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Is This a $700 Billion Game of “Rock, Paper, Scissors”?

September 23rd, 2008 . by economistmom

I’m certainly with the skeptical economists quoted in this New York Times article written by Peter Goodman  They ask: why is moving bad debt (troubled, illiquid “assets”?) onto the federal books a good deal for taxpayers?  What exactly are taxpayers getting in return for taking on all this risky paper?  The article quotes Doug Elmendorf of the Brookings Institution (and a Fiscal Wake-Up Tour panelist):

“At first it was, ‘thank goodness the cavalry is coming,’ but what exactly is the cavalry going to do?” asked Douglas W. Elmendorf, a former Treasury and Federal Reserve Board economist, and now a fellow at the Brookings Institution in Washington. “What I worry about is that the Treasury has acted very quickly, without having the time to solicit enough opinions.”

(See Doug’s concerns about the Treasury plan here.)

And Dean Baker of the Center for Economic and Policy Research:

“This administration is asking for a $700 billion blank check to be put in the hands of Henry Paulson…It’s almost amazing they can do this with a straight face. There is clearly skepticism and anger at the idea that we’d give this money to these guys, no questions asked.”

The problem is this:  why should we believe that the federal government taking on more (and “bad”) debt would be good for American taxpayers, or in particular, future American taxpayers, when the federal government has already been living beyond its means?  Can a sinking ship really rescue another sinking ship?  Exactly how much credibility in international capital markets does the U.S. government have at this point, such that their taking hold of the bad debt would suddenly make it better debt?

Or, as Peter Goodman puts it (emphasis added):

The trouble is that these investments are so intertwined and complex that no one seems able to figure out what they are worth. So no one has been willing to buy them. This is why banks have been in lockdown mode: with mystery enshrouding both the value of their assets and their future losses, banks have held tight to their remaining dollars, depriving the economy of capital.

Now, the Treasury aims to clear the fog by buying up these investments. But their value is as mysterious as ever.

And Peter concludes with the thoughts of my former Chairman of President Clinton’s Council of Economic Advisers, Martin Baily (emphasis added):

It’s a straight subsidy to financial institutions,” said Martin Baily, a former chairman of the Council of Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings Institution. “You’re essentially giving them money.”

Mr. Baily favors the basics of the Paulson plan, albeit with some mechanism that would give the government a slice of any resulting profits. And yet he remains troubled by the dearth of information combined with the abundance of zeroes in the bailout request.

“I’d like a clearer statement of what we were afraid was going to happen that requires $700 billion,” Mr. Baily said. “Maybe they don’t want to talk about it because it would scare everybody, but it’s a bit much to ask.”

(See this paper on ”fixing finance” by Martin and his Brookings colleague, Bob Litan.)

This all strikes me as a bit of a crap shoot that the Administration is asking Americans to trust them on. 

In a freshman seminar course I guest taught today at George Washington University, students participating in the Concord Coalition’s ”Principles and Priorities” exercise started to run into gridlock in deciding whether or not to extend the Bush tax cuts.  The vote was split.  Their solution:  a coin toss, followed by a rousing round of “rock, paper, scissors.”  The outcome just happened to be that the tax cuts were allowed to expire, with trillions of dollars saved (relative to the policy-extended baseline), but of course there was a 50-50 chance that they would have been fully extended instead.  The students were pleased for having broken the gridlock, but also relieved that it “wasn’t real life.”

Well, the financial bailout being proposed sure seems like a real-life game of rock, paper, scissors–with potentially trillions of (real) dollars at stake.  We should be somewhat relieved that Congress seems willing to ask the critical question this week:  how can we make this a safer bet, so we know with greater certainty that taking such a bold step is worth it?

Learning From Ordinary Americans About Fiscal Responsibility

September 22nd, 2008 . by economistmom

Today Viewpoint Learning released this report, the result of a two-year initiative in partnership with Public Agenda, The Concord Coalition, The Brookings Institution, and The Heritage Foundation, to better understand public sentiment toward the fiscal challenges facing the federal government.

As the report summarizes:

What we found, in ["choice] dialogue["] after dialogue across the country, is that the main obstacle to building public support for the difficult choices we face is not public opposition to tax increases or program cuts, nor is it public lack of interest. The main obstacle is a deeply felt and pervasive mistrust of government. Americans were clear: It’s not about taxes. It’s not about spending. It’s about trust.

In particular, on tax increases, here’s a nice quote from a dialogue participant:

“We came to the conclusion, which was not happy for any of us … that taxes had to increase. This wasn’t something we liked; it was something we concluded. It’s not like we walked in saying, let’s raise taxes.”

(Gee, sounds like something Ben Stein or Bruce Bartlett, two good Republicans, might say.)

And the report highlights these results on taxes (emphasis added):

At the end of the dialogue, 57% of participants supported raising taxes as a means of reducing the deficit; and 67% were willing to invest in programs like education and transportation even if taxes go up. In the summer 2008 follow-up survey, 69% of respondents said that they would be willing to pay more in taxes if they could trust that the money was being well spent.

It’s obviously going to be important to convince the American public that the $700 billion for the financial market rescue will be “well spent.”  Otherwise that “mistrust” of government–the biggest obstacle to getting Americans to embrace fiscal responsibility–will just grow bigger.  How are Americans feeling about the “King Henry” factor?…

News Flash: The Problem Isn’t That the Government Is Too Little In Debt

September 21st, 2008 . by economistmom

Two wise columns in this morning’s Washington Post convey the same reminder:  the financial crisis seems to be encouraging ideas that clearly increase the debt position of the federal government, when clearly the federal debt has been part of the big problem.

Bruce Bartlett, a Reagan Administration official, urges the candidates to lay out real plans that would seriously reduce the budget deficit (emphasis added):

[I]t is extremely unlikely that either man envisioned the magnitude of the economic problems that are becoming more obvious by the hour.

Now, federal officials are crafting an entity akin to the Resolution Trust Corporation to buy up bad debts and get them off bank balance sheets. That’s how the RTC cleaned up the savings and loan mess in the early 1990s — to the tune of about $125 billion. Today’s problems will cost a lot more.

What this means is that we cannot afford either candidate’s tax and spending plans. The money that Obama would like to spend on the poor will have to be used to clean up the financial mess. Similarly, the tax cuts that McCain would like to hand out are off the table. The federal government is going to need new revenue and fast. We cannot continue to cut taxes as if the budget deficit doesn’t matter. The fundamental problem of the U.S. economy is too much debt. Fixing that will require belt-tightening from everyone — including the federal government, which must get its fiscal house in order to help the financial sector heal.

Voters should insist that McCain and Obama throw out their tax and spending plans and offer something that reflects current economic realities. These new plans must be more than vague generalities and should commit the next president to a course of action that involves real spending cuts and real tax increases.

…It would be useful for both candidates to work from the same benchmark, such as reducing the projected deficit by $1 trillion over 10 years. That would pretty much eliminate the use of “smoke and mirrors” and unserious proposals. If one candidate wants to raise taxes by, say, $1 trillion, then he should say so and spell out how. If he thinks we can get $1 trillion out of the income tax without burdening middle- and lower-income workers, let’s hear how. If he thinks we can cut spending by that much, he should explain how. If he thinks it can be done without significantly cutting popular programs such as Medicare, I for one would like to know how…

…It’s probably realistic to assume that the balance would be roughly 50-50 between taxes and spending, though each candidate could offer a different balance. But if the proposed package is so one-sided as to make enactment by Congress impossible, this is also useful information for voters.

The time for free lunches is past…The people deserve to know what is really going to happen in January…right now we need quick and decisive action if we are to right the economy.

And Sebastian Mallaby points out that the government bailout moves more debt onto the federal balance sheet (and onto the “taxpayers’ portfolio”)–not exactly just what the federal books needed.  He asks this really good question:  why couldn’t we consider the government taking on some equity instead? (emphasis added):

Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into a bad-loan bazaar and being ripped off by every merchant.

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments…Second, the government should tell all healthy banks to issue new equity…

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks’ bad loans but by buying equity stakes in the banks themselves. Whereas it’s horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Congress and the administration may not like the sound of these ideas. Taking bad loans off the shoulders of the banks seems like a merciful rescue; ordering banks to raise capital or buying equity stakes in them sounds like big-government meddling. But we are in the midst of a crisis, and it shouldn’t matter how things sound. The Treasury plan outlined on Friday involves vast risks to taxpayers, huge complexity and no guarantee of success. There are better ways forward.

Here we are, staring at a budget deficit that looks likely to top a trillion dollars next year.  Not exactly just what we needed… But is it too late to “wake up” and change course, along the lines that Bruce and Sebastian suggest?  I hate to sound so pessimistic, but the political momentum of the wrong course seems far too great.

$700 Billion

September 20th, 2008 . by economistmom

Right now I understand very little about where the figure comes from, but the figure for today is $700 billion.

Gulp.

UPDATE, 7:30 pm:  This story from The Economist is good at explaining why “the price of stability” may be a lot of uncertainty about the federal government’s exposure–yet why we can still hope that despite the very high cost, that the net benefit of the move will turn out to be positive:

The bail-out plan’s large size is designed to provide meaningful support. As of June 30th, $10.6 trillion of home mortgages were outstanding (the vast amount current). Once authorised, the money may not be spent: mere knowledge of the fund’s existence might restore confidence. And banks don’t have to sell their mortgages to benefit; merely having a credible market price for those they hold could restore the confidence of investors. And if the Treasury is astute in its buying, it could even make money. After all, thanks to investors’ panicked flight to the safety of Treasury debt, it can now borrow for close to nothing.

The Treasury would have to recognise that it could lose a lot of the money too: there’s a reason no one wants this paper. At 5% of GDP, $700 billion would be larger than the net amount spent on the savings-and-loan clean-up in the early 1990s which came to around 3% of GDP. The final price tag of this bailout should be less since the government would eventually recoup some of the money owed on the mortgages. Even 5% of GDP is cheap compared to an average of 16% that banking crises around the world have cost in the past 30 years, according a recent staff study of the International Monetary Fund.

The uncertainty is in how much money will eventually be “recouped” by the government, but I guess we have to focus on 5% being less than 16% and far from a catastrophic loss of GDP.  But how we know that the alternative scenario (or the “opportunity cost”) would have been a 16% loss or worse, I’m not sure.

Well, Here We Go

September 19th, 2008 . by economistmom

Have I been talking about reducing the federal budget deficit?  Well, never mind.  Secretary Paulson did not beat around “the bush” today about how this will impose a cost on all Americans (CNN-Money story):

Paulson said that federal action would target the mortgage-related “illiquid assets” that are burdening the finance industry.

“The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy,” said Paulson. “This troubled asset relief program must be properly designed and sufficiently large to have maximum impact.”

The new program would cost hundreds of billions of dollars, according to Paulson.

“This has got to be big enough to make a real difference,” he said.

I believe Secretary Paulson is right that doing nothing would have been far riskier to the American economy…

The ultimate taxpayer protection will be the stability this troubled asset relief program provides to our financial system, even as it will involve a significant investment of taxpayer dollars. I am convinced that this bold approach will cost American families far less than the alternative - a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.

…but the Administration is being less than crystal clear about the fact that the risk does not disappear–it just gets moved around.  What federal officials are proposing to do is to have the government take ownership of these “troubled assets” (as Secretary Paulson refers to them, emphasis added):

Many of the illiquid assets clogging our system today do not meet the regulatory requirements to be eligible for purchase by the GSEs or by the Treasury program.

I look forward to working with Congress to pass necessary legislation to remove these troubled assets from our financial system.

But where will the “trouble” in those “troubled assets” go?  There’s lots of talk about the expectation that the government would eventually get a positive net return out of this deal.  But what exactly is the government taking ownership of here–i.e., how much are these “troubled assets” actually going to be worth when everything settles down?  I think they’re sounding less than crystal clear because the answer in their minds is not at all clear.  This is not like the government bailout of Chrysler (in 1979), which eventually turned profitable because Chrysler was able to produce a tangible product that Americans wanted to buy at the time(minivans…note, I said wantED to buy).  (Note that David Leonhardt of the NYTimes argues that the Chrysler bailout may have nevertheless enabled the slow decline of the Detroit auto industry.)  But there is no tangible product in today’s case and it seems to me no clear direction to head in producing a better “product.”  (And if the government will on net turn a profit from taking over these financial companies, why didn’t the private sector scoop it up first?)

Seems to me that policymakers have decided to swap risky private-market debt for an increase in (what we hope is) less-risky public-sector debt.  That was probably the short-term, risk-averse (prudent) thing to do, but it’s certainly not without signficant risk to the longer-term health of the U.S. economy.

More on the Ouch and the Whoa

September 18th, 2008 . by economistmom

Here’s more on the “ouch” and the “whoa” in the economy, from people who know better than I…

First, from Ken Rogoff, Harvard professor and former Chief Economist of the International Monetary Fund, published in today’s Financial Times (emphasis added):

[D]espite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, yesterday’s $85bn bail-out of the insurance giant AIG.

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn-$2,000bn...

A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.

The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.

It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.

And Steven Pearlstein in today’s Washington Post reminds us that what we’re experiencing this week is just another symptom of the “super subprime” problem our economy’s been experiencing for years now:

What we are witnessing may be the greatest destruction of financial wealth that the world has ever seen — paper losses measured in the trillions of dollars. Corporate wealth. Oil wealth. Real estate wealth. Bank wealth. Private-equity wealth. Hedge fund wealth. Pension wealth. It’s a painful reminder that, when you strip away all the complexity and trappings from the magnificent new global infrastructure, finance is still a confidence game — and once the confidence goes, there’s no telling when the selling will stop.

But more than psychology is involved here. What is really going on, at the most fundamental level, is that the United States is in the process of being forced by its foreign creditors to begin living within its means.

That wasn’t always the case. In fact, for most of the past decade, foreigners seemed only too willing to provide U.S. households, corporations and governments all the cheap money they wanted — and Americans were only too happy to take them up on their offer.

The cheap money was used by households to buy houses, cars and college educations, along with more health care, extra vacations and all manner of consumer goods. Governments used the cheap money to pay for services and benefits that citizens were not willing to pay for with higher taxes. And corporations and investment vehicles — hedge funds, private-equity funds and real estate investment trusts — used the cheap financing to buy real estate and other companies…

Steven concludes with the hard part about getting ourselves out of this funk, reminding us why it’s always been hard for Americans to get focused on long-term economic goals, because they’re often inconsistent with our short-sighted inclinations:

In the end, however, there is only so much the government can borrow and so much the government can do. The only other choice is for Americans to finally put their spending in line with their incomes and their need for long-term savings. For any one household, that sounds like a good idea. But if everyone cuts back at roughly the same time, a recession is almost inevitable. That’s a bitter pill in and of itself, involving lost jobs, lower incomes and a big hit to government tax revenues. But it could be serious trouble for regional and local banks that have balance sheets loaded with loans to local developers and builders who will be hard hit by an economic downturn. Think of that…as the inevitable second round of this financial crisis that, alas, still lies ahead. 

And what about the possibility that the AIG bailout would not end up costing taxpayers anything–despite yesterday’s Treasury announcement of new debt to be issued, to assist the Fed with its cash flow?  (Whoa –and yikes.)  Well, this Washington Post article (which incidentally quotes David Walker) does not comfort me.  Note these two expert opinions:

Even with intervention, economist Allen Sinai of Decision Economics said AIG still could end up in bankruptcy protection. He said the government is likely to lose money on its loan, and the Federal Reserve’s support will contribute to inflation over the long run. Nonetheless, “the cost of doing nothing was probably greater,” Sinai said…

…”What isn’t really clear at this point is — how the government eventually stops owning AIG,” said Rodney Clark, an analyst at the credit-ratings agency Standard & Poor’s. “They haven’t disclosed anything about how those securities are being structured or how the arrangement might one day be unwound,” Clark said.

Ouch….   Whoa…. 

Whoa

September 17th, 2008 . by economistmom

Regarding the AIG bailout, this morning I was just explaining to a reporter why the takeover by the Federal Reserve is quite different from a takeover by the Treasury Department and very different from Congress enacting additional fiscal stimulus, in terms of the “cost to taxpayers.”  I was saying that when the action is taken by the Fed, it’s a monetary policy intervention (suggesting only the risk of an “inflation tax” from the injection of Fed money into the economy), rather than a fiscal policy intervention through an increase in the budget deficit (implying necessary tax increases or spending cuts down the road).  This distinction is what allowed the Federal Reserve, in their official statement last night, to reassure Americans that (emphasis added):

The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayersThe interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries…The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. 

…and led Treasury Secretary Paulson to concur:

“We are working closely with the Federal Reserve, the SEC and other regulators to enhance the stability and orderliness of our financial markets and minimize the disruption to our economy,” said Treasury Secretary Henry Paulson. “I support the steps taken by the Federal Reserve tonight to assist AIG in continuing to meet its obligations, mitigate broader disruptions and at the same time protect the taxpayers.

But then this morning came the breaking news of the Treasury Department announcing:

…the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve.  The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

In other words, the Treasury will be issuing new debt to help finance the Fed’s takeover of AIG–an action that the AP story describes as “an unprecedented action in which Treasury will be selling debt securities in the form of Treasury bills for the nation’s central bank.”

Uh oh…  Never mind what I said earlier.  The lines between monetary intervention and fiscal stimulus (and exposure to American taxpayers, current or more likely future) have just been blurred.

And have you checked out what’s happening to the stock market today?

Whoa.  This is the real deal.  Are you paying attention to what the candidates have to say about it?

“Dilbert” Survey of Economists on the Candidates

September 16th, 2008 . by economistmom

Wow, this is pretty interesting.  I just learned on CNN.com that the cartoonist who draws “Dilbert” commissioned a survey of 500 economists from the American Economic Association (what I’m sure is the largest U.S. association of professional economists), asking them which presidential candidate they preferred on a variety of economic issues.  Note that “reducing the deficit” ranked 10th in priority out of 20 issues–the top two issues being education and health care, and the last being eliminating the estate tax.  (Those top and bottom rankings alone should give everyone at least some faith in economists as human beings.)

On the issue of reducing the deficit, 37 percent favored Obama’s position (i.e., presumably thought Obama would be more successful), 29 percent favored McCain’s, and 33 percent said there would be no difference.  Seems about right given what we know of the candidates’ proposals and how much they are likely to increase the deficit.  On the mortgage/housing crisis (ranked #7 in priority), 41 percent favored Obama, and just 18 percent favored McCain–with 41 percent saying there would be no difference.  (Sounds like McCain has some convincing to do regarding the latest “ouch“, at least among folks who well understand economics.)  Now, on “reducing waste in government,” the numbers are just about the opposite:  16 percent favor Obama, 38 percent favor McCain, and 46 percent say there would be no difference–but right now how concerned are voters over earmarks and “porkbarrel” spending compared with the financial market crisis we’re in?

How National Parks Can Inspire Fiscal Responsibility

September 16th, 2008 . by economistmom

It’s great to have Stan Collender back in town from his vacation.  In this week’s ”Fiscal Fitness” column for Roll Call, posted on the Capital Gains and Games blog here, Stan makes this lovely (and inspired) analogy:

I’ve just returned from a heavenly week in Yosemite National Park in California. As I typically rediscover whenever I visit any of the national parks, hiking through, by, under and around the cliffs, gorges, waterfalls and lakes created by a power that is obviously far stronger and more innovative than anything that happens in Washington is a great way to renew your soul.

But I’m a budget guy, so no matter how much I try, it’s hard for me not to think about the federal budget implications of what I’m looking at.

From a federal budget perspective, what makes the national parks remarkable is that we use current taxes to maintain them. We’re not doing that just so those who are living and paying taxes today can enjoy the parks. We’re also doing it so that, unless nature decides something different, the parks will still be around for the great-grandchildren of our great-grandchildren and beyond. Taxpayers in 2008 are paying to preserve and maintain the parks that others will enjoy for a long time into the future.

In many ways, this seems be the essence of most other federal budget issues. The annual fight over spending and taxes is increasingly between those who don’t want to pay for federal activities they won’t enjoy personally and those who are willing to be taxed for activities that will primarily benefit someone else in another year, generation or life.

If you think about it in these terms, the constant debate over the deficit and national debt includes only part of what should be considered. Instead of being good or bad just for this year, the debate should also include at least some discussion about whether we are also doing what’s necessary to provide for the future.

Of course, then Stan breaks out of his nirvana and gets down to the reality of the latest ugly news on the economy and the extra federal (deficit) spending we’re facing before the end of this year.  That’s always the trouble with vacations having to end… 

Ouch

September 15th, 2008 . by economistmom

More symptoms of the “super subprime” problem today, with Lehman Brothers declaring bankruptcy, Merrill Lynch’s takeover, and the Dow suffering its worst decline in seven years (more than 500 points). 

Guess it’s time for voters to start paying a little more attention to what the candidates have to offer in terms of a true change in direction for economic policy–as Chris Cillizza and Dan Balz suggest on their Washington Post blogs today.  If I were the McCain campaign, I’d stop calling attention to all their deficit-financed tax cuts for the rich (which would include the CEOs they were so critical of today) and their general philosophy of (as Sarah Palin put it) getting government “out of the way…of the private sector” (which would seem to preclude McCain’s promise today to “clean up Wall Street”).  And if I were the Obama campaign, I’d stop calling attention to how close to Bush policy extended their proposed tax cuts are, in that contest they seem to be having with the McCain campaign about who’s cutting taxes (and increasing the deficit) more.

(Oh, glad to see Brad DeLong noticed the irony in McCain’s comments about the CEOs, too, in a thread with an even shorter title than this one.)

Yes, it’s time for all of us to start paying attention to the real issue of the economy in this campaign–time to listen to the substance of what these candidates are actually proposing to change regarding the course of economic policy.  I know it’s not as fun as talking about lipstick, but we’ve got to try.

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