Euro Developments

First, the ECB is quarreling with Berlin:

The cold war between Berlin and Frankfurt reached a new high last week. Should Germany implement its plans, the ECB would have to cut off funding for Greece, the monetary watchdogs warned. The consequences for Europe's banks and the Greek economy would be devastating.

The mere suggestion of what the Financial Times called the " central bank equivalent of nuclear deterrence" was enough to prompt German Finance Minister Wolfgang Schäuble to withdraw the German proposal immediately. A debt restructuring, Schäuble admitted sheepishly, could lead to a repeat of the events triggered by the bankruptcy of Lehman Brothers in September 2008.

In addition to revealing how serious the euro's problems are, the slugfest proves how much of its reputation the Frankfurt-based ECB has lost in the euro zone's strongest economy.

In the past, the central bank was seen as the undisputed economic authority in Germany. Anyone who opposed the monetary policy experts was quickly marginalized. Today, however, the central bank must threaten with the most drastic of measures just to force the German government to toe the line. A majority of German economic politicians and economists see the ECB's crisis strategy as unrealistic and contradictory.

But would a Greek restructuring really be so devastating for Germany? It would have some costs, but at this point these would be manageable:

A debt reduction -- known as a "haircut" -- of as much as 50 percent would be an expensive proposition for Greece's creditors. With around €330 billion ($467 billion) in loans, that would mean cutting as much as €165 billion. Most of Greece's debt is with foreign creditors, and so foreign banks and governments would have to take massive hits over the loans Athens is unable to repay in full.

But what would this mean in reality for Germany? ...

The answer to all of these questions is reassuring -- at least at first glance. The consequences of a debt write-off against the government in Athens would be manageable for Germany. At the moment, some €25 billion in Greek debt is held by Germany's commercial banks and the so-called "bad banks" set up to take on toxic assets. This debt takes the form of either Greek sovereign bonds in their portfolios or loans made to the Greek government. ...

With a 50-percent haircut, the two bad [government-backed] banks would lose around €4.4 billion in total. Taxpayers would end up indirectly footing the bill. ...

Of mild comfort is the fact that the state would probably not have to come to the rescue of any private institutions. Commerzbank, Deutsche Bank and the DZ Bank, which acts as the central bank for Germany's roughly 1,200 partly state-owned co-operative banks, are (once again) in a position to be able to cope with possible shortfalls by themselves.

But that's just the banks. The taxpayers have already loaned Greece a lot of money, either directly or via the ECB:

But the situation looks different for the German government and the federal states. At the very least, the large exposure of KfW and the bad banks of Hypo Real Estate and WestLB could end up being expensive. Taxpayers might need to step in, as might the savings banks that are owned by municipalities.

In addition, the European Central Bank (ECB) has bought up tens of billions of euros of Greek sovereign bonds. Because the Bundesbank, Germany's central bank, holds more than a quarter of the ECB's capital, it would have to take its share of losses accordingly.

However the Irish and Portuguese banking sectors are still exposed to Greece, and are much weaker than Germany's banking sector. Still, the fact that the Germany financial system has largely healed since 2008, and has already taken many steps to lessen their exposure to Greece, gives Germany a lot of negotiating leverage in the EU. And, as EU Monetary Affairs Commissioner Ollie Rehn says, political will for continued aid is running low in northern Europe.

In Brussels, we Finns are referred to as "English-speaking Germans," because we pursue the same economic policy principles: stability, sustainable growth and fiscal responsibility. The Germans aren't the only ones who are concerned. There is a certain aid fatigue in all of northern Europe. And we are experiencing a certain reform fatigue in southern Europe. As monetary commissioner, I feel this schizophrenia every day. We must try to build a bridge between these two camps.

Put it all together? Time is running out for Greece.

Is American Political Science Ignored?

In American academic circles, there is often much weeping and gnashing of teeth about how government and academic political science are separated. Few policymakers read academic research, complain academics. Few academics do anything substantively important or intellectually accessible, complain policymakers. So I found it interesting to read this, from a profile of Joe Nye in the UK Independent:

The advantages of the revolving door between academia and government, as it works in the United States, however, are indisputable. It gives academics an opportunity to test their ideas in practice and it gives politicians the benefit of specialist advice. Mid-career, Joseph Nye spent two years as a security official specialising in nuclear non-proliferation in the administration of Jimmy Carter. Fifteen years later, he joined the Clinton administration as assistant secretary for defence, and then became chairman of the National Intelligence Council, a body that coordinates intelligence estimates for the President. Had John Kerry won the 2004 election, Nye was seen as the natural choice to be National Security Adviser. When the Republicans were in power, Nye returned to Harvard.

Such a career would be unusual, not to say impossible, in Britain. Despite hints by Tony Blair, among others, that he would favour academics, business people and others moving in and out of government, the structures are not there and no-one – not the professional politicians, not the civil servants – has a real interest in fostering change. When it does happen, it is the exception and the beneficiaries – Admiral Lord West, for example – have tended to be more accident-prone than other ministers. Sharing a platform with Nye during his sojourn in London, Mark Malloch-Brown – former Deputy General Secretary of the UN and Foreign Office minister under Labour – lamented Britain's single track with more than a touch of envy. At very least, serving in government can be said to lend a practical aspect to the various branches of political science at America's leading universities.

Nye's direct experience of academia and politics – two worlds which in Britain tend to be seen as alien to each other, if not inimical – is the rule rather than the exception for senior US scholars and it ensures that their ideas are given a hearing on both sides of the fence. It allows the two worlds to feed off each other to mutual benefit and those who excel in both become a particular kind of superstar, guaranteed a global audience and needing to feel beholden to no-one.

Clearly Nye is an exceptional case, but the article makes a more general argument. I don't know much about the reporter, Mary Dejevsky, so I'm not sure what cred she's got. I just found it interesting that for all the hand-wringing American academics do over the fact that policymakers don't pay enough attention to us, one view from across the Pond is very different.

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.

The Politics of IMF Leadership

Daniel Davies titles a recent post on the selection process of the new IMF chief "Taking the politics out of politics, and the international relations out of international institutions". Davies is correctly pushing back the notion that the IMF exists for technocratic perfection, specifically the argument (by Martin Wolf among most other popular writers) that the IMF chief needs to be an economist.

This is real "too important to be left to generals" territory. A "merit-based" selection process for the IMF top job is effectively assuming that all the issues the IMF faces are technical (not political), and that the problem is to find someone with sufficient technical economic skills to pick the right solution from a mass of confusing alternatives.

In fact, in general the IMF tends to face situations in which there are only about three or four real options, one of which is usually both massively obviously the best idea, and politically very difficult for some powerful constituency or other. That's why it's a political job. And the allocation between the USA and Europe was agreed at the original Bretton Woods conference as part of a very dicey compromise between the only two blocks which can print unlimited hard currency. It's an international institution, and one of the biggest problems in designing such an institution is to persuade the major powers that it is worth their while working through the institutional framework rather than through bilateral diplomacy. That's why the UNSC has permanent members, for example, and it's why France and Germany tend to get first dibs on important Commission posts.

I am no fan at all of the IMF (or of the way in which history is being rewritten to cast them as opponents of pointless austerity). But it does at least kindasorta work as an international institution, which is why I'm in favour of not fixing it.

Davies is right that the IMF is more about politics than about economics. That's the whole point of having an established international institution rather than a series of ad hoc transfers as needed: sometimes the ad hoc transfer won't come for political reasons, and that can lead to disasters like the 1930s. There are a number of political dimensions related to the IMF. One is the austerity politics in the debtor nation. The IMF is routinely portrayed (including by Davies here) as some kind of bogeyman, externally imposing its imperial will (or the imperial will of the US) onto smaller, less powerful countries. This is only some of the story. James Vreeland has done a lot of the best research on the IMF, and here's the abstract of a new working paper by him:

Many argue that governments use IMF programs to push unpopular policies past domestic political opposition. Many others have argued that the IMF is merely a tool of US foreign policy, providing loans without enforcing policy conditions. This paper addresses the inconsistencies between these two views, presenting large-n evidence supporting both. The domestic politics story, however, depends on international politics. The IMF can only be used to push through unpopular policies when the institution is not being used to reward friends of the US.

In other words, the IMF is a useful bogeyman for domestic leaders that want (or need) to pursue unpopular reforms, but do not have the domestic political constituency to do so. To the extent that some of these reforms are necessary (as they certainly are in Greece today), we may not want a kinder, gentler IMF. Better for the IMF to remain the scapegoat, thus giving domestic reformers some political room to move. Blame the institution, but pass the reform. Some of Vreeland's other work supports this idea.

There's another political aspect of the IMF that is less discussed. Dr. Oatley wrote a post last year about the politics of bailouts in creditor nations. Basically, the story runs like so: it is often politically unpopular for one country to give aid to other countries in times of need. Think about the typical German voter, who wonders why her tax dollars should be spent to reward the Greeks for their profligacy? A direct funding mechanism (like EFSF?) may not be politically sustainable in democracies. But an indirect funding mechanism (like the IMF) may be more politically successful, by making the bailout one step removed from budget politics in creditor countries.

We're seeing both elements at play in this crisis. Austerity is unpopular in debtor countries like Greece but is inevitable in some form, so if politicians can shift some of the blame onto the IMF it may help them get necessary reforms through. At the same time, voters in Germany and France don't like being expected to pick up the tab of the Europeriphery indefinitely, and have set 2013 as the expiration date for bailout funds. But the IMF doesn't have such a limit. It can extend funds when and where they are necessary. And funding the IMF is not as politically salient as funding other countries directly.

Because the IMF is facing domestic political pressures in creditor and debtor nations, as well as international political pressures from its constituent governments (particularly the US, but the role of EMs are growing too), its next leader should be someone that can navigate the political space and doesn't mind be blamed for everything that goes bad in debtor countries. The next leader should not be someone chosen for their technical economic nous, much less for their country of origin, but for their political sensibility.

I have no idea of Christine Lagarde is that person. I know very little about her. What I do know is that she's a bureaucrat, not an academic, and so presumably has a good sense of the European political situation. That's a start.

Blogging May Be Light

New Research

A Fistful of Dollars: Lobbying and the Financial Crisis
Deniz Igan, Prachi Mishra, Thierry Tressel
NBER Working Paper No. 17076

Has lobbying by financial institutions contributed to the financial crisis? This paper uses detailed information on financial institutions’ lobbying and mortgage lending activities to answer this question. We find that lobbying was associated with more risk-taking during 2000-07 and with worse outcomes in 2008. In particular, lenders lobbying more intensively on issues related to mortgage lending and securitization (i) originated mortgages with higher loan-to-income ratios, (ii) securitized a faster growing proportion of their loans, and (iii) had faster growing originations of mortgages. Moreover, delinquency rates in 2008 were higher in areas where lobbying lenders’ mortgage lending grew faster. These lenders also experienced negative abnormal stock returns during the rescue of Bear Stearns and the collapse of Lehman Brothers, but positive abnormal returns when the bailout was announced. Finally, we find a higher bailout probability for lobbying lenders. These findings suggest that lending by politically active lenders played a role in accumulation of risks and thus contributed to the financial crisis.

Exchange Rates in Emerging Countries: Eleven Empirical Regularities from Latin America and East Asia
Sebastian Edwards
NBER Working Paper No. 17074

In this paper I discuss some of the most important lessons on exchange rate policies in emerging markets during the last 35 years. The analysis is undertaken from the perspective of both the Latin American and East Asian nations. Some of the topics addressed include: the relationship between exchange rate regimes and growth, the costs of currency crises, the merits of “dollarization,” the relation between exchange rates and macroeconomic stability, monetary independence under alternative exchange rate arrangements, and the effects of the recent global “currency wars” on exchange rates in commodity exporters.

Financial Protectionism: the First Tests
Andrew K. Rose, Tomasz Wieladek
NBER Working Paper No. 17073

We provide the first empirical tests for financial protectionism, defined as a nationalistic change in banks’ lending behaviour, as the result of public intervention, which leads domestic banks either to lend less or at higher interest rates to foreigners. We use a bank-level panel data set spanning all British and foreign banks providing loans within the United Kingdom between 1997Q3 and 2010Q1. During this time, a number of banks were nationalised, privatised, given unusual access to loan or credit guarantees, or received capital injections. We use standard empirical panel-data techniques to study the “loan mix,” domestic (British) loans of a bank expressed as a fraction of its total loan activity. We also study effective short-term interest rates, though our data set here is much smaller. We examine the loan mix for both British and foreign banks, both before and after unusual public interventions such as nationalisations and public capital injections. We find strong evidence of financial protectionism. After nationalisations, foreign banks reduced the fraction of loans going to the UK by about eleven percentage points and increased their effective interest rates by about 70 basis points. By way of contrast, nationalised British banks did not significantly change either their loan mix or effective interest rates. Succinctly, foreign nationalised banks seem to have engaged in financial protectionism, while British nationalised banks have not.

IPE Everywhere: DSK Gets Euro Advice in Rikers

Ferguson + Kissinger = Mush

This has to be the worst thing I'll read this week. Niall Ferguson slobbering over Henry Kissinger for discovering... wait for it... the security dilemma:

Such fundamental cultural differences may give rise to conflict with China in the future, Kissinger warns: “When the Chinese view of preemption encounters the Western concept of deterrence, a vicious circle can result: acts conceived as defensive in China may be treated as aggressive by the outside world; deterrent moves by the West may be interpreted in China as encirclement. The United States and China wrestled with this dilemma repeatedly during the Cold War; to some extent they have not yet found a way to transcend it.”

Could the United States and the People’s Republic come to blows again? The possibility cannot be excluded. As Kissinger reminds us, war was the result when Germany rose to challenge Britain economically and geopolitically 100 years ago. Moreover, the key factor that brought America and China together in the 1970s—the common Soviet enemy the Chinese called “the polar bear”—has vanished from the scene. Old, intractable differences persist over Taiwan and North Korea. What remains is “Chimerica,” a less-than-happy marriage of economic convenience in which one partner does all the saving and the other does all the spending.

This is the most basic principle in IR, and remains the orthodox story for how major power conflicts occur. Of course there are big problems with it -- Germany challenged Britain, but the U.S. did not -- but it's the basic story. For this staggeringly simple insight, which any of my Poli 150 students should be able to regurgitate in their sleep, Ferguson writes that Kissinger "remains without equal as a strategic thinker". I sure hope not.

The worst part is that Kissinger hasn't appropriately internalized his own lesson. The bulk of his new book On China (per Ferguson's description) seems to focus on cultural and psychological explanations of China's behavior and the possibility of Sino-US conflict. The Korean War happened because of a "cultural gap"; China entered into it to "change the psychological balance" by changing the US's "calculus of risk". In other words, China was signaling resolve. But there's nothing cultural or even psychological about that. It's pure information revelation, of the sort Schelling (and plenty of others) described.

And cultural explanations are notoriously fraught; why would cultural differences cause conflict with China, but not other Asian (or non-Asian) countries? Why have major European countries, about as culturally similar as nations will be, historically been antagonists? Why would the US get along with India in the future, but not China?

How about this sophistry:

The Chinese value patience; as Mao explained to Kissinger, they measure time in millennia.

I recall being told that the most notable thing about China's rise was its rapid pace. I remember hearing that China's advantage was that its authoritarian government was able to more quickly adapt to new circumstances, and more perfectly practice mercantilism. This was how they'd win the future. These cultural "explanations" sure get confusing... forgive me if I continue to think that conflicts occur because power shifts are not accommodated by governance structures, and bargaining under anarchy is perilous.

I'm not sure how much of this is Kissinger and how much is Ferguson. After all, Kissinger does pick up on the fairly important fact that China has no intention of challenging the US' order:

Yet Kissinger remains hopeful that cooler heads will prevail in Beijing: thinkers like Zheng Bijian, who urges China to “transcend the traditional ways for great powers to emerge” and “not [to] follow the path of Germany leading up to World War I.” Rather than attempting to “organize Asia on the basis of containing China or creating a bloc of democratic states for an ideological crusade,” the United States would do better, Kissinger suggests, to work with China to build a new “Pacific Community.”

In fact, it seems like the opposite is of the nightmare scenario is true, as China seems perfectly happy to integrate more fully into the US-led system:

China’s economic rise has been facilitated by the regional security provided for by the United States since the end of Cold War hostilities in the region. Ashely J. Tellis, former advisor to the Undersecretary of State for Political Affairs and senior policy analyst at the RAND Corporation, similarly states that American protection provided a “stable security environment” which allowed Asian states to “mitigate the most acute tradeoffs between guns and butter.” U.S. hegemony has allowed China to benefit from globalized trade without having to incur costs for maintaining the necessary stable environment. In a 2008 diplomatic cable from the Beijing Embassy, U.S. Ambassador Clark T. Randt recalls a conversation with an unnamed Chinese party: “when it comes to the basic Chinese interest in securing energy supplies and raw materials for our economic growth, free-riderism works for us right now.”

Free-riderism will continue to work for China for the foreseeable future. China is still a poor country, facing a number of internal adjustments that will test the new political leadership in the coming years. Moreover, China's economy has grown faster than its political capital. China has a lot of business partners, but not a lot of allies. Certainly not many allies that would take its side against the US in an attempt to overturn the post-WWII order. China will continue to build up goodwill in Asia, Europe, and elsewhere, but it will be quite a long time before China has a set of allies that rival the US's. During that period, China may become one of the US's allies, as other formerly antagonistic regional powers have done.

I haven't read Kissinger's book, but based on Ferguson's recommendation it doesn't sound like there's anything new or profound in it. I know the man has plenty of disciples, and it may be good for some of them to read this stuff, but for people who study IR in an academic context this is pretty weak sauce. This take, by Princeton political science Prof. Aaron Friedberg, is better. Still too pessimistic, I think, but greater clarity of thought and all the appropriate caveats.

Spain Feels the Pressure

To this point Spain's economy hasn't suffered as much as Portugal, Greece, or Ireland, but that doesn't mean things are going well. Economic pressures continue to mount, and Spain faces the same exchange rate pressures as those other countries. A currency devaluation would help boost competitiveness and thus employment, but that isn't possible under the euro. In a fixed exchange rate system, internal devaluation via wage cuts and increased unemployment is the only option. And democratic publics don't like that very much:

About 28,000 people, most of them young, spent Friday night in Puerta del Sol, a main square in downtown Madrid, the police said. They stayed even as the protest ban went into effect at midnight under rules that bring an official end to campaigning before the election in 13 of Spain’s 17 regions and in more than 8,000 municipalities.

Fueling the demonstrators’ anger is the perceived failure by politicians to alleviate the hardships imposed on a struggling population. The unemployment rate in Spain is 21 percent.

And Spain looks likely to be the next European country to tilt right since the economic crisis:

Sunday’s election is expected to result in a countrywide sweep by the Popular Party, the main center-right opposition, at the expense of the governing Socialists, whose popularity has plummeted because of the economic crisis. The most recent opinion polls suggest that the Socialist Party may lose in regions and municipalities where it has been in power since Spain’s return to democracy in the late 1970s, notably Castilla-La Mancha.

There are other issues at stake, including concerns about corruption, but those get magnified when unemployment is at 21%. Some folks on Twitter are saying that the police tried to break up some protests, but I haven't seen a credible report on that yet. Either way, these issues aren't going away.

Some Politics of Housing

At a few points recently I've heard people argue that housing policy is either not politically salient, or has little to do with the sorts of macro outcomes that led to the housing crisis. So I was interested to receive an e-mail from my senator, Kay Hagan, pointing me to this Politico op-ed she co-wrote with Sen. Isakson and Sen. Landrieu:

Families are working hard to rebuild savings while the housing market remains unstable. Recent news from the Commerce Department shows that U.S. home builders continue to struggle despite signs of recovery in other segments of the economy. According to real estate data released this week, home prices in the first quarter of 2011 suffered their worst decline since 2008.

Yet banking regulators are dangerously close to issuing a rule that would put homes out of reach for many Americans and further cripple the fragile housing recovery. ...

But federal banking regulators last month proposed a 20 percent down payment requirement on QRMs. Regulators went for rigidity, rather than a balanced, flexible approach.

In contrast to our express intent — and despite repeated warnings from other members of Congress, consumer groups and bankers — regulators crafted a narrow definition that could unnecessarily slow the housing market recovery, increase costs to otherwise qualified homebuyers and dampen incentives for sound underwriting.

The 20 percent down payment requirement leaves millions of qualified potential homeowners with two grim alternatives: pay higher rates upfront for a mortgage that falls outside the regulators’ proposed QRM standard or delay homeownership for a decade or more to save for an onerous down payment.

Here we have three senators, two Democrats and one Republican, arguing against tougher regulation that would lead to higher lending standards. They obviously think this issue is salient enough to write an op-ed about it, at a time when most political attention is being paid to budget reform and other issues. And this is the first e-mail of this sort that I recall having received from Hagan's office. In fact, I'm not even sure how I got on their mailing list.

This is merely the most recent in a series of policy choices that incentivize home ownership in the U.S. The most notable of these is probably the mortgage interest deduction, which not only encourages home ownership, but also encourages the building and purchasing of larger homes. And the mortgage interest deduction is pretty firmly embedded in the U.S. political economy. In Showdown at Gucci Gulch, journalists Alan Murray and Jeffery Birnbaum describe how the proposal to end the mortgage interest deduction was almost immediately removed from early versions of the 1986 Tax Reform Act, because it was a political non-starter. Indeed, Congress was better able to reduce and eliminate subsidies to some of the interest groups usually considered to be among the most powerful -- finance and energy -- than subsidies for home ownership.

The 1986 Tax Reform Act did eliminate some loopholes in the tax code that incentivized tax sheltering through real estate investment, but these did not affect primary residences. And TRA1986 also eliminated tax deductions from other types of interest, such as on credit cards and other personal loans. But not mortgage interest on primary homes. Nor was TRA1986 able to reduce or eliminate the exemption of capital gains on home investment, so long as it was a primary residence and the capital gains were under $500,000 (for a married couple filing jointly). Some estimations have claimed that these subsidies increase home values by 15%. Considering that roughly 65% of the country are homeowners, and it is not uncommon for a majority of peoples' equity to be in their homes, it's no surprise that this is a politically salient issue.

This despite the fact that there is a broad consensus among economists, environmentalists, and urbanists that this policy skews behavior away from the social optimum. An inflated market incentivizes speculation and over-purchasing. It leads to too much investment. It also leads to suburbanization, and increased energy usage from heating/cooling/commuting. Consider as well that it benefits the middle-class and wealthy at the expense of the poor, particular those poor that live in urban areas. To make up for it, the government extends loans to lower-income (or otherwise less creditworthy) borrowers through Fannie Mae, Freddie Mac, and the Federal Home Loans Banks. These organizations fund or guarantee over $6tn in mortgages, or over 40% of U.S. GDP, representing nearly half of the country's real estate market. The GSEs are well-known to have a lot of political clout, and have resisted repeated calls for reform during every presidential administration since Reagan, at least. And, of course, they were the biggest originators of subprime (and Alt-A and interest-only) loans, the securitization of which was rewarded by the pre-crisis regulatory structure. (Note that current research indicates that the bulk of GSE losses were Alt-A, which are prime loans, if untraditional.) The GSEs held approximately 45-50% of all mortgages in the country throughout the 2000s. Fannie and Freddie were also the largest purchaser of AAA-rated MBS, which created a market for other mortgage lenders to lend subprime and securitize the loan, which fulfilled their requirements to support affordable housing, particularly for low-income borrowers*.

Other aspects of public policy incentivized home ownership (or real estate speculation) in less obvious ways. The large, persistent current account deficit did not lead to a currency crash as many had predicted, but it did lead to an increase in demand for non-tradable goods. Like housing. This current account deficit is not attributable to any single factor, but persistent budget deficits in the private and public sectors certainly played a major role. The large demand for AAA-rated financial instruments in which to invest a "global savings glut" also led to a demand for securitized home loans. Finance was happy to oblige. There were major geopolitical dynamics at play as well.

All to say that housing policy is an important political issue. It's important for citizens in the United States, and therefore for politicians. It's important for numerous interest groups, in the U.S. and abroad. The housing bubble wasn't engineered entirely by Wall Street, although they certainly worked hard to accommodate it. There was demand from many corners.

*I'm not trying to argue here, as many have, that the financial crisis was caused by the GSEs. It wasn't. I'm merely trying to demonstrate that public policy is oriented towards promoting home ownership in many ways that take many forms. The GSEs are part of that. The have a public mandate to extend loans to less-qualified borrowers, but that is not all of their business or even the largest part.

It's the Stupidity, Stupid

Roger Lowenstein says the reason no Wall Street executives have been prosecuted is likely because their actions were stupid but not criminal. But people don't find that satisfying:

While it may be harder to prove criminal guilt, it's easier for people to believe that some bad actor is the cause of bad things. This is a persistent trait in the national character. Historian Richard Hofstadter identified it in 1964 as The Paranoid Style in American Politics. He was writing mostly about McCarthyism, though he recognized that paranoia isn't limited to the political Right. Nor is it always harnessed to an unworthy cause; convicting criminals, especially in high places, isn't just worthy, it's crucial to democracy.

The paranoid style, as Hofstadter defined it, has as much to do with "style" as paranoia—it's about "the way in which ideas are believed [more] than with the truth or falsity of their content." It spawned a rhetoric that tilted every question toward conspiracy, so that random or unfortunate events were seen to compose a "baffling pattern." Thus, the "sharp decline"—Hofstadter was writing about America's perceived international strength, not the price of real estate—did not "just happen." It was inevitably brought about by "will and intention."

He writes elsewhere that the crisis was caused mostly by rank idiocy, not by fraud. He puts it something like "fraud accompanied the crisis, it didn't cause it". This is a view that I am pretty sympathetic to. I believe there was a some outright fraud, but I suspect that is always the case in financial markets. The bigger problem during the crisis was that all sorts of people thought very risky assets were not very risky. And, while some actions taken in the lead-up to the crisis are obviously crazy in retrospect, being wrong is not criminal. We don't imprison the gambler for backing the wrong horse and losing his rent.

In general I think we are too quick to assign bad motives to people when things go wrong, and are too slow to accept that people do very stupid things all the time without intending to. We often assume that people in high positions of business or government are more competent than they really are, so when things go wrong we conclude that it was intentional. I think we're also too quick to connect unrelated dots, rather than starting from the assumption that the world is pretty stochastic. This gets to the "Black Swans" post from yesterday.

There's a political element to this, of course. Hofstadter's famous essay largely focused on 1960s examples of right-wing paranoia (e.g. McCarthyism), but he was clear that this particular pathology affects people across the political spectrum. (One of the examples he mentions, but does not dwell on, is scare-mongering against bankers in the 1890s. It reads like it could have been writing today.) Politicians often try to tap into latent paranoia, and in some cases actively encourage it. (Think of Gingrich's "secular atheist radical Islamist" nightmare, which must have filled out somebody's Bingo card.) Sometimes, as in the case of the Republican establishment, incorporating the Tea Party movement (which I view as a somewhat-coherent but certainly-paranoid mass movement) is more an act of desperation: if they don't, their coalition risks fragmentation, as happened during the populist movements in the 1990s that led to Ross Perot's presidential runs. A big part of Perot's success was manipulation of fear of a "giant sucking sound", and Perot's relative success may have affected legislators' later votes on NAFTA.

Sometimes encouraging isn't really needed. Current populist movements in America on the left and right have strong grassroots characteristics, although media and policy elites sometimes encourage and try to co-opt them. Just as often they try to minimize them. The Birther, Truther, and Deather movements started small and grew, although none have really affected the political landscape in the same way as Perot or the Tea Party. As Hussein Ibish witnessed recently, fear of an Islamic conspiracy to annihilate Western civilization approaches common belief. It doesn't take much to convince lots of people that the financial crisis was the result of conspiratorial actions of bankers, and both Glenn Beck and Michael Moore have built careers playing to certain types of American paranoia. It doesn't take a lot to convince people that foreigners will take their jobs, or attack the homeland, or brainwash their children, or otherwise take away everything they hold dear.

Conspiratorial explanations are obviously appealing, and clearly conspiracies do sometimes exist. But quite often it might be worth taking a step back, acknowledging that the world is a messy place that often doesn't make sense, and chalk up bad outcomes to stupidity instead.

*Capitalizing on Crisis*

I'm going to try to stay with OrgTheory's book forum on Greta Krippner's book. This appears to be an article version. Krippner has been doing research on this since at least 2005. Here's the author's book summary:

In the context of the current economic crisis, the extent to which the U.S. economy has become dependent on financial activities has been made abundantly clear. The conventional explanation for this development – a process I refer to as “financialization” – is that the U.S. economy has been in the grip of a speculative mania that has swept firms and households alike into its vortex. In my book, I take a somewhat different perspective, suggesting that recent developments in U.S. financial markets rest on a broader transformation of the U.S. economy, with deeper historical roots, than a focus on speculative bubbles allows. This is not to deny that a financial bubble developed in the U.S. economy in the 1990s and 2000s, and that it has shaped (or more aptly, distorted) patterns of accumulation in the U.S. economy. But I argue that an examination of processes internal to financial markets is incomplete as an account of the turn to finance, and that these processes must be understood in the context of wider shifts in the political, economic, and social environment. In this regard, my central thesis is that our own era of free-flowing credit, financial manias and panics is the result of a state-organized response to the economic crisis of the late 1960s and 1970s. More specifically, I argue that state policies that promoted the turn to finance allowed the state to (at least temporarily) avoid the economic, social, and political difficulties that observers at the time believed would soon overwhelm policymakers. Thus, the creation of a policy environment conducive to financialization was not a deliberate outcome sought by policymakers but rather an inadvertent result of the state’s attempts to solve other problems.

Bold added. The book is sociology, but the interesting thing to me is how much the central argument dovetails with research in other disciplines. For instance, Cowen's "Great Stagnation" hypothesis, Rajan's political economy of credit access as inequality palliative, the divergence between income and consumption inequality (pre-crisis at least) that was partially due to increased credit access. Herman Schwartz has a book chapter in Konings' Beyond the Subprime Headlines. Here's one selection:

Put simply, America’s ability to securitize large quantities of mortgage debt and sell it into global markets enabled the US economy to temporarily escape the normal economic constraints, to grow faster than its peer competitors, and to expand its firms’ control over global production chains. These three conditions restored US global economic power after the troubling 1970s and 1980s.

His book expounds on the argument. All of these narratives complement the Blyth/Taleb argument that moderating risk by shifting it into the tail compounds crisis in the end. It also is reconcilable with various accounts of how the "Greenspan put" interacted with loose monetary policy in bad ways.

The story that appears to be emerging is one in which policy makers try to mitigate the effects of a stagnating economy, in which real income growth is low and unequally distributed, by encouraging improved standards of living through financialization. In essence, the government encourages the levering up of the economy, and financiers are happy to go along because it means big profits for them. The Greenspan put gives them some security, too. Citizens may have preferred broad real wage growth, but access to cheap credit provides opportunities for increased standards of living in the absence of that growth.

As I said, I haven't read the book yet, but I'm looking forward to seeing how well it pulls strands like the above together.

Black Swans and the Arab Spring

Nassim Taleb and IPE Prof. Mark Blyth apply "Black Swans" to foreign policy and the Arab Spring:

Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to "Black Swans"--that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.

Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems. ...

Take, for example, the recent celebrated documentary on the financial crisis, Inside Job, which blames the crisis on the malfeasance and dishonesty of bankers and the incompetence of regulators. Although it is morally satisfying, the film naively overlooks the tact that humans have always been dishonest and regulators have always been behind the curve. The only difference this time around was the unprecedented magnitude of the hidden risks and a misunderstanding of the statistical properties of the system. ...

Humans fear randomness--a healthy ancestral trait inherited from a different environment. Whereas in the past, which was a more linear world, this trait enhanced fitness and increased chances of survival, it can have the reverse effect in today's complex world, making volatility take the shape of nasty Black Swans hiding behind deceptive periods of "great moderation." This is not to say that any and all volatility should be embraced. Insurance should not be banned, for example.

But alongside the "catalysts as causes" confusion sit two mental biases: the illusion of control and the action bias (the illusion that doing something is always better than doing nothing). This leads to the desire to impose man-made solutions. Greenspans actions were harmful, but it would have been hard to justify inaction in a democracy where the incentive is to always promise a better outcome than the other guy, regardless of the actual, delayed cost.

I don't have too much to say about this right now, but I find the basic argument very interesting. (For those without institutional access to Foreign Affairs, Blyth describes the basic principles in this audio interview.) It's not especially new, especially for Taleb, but generalizing the argument that economies, polities, and other social systems are complex adaptive systems is important. The central claim -- the more we try to keep a lid on volatility, the bigger the inevitable explosion -- may or may not be strictly true. It's the sort of claim that needs more empirical support than they provide in this essay alone. But the bigger argument about complex systems is surely true, and internalizing it is important for social scientists and policy makers. I expect this sort of thinking to guide a lot of future research in the social sciences.

Dominique Strauss-Kahn Arrested

Yes, that's the head of the IMF. No, it wasn't for impoverishing a poor country. It was for something lewder.

Some dinner companions told me about this tonight. My first (non-serious) thought: Sarkozy's trying to knock Strauss-Kahn down so he can't run against Sarkozy in the next election. But the alleged assault took place in Manhattan and he was arrested by U.S. policy, so now we get to look forward to years of the French lecturing us on how prudish we are. Great. Or maybe not:

“He came out of the bathroom, fully naked, and attempted to sexually assault her,” Mr. Browne said.

That's pretty horrible, if true. Maybe we can trade him back for Polanski.

1937

(click here for animation)

I agree with Krugman again:

How bad will it be if we don’t manage to raise the debt ceiling? ...

First, US government debt plays a special role in the financial system: T-bills are the universal safe asset, the ultimate collateral. That’s why, during moments of financial stress, the interest rate on T-bills has actually gone negative. Make that safe asset suddenly unsafe, and it might cause vast disruption.

Krugman should make the point much stronger. It will cause vast disruption. And not just for the U.S. financial system, although that would be bad enough. The effect on the global financial system would be far worse. There's a reason why, following the biggest financial crisis since the Great Depression, capital actually flowed into the U.S. banking system, which was the epicenter of the storm. It's because the U.S. was at the epicenter of the storm. Stabilizing the U.S. was necessary to stabilize the global financial and economic system. If you click on the link above and watch the animation, you'll notice that the U.S. becomes more central to the global banking system over the period 1999-2010. And you'll even notice that, while the network wobbles after the shock in late-2008, it reinforces itself pretty quickly. Why? Because if the U.S. went under, then all those thick black lines would disappear, and everyone else would go under too.

What does this mean? It means that the rest of the world is heavily invested in the U.S. Which means that if the U.S. has a downturn, the global economic system has a downtown. If the U.S. refuses to raise the debt ceiling, there are two possible outcomes, which are not mutually exclusive: quick, harsh austerity that will crush what little recovery we've had; some form of default on debt. In truth, one implies the other. Both of them involve a massive collapse in global aggregate demand, as well as the mother of all bank runs. This is important because U.S. Treasury bills are considered "riskless" by financial institutions around the world. If the "riskless" assets become risky overnight, the effects on bank balance sheets will be catastrophic. Global regulatory structures will effectively cease to exist (since enforcing capital requirements would make every bank insolvent), and runs on financial institutions will occur almost immediately. The U.S. won't be able to intervene to stabilize the banking sector since its debt-spending capacity has been eliminated, so the banks all melt down. If that happens, not only would the U.S. economy crash the world economy would crash as well. There are few countries immune from an American virus. This would be a pandemic.

Moreover, it's just not necessary. The U.S. can currently borrow for five years at negative real interest rates (i.e. adjusted for future inflation). That means that other people will currently pay us to take their money. Let me repeat: Other people will pay us to take their money for the next five years. Instead, we're considering blowing up the global economy. Bad deal.



What happens when global economies blow up? Well, all of the examples we have are pretty bad. They tend to lead to long depressions, world wars, nuclear bombs being dropped, that sort of thing. I'm trying not to be too hyperbolic, but the major thing separating this crisis from the 1930s is a series of global institutions that are buttressed by economic stability in the U.S., integrated Europe, and Asia. If we blow that apart, then things can get ugly very quickly. Quite frankly, I'd rather not conduct a natural experiment to see how well various IR theories hold up.

For these reasons, I don't think it will happen. I don't want to put anything past the current Congress, which is as petty and short-sighted as every other Congress, but the stakes here are just too high. Then again, we've been in similar situations before, and they didn't always end well. If Congress is engaged in a game of chicken, then I hope they're ready to jump. This isn't worth toeing the line.

Offered Without Comment

Felix Salmon:

Ezra’s fixated on economic growth as the goal which politicians are aiming for. But that’s not the goal at all. The real goal is the same as it’s always been: to get re-elected. And if you want to get re-elected in America, a hard-line stance against any kind of tax hike looks entirely rational.

This doesn’t mean that people like John Boehner are lying when they say that it’s better to risk a federal default than it is to raise taxes even a little bit. It’s just that incentives matter. And the kind of people who believe those things tend to do quite well in today’s Republican Party — especially since the Tea Party became a serious political force. ...

The only thing you need to understand the Republican position on the debt ceiling is this number: 47% of Americans oppose raising the debt ceiling, while only 19% support it. Republicans will vote no on this for the same reason that they voted no on TARP — politically speaking, doing so makes all the sense in the world.

When asked why they’re voting as they are, they could simply cite the will of the people, which is quite a good reason in a democracy.

Will Wilkinson:

In their book " Degrees of Democracy: Politics, Public Opinion, and Policy", Stuart Soroka and Christopher Wlezien, political scientists at McGill and Temple, find that policy tends to track public opinion fairly closely, and that there is generally little difference between the preferences of voters in the lower, middle, and upper third of the income distribution. Income-based differences in policy preference are greatest, however, on issues clearly related to inequality, such as welfare spending and taxation. But on these issues, for which there is a relatively large gap in preference between lower- and upper-income voters, there is practically no gap between middle- and upper-income voters. And, of course, the middle-class is where most voters are. ...

This may be cold comfort to low-income voters who disagree with the middle-upper consensus, but that's democracy. The minority does not prevail. ...

The public doesn't know or particularly care about the regulatory environment within which competitors in the widget industry vie for advantage, so public opinion can hardly rule. ...

Now, it's important to remember that corporate favour-seeking is a negative-sum game in which wealthy people mainly screw over competing wealthy people—a far cry from a conspiracy of the rich against the rest of us. But the cumulative effect of all this piecemeal, competitively anti-competitive rent-seeking—of all the major firms in all the economy's sectors constantly seeking a government break here, a government boost there—can be a comprehensive regulatory climate that appears for all the world as if it were designed by the executive committee of the top 1% for its exclusive benefit. ...

If it turns out that the road to plutocracy is paved with co-opted political discretion, and not the selfish wishes of the conspiring super-rich, we'll need to consider carefully what to do about it. The good news is that democracy works reasonably well. Policy does tend to reflect majority public opinion if the public is paying attention to the right things and knows what it wants. The bad news is that the public isn't paying attention to the right thing, and I fear the way we have been talking about inequality and plutocracy isn't helping.

Hooliganism and the Unholy Trinity

I’m with Krugman on this:

Putin says we’re hooligans; Brazil accuses us of “currency wars”; and the Chinese are, well, being their usual charming selves. But what’s going on in the international currency scene?

I don’t know why I didn’t think to put it this way before — and I don’t know if anyone else is saying this — but what we have here is a classic example of the Mundellian impossible trinity, aka the trilemma, which says that you can’t simultaneously have free movement of capital, a stable exchange rate, and independent monetary policy. …

So, how does this apply to current issues? Advanced countries, very much including the United States, are weighed down by the aftereffects of the 2008 financial crisis; this has led to low investment returns. Meanwhile, emerging markets are in much better shape, so capital wants to go there.

And this creates a problem for the EMs. They don’t want their currencies to rise sharply…

But not letting the currency rise would be inflationary – that is, Brazil doesn’t want to give up on its independent monetary policy. So what’s the answer?

All those accusation of hooliganism, currency wars etc. are in effect demands that the trilemma be resolved by having America give up having an independent monetary policy — basically, that the Fed give up on trying to stabilize the US economy so that emerging markets aren’t faced with the uncomfortable tradeoff between massive appreciation and imported inflation. But this shouldn’t and won’t happen.

Yes. And thinking in terms of the Trilemma is important because it helps us understand domestic politics within an international context. Brazil and the other EMs are worried about (nominal) exchange rate appreciation because it hurts their exporters, which is a politically powerful group. Inflation hurts consumers (and creditors), which is also bad for democratically-elected politicians. So that leaves capital controls, which remains the preferred trade-off of many EMs.

This is an illustration of how the U.S. really is still the most powerful global economic actor, as everyone else is having to adjust to U.S. policy rather than the other way around. The same thing happened (in slightly different ways) during the collapse of Bretton Woods, as Yglesias noted:

This is one reason why I’ve grown impatient with nostalgia for the good old days of the Bretton-Woods system.This system, which really was working great in its heyday, essentially involved the United States playing precisely the role that we now reject. The dollar was pegged to gold, other currencies were pegged to the dollar, foreign countries could change the dollar price of their currencies, and we couldn’t reset the value of the dollar. This worked fine as a means of facilitating catch-up growth in Japan and Western Europe but that growth make it impossible to sustain, so it wasn’t sustained and there’s no practical method of bringing it back.

I would add one thing. The Trilemma refers to the ubiquitous "small, open economy" and therefore leaves out a component that is highly salient for politics: one country in the system can have all three of free capital movement, fixed exchange rates, and independent monetary policy. As Dr. Oatley explained awhile back, this is because exchange rates are not monads:

But in what sense does the US not pegging the dollar imply that the dollar is not pegged? China and the other East Asian governments peg to the dollar. And even Japan, which doesn't peg the yen, does limit its fluctuation as if it has a target zone. For all practical purposes, then, the dollar is pegged against many of its most important creditors (the Euro is the only exception, but the euro area as a whole is a debtor rather than creditor area). If this wasn't the case, we wouldn't be having this conflict.

More generally, any discussion about the unholy trinity needs to recognize the n-1 problem. In any system of n countries there are n-1 independent exchange rates. Think about a three-country system. If China pegs to the dollar and South Korea pegs to the dollar, the China-South Korean rate is fully determined by the cross rate.

As a result, every exchange rate system (other than a gold standard) has one degree of freedom: one country can attain a fixed exchange rate, and capital mobility, and monetary independence. Whichever country holds this position gets to set monetary policy for the system as a whole. International monetary politics revolve who gets this degree of freedom and how it is employed. …

This suggests that we are back in a world very much like the late Bretton Woods: the US has a pegged exchange rate against many of its major creditors and capital mobility and monetary autonomy. The current conflict is a consequence of East Asian governments forcing the US to accept a peg at a rate it does not think is appropriate. Like Geithner and Co. now, the Nixon administration believed it couldn't devalue an over-valued dollar unilaterally.

And this is why the U.S. gets called “hooligans” and everything else.

Closing Thoughts on Elites

I spent a lot of time in this Crooked Timber comment thread discussing my previous two posts and the reactions to them. I think it's safe to say that I convinced exactly no one, and it's now devolved well past the original point of contention, so I want to clarify a few things and then I'm letting this go. I suspect that in terms of actual views of politics there’s less disagreement than first appears, but I could be wrong. The first point is related to the initial context of Krugman, and why I reacted the way I did to him. The other points are more general, and mostly refer to specific arguments brought up by commenters at CT. Drezner has additional thoughts. Phil Arena had a good post too. And Michael Flynn adds some important points. Dan Nexon jumps back in, and I agree completely with him that politics is almost entirely about rent-seeking and redistribution, but interest groups are part of the public and elite opinion is only one component of political competition. I expound on this below.

1. (NOTE: After I wrote this, but while Blogger was down so I couldn’t post it, Krugman himself took note, although he tries to rise above it by not offering comment. Too bad… he might’ve used the opportunity to express what it is, exactly, I’m “creatively misreading” by saying how much responsibility he believes the public bears. Since he says my accusation – that he’s trying to exculpate the public – is a misreading, I’ll take that to mean that he agrees that the public does deserve some blame. This makes his column, as written, very odd. It also makes many of the criticisms of me in the CT thread criticisms of Krugman as well. Anyway, I’m leaving this in the post because it gets at the reading I originally had, and the reasons I had it, which is the most interesting thing from the perspective of argument rather than piss-contest.) A lot of people think I misread Krugman, or was otherwise uncharitable. I was definitely uncharitable, because I have a pretty strong distaste for Krugman's predilection towards a "good vs evil" characterization of politics. CTers, who all seem to like Krugman quite a bit more than me, were much more charitable. That's fine with me. But I don't think I misread him. [Ed.: I accept that I did, now that he says I did. I stand by my general argument, which may be knocking down a straw man in Krugman's case, but as I learned at CT there are certainly others who hold a view close to this.] The point of his op-ed was to place responsibility for policy disasters on policy elites (at least the ones he disagrees with). To do that, he felt he needed to exculpate the public. So he argued that these were "top-down" policies, not "responses to public demand". Only once in his column (Greece) does he mention that the public had any role in this ("So who was to blame for these budget busters? It wasn't the man in the street")*. There wasn’t any sort of “and the public went along with it” or even “and the public was gullible enough to buy Dubya’s lies hook, line, and sinker” or anything like that. A lot of time in CT comments was spent dissecting exactly what was meant by "responses to public demand", and no agreement was reached, but my definition (and Drezner's) included "doing things that the public broadly supports so that you get elected". The modal CT commenter seemed to prefer a stricter definition of "demand", and perhaps a lot of our disagreement stems from that semantic question, but short of election results and polling data I'm not really sure what they could mean by that and none of them was able to say. Krugman’s “top-down policies” implies, to me, that the bottom-up public had nothing to do with it.

My argument against what Krugman is saying now is actually congruent with what Krugman has written previously. Not just on Medicare Part D, as Henry Farrell pointed out, but more generally. When it comes to enacting policies that Krugman prefers, he has no problem at all citing poll data or election results as evidence of public demand, so I remain unconvinced that I was misreading him [Ed.: Caveat above applies here too.]. To drive this point home, here's what Krugman wrote a few weeks ago:

Eventually, of course, America must choose between these differing visions [from competing elites]. And we have a way of doing that. It’s called democracy. ...

For what it’s worth, polls suggest that the public’s priorities are nothing like those embodied in the Republican budget. Large majorities support higher, not lower, taxes on the wealthy. Large majorities — including a majority of Republicans — also oppose major changes to Medicare. Of course, the poll that matters is the one on Election Day. But that’s all the more reason to make the 2012 election a clear choice between visions. ...

So let’s not be civil. Instead, let’s have a frank discussion of our differences. In particular, if Democrats believe that Republicans are talking cruel nonsense, they should say so — and take their case to the voters.

This is the same evidence -- polls and election results -- that Drezner and I cited when arguing that the macro polity supported Bush's policies while Krugman says they didn't (or didn't "demand" them). So Krugman is trying to have it both ways: public demand as measured by polls and elections matters when it agrees with him, but does not when it doesn't. If the Democrats take their case to the voters and win, Krugman will claim a public mandate; If the Republicans win, he will claim elite manipulation by Very Serious People. How is this not a double-standard?

And I agree; let's not be civil. When an elite "pundit in good standing" plays intellectual three-card monty, let's call it what it is: "Unwisdom", to borrow Krugman's expression. Krugman is a partisan, and that's fine, but that shouldn't give him license to be this selective in evidence.

2. I very much believe that elites (and interest groups) play a huge role in creating policy, particularly in the details (i.e. where the devil is). In fact, the conclusion of my post previous to the one that started all this was:

It's no secret that investors will try to move markets in ways that are advantageous to them, nor that political elites will try to turn public opinion through the media. But in this case basically everyone agrees that Greece is insolvent, and that some form of restructuring is all but inevitable. That doesn't mean that the terms of that restructuring, nor the political implications for the eurozone, are assured. These might be examples of certain investors, government officials, or policy entrepreneurs [trying] to influence the timing of the restructuring, as well as the political response to it.

Elites matter, but within the context of public opinion plus institutional and other constraints. The relative weight of each of those -- public, elites, institutional constraints -- will vary by issue, but for high salience issues like tax policy and wars the public will play a large role in shaping the policy space.

One example (of several) I gave in comments at CT to illustrate this fact is that in addition to tax cuts that largely benefitted the wealthy, Bush also wanted to privatize Social Security. Many of the same elites that Krugman is attacking supported both policies. One of those became policy. The other didn't. Reference to "elites" in the way we've been discussing them doesn't tell us anything about why there were divergent outcomes in these cases. What we do know is that the public supported one, and not the other. Therefore, is it really so unreasonable to conclude that public opinion might be a relevant variable? And if it is, then shouldn't the public share some (not all) of the blame when things go wrong?

3. What we mean by "elites" isn't clear. As I pointed out in CT, and as Drezner mentioned too, by the definition Krugman uses -- "self-appointed wise men, officials, and pundits in good standing" -- Krugman himself qualifies as an elite. As does practically everyone else with a recognizable name. Elites often have different preferences, so ex post it will always be easy to find some that supported any particular policy, and then blame them for any bad outcomes following from it. While this might be cathartic, it doesn't help us understand which elites got their way and why. For example, many elites (including Greenspan and the whole Republican party) wanted the Bush tax cuts. Many others (including Krugman and the whole Democratic party) did not. If that's all we knew, and we start from the assumption that only elites matter, how could we understand outcomes? And if elites aren't the only thing that matters, why should they be the only ones to take the blame when things go wrong?

Similarly, the “public” does not refer to 100% of everyone. Krugman’s definition of an elite – “self-appointed wise men, officials, and pundits in good standing" – actually excludes the sort of interest groups that we generally think are involved in rent-seeking political behavior: industry groups (e.g. Wall Street), trade unions, religious organizations, farm associations, AARP, etc. According to Krugman’s definition, those would all be included in the “public” that had little-to-nothing to do with this. Instead, it’s all David Brooks’ fault.

The modal CT commenter surely thinks that the people who voted for George W. Bush made a big mistake, borne of ignorance, stupidity, or a view of politics that they completely disagree with. What’s wrong with saying that people who make mistakes deserve some portion of blame? (This is Krugman’s primary thesis, just applied to elites rather than voters.) If folks wish to exempt themselves from that slice of the public they are free to do so, without complaint from me. For my part, I never voted for Bush, actively campaigned against him in 2000 (I sat out 2004), and did not support any of the policies under discussion at the time they were put in place. So I’m more than happy to criticize those that did.

I didn’t highlight the role of interest groups within the public in my first post. That was a mistake. I think about politics is as interest group competition, and since (I believe) Krugman does too it didn’t occur to me that such a clarification was necessary. Sometimes interest groups coalesce around certain policies – tax cuts, wars – in sufficient numbers that referring to a macro polity as if it was unified makes sense (to me, at least), but that’s not to imply that interest groups are homogenous.

To reiterate and close: I'm fine with blaming elites for bad outcomes. I do it all the time. It's fun, they deserve a lot of scorn, and are rightly punished at the polls when they screw up. The thing I like most about Krugman, and basically the only constant thread in his popular writings from the 1990s until now, is that he's great at punching holes in bad numbers and illogic that pundits and politicians often use. But some blame is surely left over for an electorate that prefers low taxes and high spending, and rewards politicians that give them both, when those policies lead to a budget mess.

My next post will about something I really like about Krugman.

P.S. Farrell suggests I read Pepper Culpepper's book. It's been at the top of my Amazon wish list since I first heard of it (I believe via Farrell) six months or so ago. I hope to get to it later this summer. But as I understand it, the book is about "quiet politics", i.e. issues that the public knows and hears little or nothing about. I don't think that accurately characterizes the public debates over tax cuts, wars, or health care. (It probably does with regard to financial regulation, in the late-1990s and early-2000s at least.) Salience with the public is important, and these are the most salient issues in American politics. I'm not sure why we should expect case studies of some of the least salient issues (in other countries) to map on to this discussion very well. In fact, if David Soskice's blurb -- "Culpepper argues with detailed empirical plausibility that democracy can only impose change in technical policy debates if they are of high salience" -- is accurate, then if anything we should take the opposite view in these high salience cases. There's appears to be a huge generalizability problem. So while I'm willing to accept Farrell's chiding on how to do IPE better, we need to make sure that we're not going off too far in the other direction of extrapolating too much from limited cases.

*He doesn't mention Medicare Part D in his column, but does toss off "with few exceptions" which is possibly a reference to that, and as Farrell pointed out to me, Krugman mentions Part D in a separate blog post as being a response to public demand. The fact that he was this selective with his examples in his column indicates to me that a charitable reading isn't the right one. He's stacking the deck on purpose. And of course I think that the tax cuts, Iraq war, and euro-adoption are about as much "exceptions" as Part D. But I've already said that I'm not inclined to give Krugman a charitable reading, so YMMV, of course.

7 Year Old Politics

Henry Farrell goes after me over this post, and says he'd rather be an unsophisticated 6 year old than... whatever I am. Dan Nexon seconds the motion. Really Farrell's making a much bigger point about IPE and is using me as an illustrative case. He's written about this before.

This puts me in a weird position. I tossed off that post, mostly because I was short of time and because Krugman perpetually annoys me. The point of the post was intended to be that Krugman's constant moralizing doesn't get us anywhere, not even as far as the most basic view of democratic politics. The point was not that the most basic view is the right one. I tried to caveat a bit ("first approximation", "doesn't always work"), but that obviously didn't get across. So I guess Farrell's response is just desserts for being lazy. I'll try to flesh out what I meant better in this post. While I don't want to run away from what I wrote, much less what I intended to convey, I also don't want to get the shit kicked out of me for something I don't really think. So this will be at least as long as Farrell's post, and much longer than Nexon's.

As (I think) Farrell knows, I agree with many of his points about IPE in general. I agree that IPE does a very poor job of explaining preference aggregation, and a pretty poor job of preference formation (although, ideally, we could just import at least some of that from comparative politics). In fact, I'd extend it: I think IPE has a generally poor view of the political space, and like other subfields of political science is too reductionist. I agree that IPE does not have a very good sense of how interest groups and elites influence policy in democracies. I agree that we should pay more attention to subfields that examine these questions in detail. As he says, IPE generally infers preferences from economic theory, then applies some crude form of the median voter theorem (if that) to explain outcomes*. IPE generally assumes (implicitly) that voters are fully informed, and actually care about whatever issue we happen to be studying.

This is lazy even when it's not entirely wrong, and a big part of my dissertation is dedicated to more rigorously exploring how interest groups shape policy in a global context. So, as a jumping-off point, I don't mind him taking me to the rails. Except. He's writing this in defense of Krugman's purely elite-driven take. Here's what Krugman says:

The fact is that what we’re experiencing right now is a top-down disaster. The policies that got us into this mess weren’t responses to public demand. They were, with few exceptions, policies championed by small groups of influential people — in many cases, the same people now lecturing the rest of us on the need to get serious. And by trying to shift the blame to the general populace, elites are ducking some much-needed reflection on their own catastrophic mistakes.

Here's what Farrell says:

On many important policy issues, the public has no preferences whatsoever. On others, it has preferences that largely maps onto partisan identifications rather than actual interests, and that reflect claims made by political elites (e.g. global warming). On others yet, the public has a set of contradictory preferences that politicians can pick and choose from. In some broad sense, public opinion does provide a brake on elite policy making – but the boundaries are both relatively loose and weakly defined. Policy elites can get away with a hell of a lot if they want to.

These are two very different statements. On the issues we're talking about -- tax cuts, Iraq war, prescription drugs covered by Medicare, housing policy -- the public did have pretty clearly identifiable preferences about policy, and those happen to map onto policy debates (and resulting legislation) fairly well**. As I linked in the prior post (via Drezner), a majority of the public supported the Bush tax cuts and the Iraq war. The former represented the biggest policy proposal of Bush's 2000 campaign, the latter represented the biggest policy proposal of his 2004 campaign. He won both of them. (Okay, only kind of won in 2000.) Moreover, the public's representatives in the House and Senate voted for both policies.

Now we could believe that public preferences had nothing to do with the Bush tax cuts becoming law and the Iraq war being prosecuted. But then how to explain how a number of other policies supported by the same elites but not the public during the same period -- Social Security privatization, immigration reform, invading Iran -- did not become law or practice? If we're to discard polls and the votes of representatives, how else are we going to get at the public's preferences to know whether they're relevant?

That's not to say that elites don't have a huge role in shaping public opinion, crafting the specific nuances of policy, or even that they have quite a lot of flexibility to shape policy to their own ends. Of course they do. Legislation is written by elected elites, who are influenced by unelected elites and interest groups within their states/districts. One casual glance at trade law is enough to convince anyone of that. Medicare Part D gets closer to Farrell's last sentence. The public supported coverage of prescription drugs by Medicare. It seems likely to me that the public did not have strong preferences over precisely how that happened, other than that they would prefer not to have to pay higher taxes. So what we got was an unfunded bill that catered strongly to the interests of the drug industry. Similarly, the public supported tax cuts. The particulars of the Bush tax cuts met that demand, but in a way that also privileged powerful interest groups and likely Republican voters (see the cartoon in the Bartels paper Farrell links to). There is nothing in the Hacker/Pierson or Bartels studies that Farrell cites that disputes this interpretation***.

But here's the key point: the policy space that elites use to manipulate for their own ends does not exist without the broad support of mass publics****. Or, as Farrell says, "It is fair to say that the Medicare changes began in a shift in partisan patterns of competition over issues. However, it surely didn’t end there." No argument from me. That, however, is not what Krugman argues. He claims that the public had nothing to do with it at all. That this is purely a top-down disaster. This view is disputed by the Campbell and Morgan quote that Farrell reproduces:

More generally, gaining the support of powerful interest groups was essential in passing a reform that was likely to garner little Democratic support and was viewed skeptically by more conservative Republicans.

Right, but this was only important because the public wanted Medicare to cover prescription drugs in the first place. If they hadn't, a bill that both Republicans and Democrats were ambivalent about is unlikely to have become law. To gain passage, and thus satisfy the public demand, it became necessary to craft a bill in such a way as to get the necessary support from powerful interest groups. But that doesn't negate the public's interest in reform along the broad lines that reform occurred. A very similar process occurred during the PPACA ("Obamacare") deliberations.

Near the end Farrell writes:

One can certainly make a reasonable case that electoral politics plays a more important role than Krugman acknowledges. But one cannot make a good case that policies of the kind that Winecoff describes are a simple reflection of public preferences.

This where Farrell is misreading me. (And, I think, Drezner.) We're not saying that the public was perfectly represented, much less "reflected". Indeed, I think such a statement is all but meaningless. Drezner has written a book about how interest groups dominate regulation of the economy, particularly in highly-technical areas in which the public is unlikely to have much information or strong preferences. We're both very interested in how power and influence is filtered through political institutions/interactions. I'm just saying, contra Krugman, that mass publics are part of that equation. After linking to a bunch of surveys showing that the public broadly supported the policies Krugman says they had nothing to do with, I wrote in my post, "This [reference to public opinion] might not work all the time, but as a first approximation this sort of thinking holds up fairly well". Or, at least, to entirely excuse the public from the outcomes of policy you should first have to show that they didn't create the political space for those policies to be enacted. Krugman can't do that. That's the point.

(As for housing policy, I'd refer Farrell (and anyone else interested) to the CPE/IPE research done by Seabrooke and Schwartz (also here and this special issue of Comparative European Politics). Ragu Rajan has argued that the rise of credit was encouraged by policymakers to offset stagnating median wages. Oatley has an argument that "what we're experiencing right now" is a result of a number of macro policies, operating within an international context, that both elites and the public broadly supported, culminating in disaster. I think, though I've done no research to back it up, that home ownership was encouraged by major public policies -- including the mortgage interest deduction and Fannie/Freddie -- supported through a host public policies by administrations and majority Congresses from both major parties across several decades, and that the most recent housing crisis is only the most recent, not the only. In many cases, bipartisan elite opinion is/was that these policies distort the economy and should be abandoned. Which mass publics wanted less access to credit and higher interest rates? Sure, finance liked it also, but they weren't the only ones. I.e., We got the housing finance we got because the public wanted credit, the politicians wanted votes, and the financiers wanted profits. NOTE: I slightly modified this parenthetical after initial posting to improve clarity and fix typos.)

*Usually IPE just pumps POLITY into a regression and mumbles something about transparency or checks and balances and then moves on.

**As for "On other [issues], [the public] has preferences that largely maps onto partisan identifications rather than actual interests"... Who's lazily inferring interests now? Why can't partisan identification be an interest?

***The dearly departed George Rabinowitz used to befuddle his Intro to American Politics students every year by assigning Showdown at Gucci Gulch, a journalistic account of the passage of the 1986 tax reform act. It does a great job of explaining how the pressure for tax reform was generated by the mass public, but how the vagaries of getting it passed heavily involved elites and interest groups.

****For one thing, saying "elites did it" doesn't actually tell us anything at all. There are elites on both sides of every issue. Krugman himself is an elite now, as he was during all of the 2000s, and yet he disagreed with most major policies enacted during that period. Which elites get to control policy is decided, among other things, by the publics.

Finance, Trade, and Growth Through History

New NBER paper:

Historical Evidence on the Finance-Trade-Growth Nexus
Michael D. Bordo, Peter L. Rousseau
NBER Working Paper No. 17024
Issued in May 2011

We study linkages between financial development, international trade, and long-run growth using data since 1880 for seventeen now-developed “Atlantic” economies and a set of cross-country and dynamic panel data models. We find that finance and trade reinforced each other before 1930, but that these effects did not persist after the Second World War. Financial development has positive effects on growth throughout the sample period, while trade affects growth strongly and independently after 1945. We attribute the rising importance of trade in explaining growth to major post-World War II changes in tariffs and quantity restrictions associated with the GATT, the establishment of the European Common Market, and the gradual elimination of capital controls after 1973. The findings are robust to the use of ‘deep’ fundamentals such as legal origin and indicators of the political environment as instruments for financial development and trade. Financial development, however, is more closely linked to these fundamentals than trade.

When all the debate over whether financial innovation added any value to society was going on, and folks like Volcker were saying that there was no evidence that it did, I always wondered what the evidence was. I've always thought that countries with deep, liquid financial markets had better economic performance than those that did not. I've always thought that financial innovation helped to create deep, liquid financial markets. Not sure this paper will settle that question, but it's worth a look.

There Will Be Politics

UPDATE: Henry Farrell and Dan Nexon have taken their shots at me, at least partly deserved, but I didn't say the things I said. A more fleshed out version of my thought is here.

Paul Krugman thinks that democratic politics does not exist:

Well, what I’ve been hearing with growing frequency from members of the policy elite — self-appointed wise men, officials, and pundits in good standing — is the claim that it’s mostly the public’s fault. The idea is that we got into this mess because voters wanted something for nothing, and weak-minded politicians catered to the electorate’s foolishness.

So this seems like a good time to point out that this blame-the-public view isn’t just self-serving, it’s dead wrong.

The fact is that what we’re experiencing right now is a top-down disaster. The policies that got us into this mess weren’t responses to public demand. They were, with few exceptions, policies championed by small groups of influential people — in many cases, the same people now lecturing the rest of us on the need to get serious. And by trying to shift the blame to the general populace, elites are ducking some much-needed reflection on their own catastrophic mistakes.

If Greenspan's "with notably rare exceptions" deserves internet infamy, and it does, then surely Krugman's less notable exceptions should too. As Drezner notes, Krugman's examples -- the Bush tax cuts and the Iraq war, mainly -- were supported by majorities of the population. Bush campaigned on a platform of tax cuts too, so it's not as if he tricked the public once elected.

What interests me about this isn't that Krugman is playing fast and loose with his factual claims, or even stacking the deck in a blatantly partisan way. That's par for his course. It's that he thinks that a simple political explanation is just not feasible. Instead, some moral lesson is needed. If something bad happens, it must be because bad people are doing it. This is the political sophistication of a six year old. The specific bad people in this case -- "self-appointed wise men, officials, and pundits in good standing" -- are less interesting than his usual coterie of sado-masochists, mythical creatures, and conspirators, but at least this time Krugman manages to indict a category of people that includes himself.

Occam's Razor can help us here. If there are tax cuts, maybe it's because people wanted tax cuts. If there is Medicare Part D, maybe it's because people wanted Medicare Part D. If there is a housing bubble, maybe it's because public policy was skewed in ways that home ownership attractive, because that's what people want*. This might not work all the time, but as a first approximation this sort of thinking holds up fairly well. In the examples Krugman gives, it's batting 1.000**. Saying that democratic polities have problems with time inconsistency and preference aggregation isn't exactly a new insight.

Krugman closes with this:

But the larger answer, I’d argue, is that by making up stories about our current predicament that absolve the people who put us here there, we cut off any chance to learn from the crisis. We need to place the blame where it belongs, to chasten our policy elites. Otherwise, they’ll do even more damage in the years ahead.

Amen, I suppose, but there's plenty of blame to go around. We all played a role in this crisis. Not an equal role of course, but a part nonetheless. Might as well own up to it.

*Mortgage interest tax deductions, subsidized subprime (and prime) loans, lower capital requirements for MBS, etc.

**Drezner wonders about public support for financial deregulation. I challenge Krugman to name the deregulatory act that led to the financial crisis. If he can't, and he hasn't, then his example fails and Drezner doesn't have to worry about it.