman** -- arguing that austerity is happening everywhere -- does not compute:

For the fact is that you can’t just look at spending levels to ask what is happening to spending programs. Here in the United States spending on unemployment insurance and food stamps has risen sharply, not because the welfare state has expanded, but because a lot more people are unemployed and poor. Similar effects are at work in European countries, which have stronger safety nets than we do. 

Right, but cutting social spending programs is pretty much the definition of austerity, at least as it used to be defined in relation to the implementation of the Washington Consensus during crisis periods. In fact, Krugman refers specifically to spending cuts elsewhere in the same post. So if we're doing the opposite of that how is it we're practicing austerity as well?

Mark Blyth has been working on a book (due out next year) detailing the history of austerity as a policy idea, so perhaps he can give us a better definition. In the video above, he describes austerity as paying down public debt through the slashing of social services. But if we're not doing that in the US (and some other countries) -- if automatic stabilizers have kicked in -- then are we really practicing austerity? If so, only on the margins and not in aggregate.

I was thankful to see Tyler Cowen considering the same question and coming to a similar conclusion. He notes that for some, it seems like "doing less than the Keynesian optimum is always a form of austerity". But does the "Keynesian optimum" really apply to countries like Greece where the bond vigilantes have already shown up? Once we start talking about cross-national transfers we're well outside of the world of the General Theory.***

I think this is important because it implies different political logics. This is what Waldman was writing about. The political logic of "austerity as penalty for emergency finance", usually to prevent moral hazard and/or force through politically unpopular reforms, is quite different from "tolerate slower recovery because of concern about future inflation".

To give one example: both the Tea Party and the Occupy Wall Street movements arose out of protest over the policy responses to the financial crisis and recession. One of them is more or less explicitly anti-inflation and also espouses principles of laissez-faire. The Tea Party movement began in 2007 during Ron Paul's presidential campaign, but really took hold in early 2009, right after the bailouts and as the stimulus fight was being played out. This was a direct response to significant government intervention into the economy via bailouts and stimulus spending. This group wanted austerity, in large part because of fears of future taxation and inflation (which they often view as a form of taxation).

Occupy Wall Street, on the other hand, is not ideologically opposed to government intervention. That movement did not form until 2011, when it became clear that the economic recovery was going to be slow overall but that the banks had recovered relatively quickly. OWS opposed the types of intervention that we, pace Waldman, chose. This group wasn't professing opposition to austerity... they were protesting expansionary fiscal policies! They opposed the distributional nature of those expansionary fiscal policies. In some cases they too wanted austerity, but via tax increases on corporations and wealthy individuals rather than cuts in spending.

The Greeks, meanwhile, are protesting the slashing of pensions and raising of taxes. These are very different movements, animated by opposition to different sets of policies. Lumping all of those policies together as "austerity" doesn't capture that. Given that, and given the loaded nature of the term, I think we need another word to describe the U.S. experience as distinct from the Greece experience. For the latter "austerity" works fine. For the former I propose "drudgery".

*Is c) true? Maybe in the eye of the beholder. In my view, the U.S.'s bailouts of Wall St/GM + extension of tax cuts + new tax cuts + automatic stabilizers + increase in nominal government spending + stimulus > the miniscule cuts that have been imposed since 2008. In which case... is that really austerity?

**Picking on him again out of laziness... I had this link at hand already.

***At least I think we are. It's been awhile since I've read it.

Not Quite Crony Capitalism?

I haven't read this yet, but Lucas Puente -- a PhD student at Stanford -- has an interesting-looking article in the new PS (I don't see an ungated version). Abstract:

I investigate one mechanism through which financial institutions could have used political influence to receive preferential treatment in the US Department of the Treasury-administered “bailout.” I find that neither proxies of political influence nor other political variables, such as public interest in specific deals, can explain variance in the sale price of warrants (a type of financial asset) Treasury acquired through TARP's Capital Purchase Program. Moreover, I find that the more politically active the firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This conclusion is not consistent with recent studies investigating the role of such variables in the initial administration of TARP and can be interpreted as good news for American taxpayers.

PS summary (bold added):

In the wake of the recent global financial crisis, many have suggested that the US government's administration of the taxpayer-funded rescue of the financial industry offered disproportionate benefits to politically active firms. However, quite the opposite occurred. Puente's research into Treasury's handling of the disposition of warrants (assets similar to stock call options) acquired through the Capital Purchase Program (CPP) shows that, at least in this phase of the "bailout," political variables did not matter. That is, lobbying expenditures, campaign contributions, and connections with Secretary of the Treasury Geithner, among other independent variables, cannot explain variance in the percentage of market value Treasury received for these warrants. Moreover, according to Puente, the more politically active a firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This suggests that Treasury is attempting to counter-act allegations of preferential treatment. Taxpayers should be pleased. By insulating itself from politics and making efforts to maximize the taxpayer return on the warrants, Treasury may have prevented billions of dollars in taxpayer losses.

I personally don't find this very surprising. Nor would I find it surprising if preferential treatment came mainly through less transparent channels, e.g. the Fed. It looks like Puente might be investigating that question in his ongoing research.

New Research

On the Network Topology of Variance Decompositions: Measuring the Connectedness of Financial Firms Francis X. Diebold, Kamil Yilmaz
NBER Working Paper No. 17490
We propose several connectedness measures built from pieces of variance decompositions, and we argue that they provide natural and insightful measures of connectedness among financial asset returns and volatilities. We also show that variance decompositions define weighted, directed networks, so that our connectedness measures are intimately-related to key measures of connectedness used in the network literature. Building on these insights, we track both average and daily time-varying connectedness of major U.S. financial institutions' stock return volatilities in recent years, including during the financial crisis of 2007-2008.

This is important work, and I know that several regulators and central banks (including the Bank of England) are starting to take this sort of modeling -- weighted, directed networks -- very seriously. When you're trying to track sources of systemic weakness you really need to know what the system looks like. The problem isn't just "too big too fail", it's also about which firms are tightly connected to many other firms. These two will often correlate, but not always and not perfectly, so knowing the difference is important.

The Stock Market Crash of 2008 Caused the Great Recession: Theory and Evidence Roger Farmer
NBER Working Paper No. 17479
This paper argues that the stock market crash of 2008, triggered by a collapse in house prices, caused the Great Recession. The paper has three parts. First, it provides evidence of a high correlation between the value of the stock market and the unemployment rate in U.S. data since 1929. Second, it compares a new model of the economy developed in recent papers and books by Farmer, with a classical model and with a textbook Keynesian approach. Third, it provides evidence that fiscal stimulus will not permanently restore full employment. In Farmer's model, as in the Keynesian model, employment is demand determined. But aggregate demand depends on wealth, not on income.

I think some of this gets to my confusion about Keynesianism from a few days back. I think the last sentence particularly drives at what I was saying before: if the monetary multiplier is low because of expectations, then how can the fiscal multiplier be high under the same set of expectations? It makes more sense (to me) for behavior to be conditioned by wealth more than income, particularly if the income is temporary. I clearly need to become more familiar with Farmer's work.

And here's a near-complete preprint of Herb Gintis' most recent book, The Bounds of Reason: Game Theory and the Unification of the Behavioral Sciences. Via one of Phil Arena's commenters.

QOTD

From Ezra Klein, upon watching Inside Job:

It was an excellent documentary for people who don’t want to understand the financial crisis but want to believe they would’ve seen it coming. Watching it, you’d think that the only people who missed the meltdown were corrupt fools, and the way to spot the next one is to have fewer corrupt fools. But that’s not true. ...

There’s a lot to dislike about Wall Street. The pay. The culture. In many cases, the people. But that doesn’t explain what happened in 2007 and 2008. ...

What’s remarkable about the financial crisis isn’t just how many people got it wrong, but how many people who got it wrong had an incentive to get it right. Journalists. Hedge funds. Independent investors. Academics. Regulators. Even traders, many of whom had most of their money tied up in their soon-to-be-worthless firms. “Inside Job” is perhaps strongest in detailing the conflicts of interest that various people had when it came to the financial sector, but the reason those ties were “conflicts” was that they also had substantial reasons — fame, fortune, acclaim, job security, etc. — to get it right.

And ultimately, that’s what makes the financial crisis so scary. The complexity of the system far exceeded the capacity of the participants, experts and watchdogs.

Extreme ignorance is still an underrated explanatory variable in models of the crisis.

I've previously written about a few of Inside Job's deficiencies here and here and here. A general rule is that smug explanations of the crisis are wrong.

The Politics of Housing Is Salient

Another anecdote:

An unprecedented alliance of organizations from the real estate industry, new home builders, mortgage companies, banks, civil rights groups and other lobbyists have descended on Washington, D.C. lawmakers to push against legislation that would require 20% down payments for a mortgage.

The Qualified Residential Mortgage “QRM” proposal would limit the number of home buyers qualified to make a purchase, require higher credit scores and send mortgage underwriting back more than 30 years. Members of Congress are struggling to reach a balance to provide new regulations for home mortgages, implement financial reform legislation and provide realistic reforms on home mortgages. ...

“The Qualified Residential Mortgage (QRM) will define who will and who will not get the most affordable mortgage products, potentially prohibiting a significant segment of qualified borrowers from being able to achieve homeownership,” said Mortgage Bankers CEO David H. Stevens. “Allowing more time for comment will enable us to prepare a more thoughtful and comprehensive analysis and response.” ...

Groups from both major political parties wrote to the six federal agencies last week implementing mortgage changes, which are the SEC, FDIC, HUD, the Office of the Comptroller of the Currency, the Federal housing Finance Agency and the Federal Reserve to urge them to focus of “sound underwriting, safe loans,” mortgage borrowers’ ability to repay loans and fully documented loans, and not to require larger down payments as they work on regulations to improve the mortgage finance system.

When major elements of both political parties line up with citizens' groups, finance, and a major industry (construction) on the same side of a policy, is it any wonder that policy gets pushed in that direction? This was what I was driving at in my previous posts on housing politics and the blame game.

Via Arnold Kling, who says that part of this is wrong: this is anything but "unprecedented"; it's been the same political dynamic for the past 20 years (some of which Kling observed directly, working at the Fed and Freddie Mac).

Too Big to Fail

I watched the HBO adaptation of Andrew Ross Sorkin's book last night, and I liked it quite a bit. I'm predisposed to like it, having both read the book and followed the news at the time and since then. The story is well done and accurate, the film itself is very well made. The cast is phenomenal and the acting delivers on that promise.

There isn't a whole lot of overt politics in it, but politics is like a fog hanging over everything in the story. Government actors routinely feel constrained by democratic politics, and end up being all but forced to make decisions that they despise. Politicians try to use the crisis for electoral gain. Private sector actors try to collect as many rents as they can, and in the end some of them get quite a lot, while others get nearly none. The movie is pessimistic in general.

Hank Poulsen (excellently played by William Hurt) is portrayed as something of a tortured saint overcome by events. Somewhat odd, given both his rough real-life demeanor and his involvement in the excesses that culminated in the financial crisis, but I believe the portrayal of his moral judgment is true to life. Anyway, William Hurt probably can't play anything but a noble figure -- at one point an aide tells him to get some sleep, as he looks worn down; except he doesn't -- but there is perhaps some nobility in the way Poulsen abandoned his guiding principles when events changed. I guess that's a matter of opinion.

Geithner (Billy Crudup) is a crass-talking pragmatist who seems to have no ideology at all, other than "don't let this blow up". Bernanke (Paul Giamatti) pops in from time to time to remind everyone of the gravity of the situation for the entire economy, not just their firms. I have no idea if the rest of the cast -- notables include Fuld (James Woods), Dimon (Bill Pullman), Blankfein (Evan Handler), Thain (Matthew Modine), Mack (Tony "Monk" Shalhoub), Buffett (Ed Asner), plus Topher Grace and Cynthia Nixon as Treasury Dept officials -- match their characters well or poorly, but the overall ensemble works very well. The dialogue and plot move quickly, and I fear that viewers without a fairly strong base of prior knowledge will have difficulty following what's happening. There are a few moments when characters (semi-awkwardly) try to break down what's going on for a slow-on-the-uptake staffer or Congressperson, but it's fairly clearly for the benefit of the audience. That's fine; those instances are few and brief and necessary.

Most of all, one gets the same sense from the film as from the book: nobody understood just what they were up against. Every CEO thought his (they were/are all men) firm was stronger than it was. Every regulator had no idea what was going on in those firms. Nobody understood how susceptible they were to a run. Nobody seemed to be aware of how reliant they all were on AIG, and how fragile AIG was. When Poulsen gets on his knees before Nancy Pelosi (a true anecdote), it's hard to tell whether he's asking for help or to be put out of his misery.

The story is about ignorance, throughout the financial sector and indeed the broader economy. And when things go wrong, the ignorant panic. And when panic sets in, the game's up. It's a confidence game.

The parts of the movie that fall the flattest are the ones that try to "humanize" some of the characters. Poulsen agonizing to his wife. Buffett entertaining his grandkids. Fuld cursing the gods (over and over). There isn't very much of that, but the film could still do with less. Other than those minor distractions, I liked it quite a lot.

The Political Appeal of Financialization

From Orgtheory's ongoing book forum on Krippner's Capitalizing on Crisis:

Ralph Nader, of course, wasn’t the only consumer activist who supported reform of Regulation Q. As Fabio described in his post, the regulation of credit was contested by a variety of interest groups, but it was the support of consumer activists like Nader that gave legislators the political cover to make these changes. Once credit markets were deregulated, the process of financialization could begin. Politicians learned from this experience that deregulation was a great way to win electoral support while also relieving them from accountability over the economy. Politicians learned their lesson and began applying it in other realms as well. The result was a gradual “depoliticization of the economy,” which Krippner describes as “the reorganization of the boundary between the political and the economic so as to allow policymakers to govern the economy ‘at one remove’” (145).

This is set in an electoral context where politicians rely on constituent approval to remain in office. The financialization of the economy, in Krippner's account, was a political winner:

On its surface this seemed like a win-win for everyone. Deregulating interest rates would expand credit availability, while also allowing banks to get more creative in their offerings to potential borrowers. In retrospect we know that this deregulation also accelerated inflation and suppressed production. This had the effect of pushing more of the economy into financial markets and fueling asset price bubbles.

What politician wouldn't love a policy that both Wall Street and Ralph Nader would support?

My first thought on reading this was to ask a comparative question: which countries financialized their economies in this way? What were the domestic and international causes of such a shift? Were the consequences similar in countries that financialized similar or dissimilar?

Any pointers to research that directly addresses these questions would be welcomed.

Explaining the Financial Crisis, Assuming No Prior Knowledge

I was a guest lecturer in a large undergrad lecture class yesterday, for Intro to International Politics. It was the first time I've gotten to speak for 50 minutes to an audience of several hundred, so good practice/preparation for me. I gave a talk on the financial crisis. Before that, I'd done an informal survey of some students to find out what they knew about the crisis, and the consensus was that some of them had some vague idea that a crisis had occurred, and a very small minority of those knew that it had something to do with housing, but that's it. The majority have no economics training at all. So the lecture was very much geared towards explaining to them why this was important, and how and why we can think about it in political terms, in ways they could understand.

I had to cover a lot of ground pretty quickly, but I think I covered my bases fairly well, given the constraints. I would've liked to spend more time on the politics than the brush-clearing, but I just couldn't assume enough prior knowledge to make that happen. Ideally, this would be split into two or three lectures, at minimum. Anyway, the students didn't complain to my face, so it couldn't've been too bad.

No video/audio, unfortunately, but here are the slides. Since I had so much to cover in 50 minutes, I made the slides pretty detailed, and gave them to the students so they'd be able to just listen to me rather than furiously scribble notes.

FinCrisisLecture

Note1: In the pdf version of the slides, there's a time series animation of banking integration embedded in slide 18 that probably won't show up in Scribd. That can be found here. The students seemed to like that part especially.

Note2: The gorgeous Beamer template was created by the excellent Skyler Cranmer. Technically, I think I'm using it without his permission -- I got it from a grad student who got it from a grad student who got it from a grad student who got it from him, or something -- so credit to him, and hopefully he doesn't mind my free-riding. Whenever he gets back from Europe I'll ask him if there's a favor I can trade in exchange.

Summers, Salmon, DeLong, and the Underpants Gnomes

Felix Salmon says Larry Summers is stupid for not thinking that the financial crisis was caused by new-fangled financial instruments. Brad DeLong leaps to Summers' defense, arguing that Summers said no such thing. Instead, Summer said that other notable financial crises -- the Japanese, Nordic, and EU debt crises -- did not arise from new-fangled financial instruments.

I think that Salmon is right about this: I think Summers was implying that new-fangled financial instruments did not cause this crisis, or at least there is no overwhelmingly-convincing evidence that they did. After all, Summers says "I am in less of a hurry to condemn the [financial] innovation as the cause of the crisis than many." I think Salmon is wrong, however, in saying that Summers should be scoffed at for saying such a thing.

Rather than denying that Summers said what he said, DeLong should have said that Summer is right: we did not have a financial crisis because of new-fangled financial instruments. We had a financial crisis because home prices rose by more than 100% from 1999-2006 (pic above), and then dropped 35% from 2006-2008 (pic below). Indeed, given the size of that bubble and the quickness of the correction, a financial crisis was inevitable.



So the question should be: why did we have a such a large bubble? One answer could be "new-fangled financial instruments created a bubble". But that is not obviously true, which is Summers' point. Other countries have had real estate bubbles without new-fangled financial instruments recently, and the U.S. has had real estate bubbles without new-fangled financial instruments in the past, so there is no a priori reason to think that new-fangled financial instruments were responsible for this particular bubble. More precisely, there is no causal mechanism that links new-fangled financial instruments to the housing bubble, much less the crash*.

(I would argue that the same is true of regulation: there is no causal mechanism that links deregulation, or more precisely "unregulation", to the crisis. But then I'm weird that way.)

Plausible causal mechanisms are important if we are to improve future outcomes. Thomas provided a pretty good one recently. Without them, we are in Underpants Gnomes territory:

1. New-fangled financial instruments

2. ?????

3. Crisis

That isn't helpful.

* Jeffrey Friedman has tried to make such a case -- that securitization that could be highly-rated was rewarded by the Basel Accords, which then led banks to do more lending that could be turned into highly-rated securities -- but I don't think Salmon had this in mind.