A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Sunday, June 28, 2009

Joseph Stiglitz on Wall Street (from Vanity Fair)

When the current crisis is over, the reputation of American-style capitalism will have taken a beating—not least because of the gap between what Washington practices and what it preaches. Disillusioned developing nations may well turn their backs on the free market, warns Nobel laureate Joseph E. Stiglitz, posing new threats to global stability and U.S. security.

Wall Street’s Toxic Message
By Joseph E. Stiglitz
July 2009

Every crisis comes to an end—and, bleak as things seem now, the current economic crisis too shall pass. But no crisis, especially one of this severity, recedes without leaving a legacy. And among this one’s legacies will be a worldwide battle over ideas—over what kind of economic system is likely to deliver the greatest benefit to the most people. Nowhere is that battle raging more hotly than in the Third World, among the 80 percent of the world’s population that lives in Asia, Latin America, and Africa, 1.4 billion of whom subsist on less than $1.25 a day. In America, calling someone a socialist may be nothing more than a cheap shot. In much of the world, however, the battle between capitalism and socialism—or at least something that many Americans would label as socialism—still rages. While there may be no winners in the current economic crisis, there are losers, and among the big losers is support for American-style capitalism. This has consequences we’ll be living with for a long time to come.

The fall of the Berlin Wall, in 1989, marked the end of Communism as a viable idea. Yes, the problems with Communism had been manifest for decades. But after 1989 it was hard for anyone to say a word in its defense. For a while, it seemed that the defeat of Communism meant the sure victory of capitalism, particularly in its American form. Francis Fukuyama went as far as to proclaim “the end of history,” defining democratic market capitalism as the final stage of social development, and declaring that all humanity was now heading in this direction. In truth, historians will mark the 20 years since 1989 as the short period of American triumphalism. With the collapse of great banks and financial houses, and the ensuing economic turmoil and chaotic attempts at rescue, that period is over. So, too, is the debate over “market fundamentalism,” the notion that unfettered markets, all by themselves, can ensure economic prosperity and growth. Today only the deluded would argue that markets are self-correcting or that we can rely on the self-interested behavior of market participants to guarantee that everything works honestly and properly.

The economic debate takes on particular potency in the developing world. Although we in the West tend to forget, 190 years ago one-third of the world’s gross domestic product was in China. But then, rather suddenly, colonial exploitation and unfair trade agreements, combined with a technological revolution in Europe and America, left the developing countries far behind, to the point where, by 1950, China’s economy constituted less than 5 percent of the world’s G.D.P. In the mid–19th century the United Kingdom and France actually waged a war to open China to global trade. This was the Second Opium War, so named because the West had little of value to sell to China other than drugs, which it had been dumping into Chinese markets, with the collateral effect of causing widespread addiction. It was an early attempt by the West to correct a balance-of-payments problem.

Colonialism left a mixed legacy in the developing world—but one clear result was the view among people there that they had been cruelly exploited. Among many emerging leaders, Marxist theory provided an interpretation of their experience; it suggested that exploitation was in fact the underpinning of the capitalist system. The political independence that came to scores of colonies after World War II did not put an end to economic colonialism. In some regions, such as Africa, the exploitation—the extraction of natural resources and the rape of the environment, all in return for a pittance—was obvious. Elsewhere it was more subtle. In many parts of the world, global institutions such as the International Monetary Fund and the World Bank came to be seen as instruments of post-colonial control. These institutions pushed market fundamentalism (“neoliberalism,” it was often called), a notion idealized by Americans as “free and unfettered markets.” They pressed for financial-sector deregulation, privatization, and trade liberalization.

The World Bank and the I.M.F. said they were doing all this for the benefit of the developing world. They were backed up by teams of free-market economists, many from that cathedral of free-market economics, the University of Chicago. In the end, the programs of “the Chicago boys” didn’t bring the promised results. Incomes stagnated. Where there was growth, the wealth went to those at the top. Economic crises in individual countries became ever more frequent—there have been more than a hundred severe ones in the past 30 years alone.

Not surprisingly, people in developing countries became less and less convinced that Western help was motivated by altruism. They suspected that the free-market rhetoric—“the Washington consensus,” as it is known in shorthand—was just a cover for the old commercial interests. Suspicions were reinforced by the West’s own hypocrisy. Europe and America didn’t open up their own markets to the agricultural produce of the Third World, which was often all these poor countries had to offer. They forced developing countries to eliminate subsidies aimed at creating new industries, even as they provided massive subsidies to their own farmers.

Free-market ideology turned out to be an excuse for new forms of exploitation. “Privatization” meant that foreigners could buy mines and oil fields in developing countries at low prices. It meant they could reap large profits from monopolies and quasi-monopolies, such as in telecommunications. “Liberalization” meant that they could get high returns on their loans—and when loans went bad, the I.M.F. forced the socialization of the losses, meaning that the screws were put on entire populations to pay the banks back. It meant, too, that foreign firms could wipe out nascent industries, suppressing the development of entrepreneurial talent. While capital flowed freely, labor did not—except in the case of the most talented individuals, who found good jobs in a global marketplace.

This picture is, obviously, painted with too broad a brush. There were always those in Asia who resisted the Washington consensus. They put restrictions on capital flows. The giants of Asia—China and India—managed their economies their own way, producing unprecedented growth. But elsewhere, and especially in the countries where the World Bank and the I.M.F. held sway, things did not go well.

And everywhere, the debate over ideas continued. Even in countries that have done very well, there is a conviction among the educated and influential that the rules of the game have not been fair. They believe that they have done well despite the unfair rules, and they sympathize with their weaker friends in the developing world who have not done well at all.

Among critics of American-style capitalism in the Third World, the way that America has responded to the current economic crisis has been the last straw. During the East Asia crisis, just a decade ago, America and the I.M.F. demanded that the affected countries cut their deficits by cutting back expenditures—even if, as in Thailand, this contributed to a resurgence of the aids epidemic, or even if, as in Indonesia, this meant curtailing food subsidies for the starving. America and the I.M.F. forced countries to raise interest rates, in some cases to more than 50 percent. They lectured Indonesia about being tough on its banks—and demanded that the government not bail them out. What a terrible precedent this would set, they said, and what a terrible intervention in the Swiss-clock mechanisms of the free market.

The contrast between the handling of the East Asia crisis and the American crisis is stark and has not gone unnoticed. To pull America out of the hole, we are now witnessing massive increases in spending and massive deficits, even as interest rates have been brought down to zero. Banks are being bailed out right and left. Some of the same officials in Washington who dealt with the East Asia crisis are now managing the response to the American crisis. Why, people in the Third World ask, is the United States administering different medicine to itself?

Many in the developing world still smart from the hectoring they received for so many years: they should adopt American institutions, follow our policies, engage in deregulation, open up their markets to American banks so they could learn “good” banking practices, and (not coincidentally) sell their firms and banks to Americans, especially at fire-sale prices during crises. Yes, Washington said, it will be painful, but in the end you will be better for it. America sent its Treasury secretaries (from both parties) around the planet to spread the word. In the eyes of many throughout the developing world, the revolving door, which allows American financial leaders to move seamlessly from Wall Street to Washington and back to Wall Street, gave them even more credibility; these men seemed to combine the power of money and the power of politics. American financial leaders were correct in believing that what was good for America or the world was good for financial markets, but they were incorrect in thinking the converse, that what was good for Wall Street was good for America and the world.

It is not so much Schadenfreude that motivates the intense scrutiny by developing countries of America’s economic failure as it is a real need to discover what kind of economic system can work for them in the future. Indeed, these countries have every interest in seeing a quick American recovery. What they know is that they themselves cannot afford to do what America has done to attempt to revive its economy. They know that even this amount of spending isn’t working very fast. They know that the fallout from America’s downturn has moved 200 million additional people into poverty in the span of just a few years. And they are increasingly convinced that any economic ideals America may espouse are ideals to run from rather than embrace.

Why should we care that the world has become disillusioned with the American model of capitalism? The ideology that we promoted has been tarnished, but perhaps it is a good thing that it may be tarnished beyond repair. Can’t we survive—even do just as well—if not everyone adheres to the American way?

To be sure, our influence will diminish, as we are less likely to be held up as a role model, but that was happening in any case. America used to play a pivotal role in global capital, because others believed that we had a special talent for managing risk and allocating financial resources. No one thinks that now, and Asia—where much of the world’s saving occurs today—is already developing its own financial centers. We are no longer the chief source of capital. The world’s top three banks are now Chinese. America’s largest bank is down at the No. 5 spot.

The dollar has long been the reserve currency—countries held the dollar in order to back up confidence in their own currencies and governments. But it has gradually dawned on central banks around the world that the dollar may not be a good store of value. Its value has been volatile, and declining. The massive increase in America’s indebtedness during the current crisis, combined with the Federal Reserve Board’s massive lending, has heightened anxieties about the future of the dollar. The Chinese have openly floated the idea of inventing some new reserve currency to replace it.

Meanwhile, the cost of dealing with the crisis is crowding out other needs. We have never been generous in our assistance to poor countries. But matters are getting worse. In recent years, China’s infrastructure investment in Africa has been greater than that of the World Bank and the African Development Bank combined, and it dwarfs America’s. African countries are running to Beijing for assistance in this crisis, not to Washington.

But my concern here is more with the realm of ideas. I worry that, as they see more clearly the flaws in America’s economic and social system, many in the developing world will draw the wrong conclusions. A few countries—and maybe America itself—will learn the right lessons. They will realize that what is required for success is a regime where the roles of market and government are in balance, and where a strong state administers effective regulations. They will realize that the power of special interests must be curbed.

But, for many other countries, the consequences will be messier, and profoundly tragic. The former Communist countries generally turned, after the dismal failure of their postwar system, to market capitalism, replacing Karl Marx with Milton Friedman as their god. The new religion has not served them well. Many countries may conclude not simply that unfettered capitalism, American-style, has failed but that the very concept of a market economy has failed, and is indeed unworkable under any circumstances. Old-style Communism won’t be back, but a variety of forms of excessive market intervention will return. And these will fail. The poor suffered under market fundamentalism—we had trickle-up economics, not trickle-down economics. But the poor will suffer again under these new regimes, which will not deliver growth. Without growth there cannot be sustainable poverty reduction. There has been no successful economy that has not relied heavily on markets. Poverty feeds disaffection. The inevitable downturns, hard to manage in any case, but especially so by governments brought to power on the basis of rage against American-style capitalism, will lead to more poverty. The consequences for global stability and American security are obvious.

There used to be a sense of shared values between America and the American-educated elites around the world. The economic crisis has now undermined the credibility of those elites. We have given critics who opposed America’s licentious form of capitalism ample ammunition to preach a broader anti-market philosophy. And we keep giving them more and more ammunition. While we committed ourselves at a recent G-20 meeting not to engage in protectionism, we put a “buy American” provision into our own stimulus package. And then, to soften the opposition from our European allies, we modified that provision, in effect discriminating against only poor countries. Globalization has made us more interdependent; what happens in one part of the world affects those in another—a fact made manifest by the contagion of our economic difficulties. To solve global problems, there must be a sense of cooperation and trust, including a sense of shared values. That trust was never strong, and it is weakening by the hour.

Faith in democracy is another victim. In the developing world, people look at Washington and see a system of government that allowed Wall Street to write self-serving rules which put at risk the entire global economy—and then, when the day of reckoning came, turned to Wall Street to manage the recovery. They see continued re-distributions of wealth to the top of the pyramid, transparently at the expense of ordinary citizens. They see, in short, a fundamental problem of political accountability in the American system of democracy. After they have seen all this, it is but a short step to conclude that something is fatally wrong, and inevitably so, with democracy itself.

The American economy will eventually recover, and so, too, up to a point, will our standing abroad. America was for a long time the most admired country in the world, and we are still the richest. Like it or not, our actions are subject to minute examination. Our successes are emulated. But our failures are looked upon with scorn. Which brings me back to Francis Fukuyama. He was wrong to think that the forces of liberal democracy and the market economy would inevitably triumph, and that there could be no turning back. But he was not wrong to believe that democracy and market forces are essential to a just and prosperous world. The economic crisis, created largely by America’s behavior, has done more damage to these fundamental values than any totalitarian regime ever could have. Perhaps it is true that the world is heading toward the end of history, but it is now sailing against the wind, on a course we set ourselves.

Joseph E. Stiglitz, a Nobel Prize–winning economist, is a professor at Columbia University.

Saturday, June 27, 2009

Chris Whalen and Derivatives Regulation

My takeaway from this is that banks involved in this sort of gaming are not producing anything or supporting production, but are simply a drain on the rest of the economy. Supporting them in this effort is only stretching out the problem.

Whalen is as good as there is on banks. When he strays into economics, like most bankers, he gets lost. But here he is very good.

Now from his prepared testimony, link here:


When you think about OTC derivatives, you must include both conventional interest rate and currency swap contracts, single name credit default swap or “CDS” contracts, and the panoply of specialized, customized gaming contracts for everything and anything else that can be described, from the weather to sports events to shifting specific types of risk exposure from one unit of AIG to another. You must also include the family of complex structured financial instruments such as mortgage securitizations and collateralized debt obligations or “CDOs,” for these too are OTC “derivatives” that purport to derive their “value” from another asset or instrument.

2) Bank Business Models & OTC

Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS). These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators.

The fact that today OTC derivatives trading is the leading source of profits and also risk for many large dealer banks should tell the Congress all that it needs to know about the areas of the markets requiring immediate reform. Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage – but are net destroyers of value for shareholders and society even while pretending to be profitable.

Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants. Every investor in the global markets pay the OTC tax via wider bid-offer spreads for OTC derivatives contracts than would apply on an organized exchange.

The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C). And most important, the regulators who are supposed to protect the taxpayer from the costs of cleaning up these periodic loss events are so captive by the very industry they are charged by law to regulate as to be entirely ineffective. As the Committee proceeds in its deliberations about reforming OTC derivatives, the views of the existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury, should get no consideration from the Committee since the view of these agencies are largely duplicative of the views of JPM and the large OTC dealers .

3) Basis Risk & Derivatives:

The entire family of OTC derivatives must be divided into types of contracts for which there is a clear, visible cash market and those contracts for which the basis is obscure or non-existent. A currency or interest rate or natural gas swap OTC contract are clearly linked to the underlying cash markets or the “basis” of these derivative contracts, thus both buyers are sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection.

With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is non-existent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ “models” that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see – and yet the large dealers, including JPM, BAC and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form.

In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.

What should offend the Congress about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks. No, what should bother the Congress and all Americans about the CDS market is that is violates the basic American principle of fairness and fair dealing.


To that point, consider the judgment of Benjamin M. Friedman, writing in The New York Review of Books on May 28, 2009, "The Failure of the Economy & the Economists." He describes the CDS market in a very concise way and in layman's terms. I reprint his comments with the permission of NYRB:

"The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.

"But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise.

"This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention."

4) CDS & Systemic Risk

While an argument can be made that currency, interest rate and energy swaps are functionally interchangeable with existing forward instruments, the credit derivative market raises a troubling question about whether the activity creates value or helps manage risk on a systemic basis. It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.

Seen in this context, AIG was the most visible “sucker” identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.

Indeed, it is my view that every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity. And for every large, overt failure in the CDS markets such as AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. The only beneficiaries of the current OTC market for derivatives are JPM, GS and the other large OTC dealers.

Friday, June 26, 2009

Roubini on a double dip recession

Roubini continues to call it well. I'm glad our forecast got out first, because one is tempted to follow his lead on everything.

The risks of a double-dip, W-shaped recession may be growing
By Nouriel Roubini

Saturday, Jun 20, 2009,

In the past three months, global asset prices have rebounded sharply: Stock prices have increased by more than 30 percent in advanced economies and by much more in most emerging markets. Prices of commodities — oil, energy, and minerals — have soared; corporate credit spreads (the difference between the yield of corporate and government bonds) have narrowed dramatically, as government-bond yields have increased sharply; volatility (the “fear gauge”) has fallen; and the dollar has weakened as demand for safe dollar assets has abated.

But is the recovery of asset prices driven by economic fundamentals? Is it sustainable? Is the recovery in stock prices another bear-market rally or the beginning of a bullish trend?

While economic data suggests that improvement in fundamentals has occurred — the risk of a near depression has been reduced; the prospects of the global recession bottoming out by year end are increasing; and risk sentiment is improving — it is equally clear that other, less sustainable factors are also playing a role. Moreover, the sharp rise in some asset prices threatens the recovery of a global economy that has not yet hit bottom. Indeed, many risks of a downward market correction remain.

First, confidence and risk aversion are fickle, and bouts of renewed volatility may occur if macroeconomic and financial data were to surprise on the downside — as they may if a near-term and robust global recovery (which many people expect) does not materialize.

Second, extremely loose monetary policies (zero interest rates, quantitative easing, new credit facilities, emissions of government bonds and purchases of illiquid and risky private assets), together with the huge sums spent to stabilize the financial system, may be causing a new liquidity-driven asset bubble in financial and commodity markets. For example, Chinese state-owned enterprises that gained access to huge amounts of easy money and credit are buying equities and stockpiling commodities well beyond their productive needs.


The risk of a correction in the face of disappointing macroeconomic fundamentals is clear. Indeed, recent data from the US and other advanced economies suggest that the recession may last through the end of the year. Worse, the recovery is likely to be anemic and sub-par — well below potential for a couple of years, if not longer — as the burden of debts and leverage of the private sector combine with rising public sector debts to limit the ability of households, financial firms and corporations to lend, borrow, spend, consume and invest.

This more challenging scenario of anemic recovery undermines hopes for a V-shaped recovery, as low growth and deflationary pressures constrain earnings and profit margins and as unemployment rates above 10 percent in most advanced economies cause financial shocks to re-emerge, owing to mounting losses for banks’ and financial institutions’ portfolios of loans and toxic assets. At the same time, financial crises in a number of emerging markets could prove contagious, placing additional stress on global financial markets.

The increase in some asset prices may, moreover, lead to a W-shaped, double-dip recession. In particular, thanks to massive liquidity, energy prices are now rising too high too soon. The role that high oil prices played last summer in tipping the global economy into recession should not be underestimated. Oil above US$140 a barrel was the last straw — coming on top of the housing busts and financial shocks — for the global economy, as it represented a massive supply shock for the US, Europe, Japan, China and other net importers of oil.


Meanwhile, rising fiscal deficits in most economies are now pushing up the yields of long-term government bonds. Some of the rise in long rates is a necessary correction, as investors are now pricing a global recovery. But some of this increase is driven by more worrisome factors: the effects of large budget deficits and debt on sovereign risk, and thus on real interest rates; and concerns that the incentive to monetize these large deficits will lead to high inflation after the global economy recovers from next year to 2011 and deflationary forces abate. The crowding out of private demand, owing to higher government-bond yields — and the ensuing increase in mortgage rates and other private yields — could in turn endanger the recovery.

As a result, one cannot rule out that by late next year or 2011, a perfect storm of oil above US$100 a barrel, rising government-bond yields and tax increases (as governments seek to avoid debt-refinancing risks) may lead to a renewed growth slowdown, if not an outright double-dip recession.

The recent recovery of asset prices from their March lows is in part justified by fundamentals, as the risks of global financial meltdown and depression have fallen and confidence has improved.

But much of the rise is not justified, as it is driven by excessively optimistic expectations of a rapid recovery of growth toward its potential level and by a liquidity bubble that is raising oil prices and equities too fast too soon. A negative oil shock, together with rising government-bond yields — could clip the recovery’s wings and lead to a significant further downturn in asset prices and in the real economy.

Nouriel Roubini is professor of economics at the Stern School of Business, New York University, and chairman of RGE Monitor.


Wednesday, June 24, 2009

Equality as Economically Efficient

From the podcast


One of the tenets of Demand Side we have not made explicit recently is the proposition that more equal distribution of income is more efficient and stable and leads to a more robust economy. You may remember that one of the similarities between the crash of '29 and the crash of '08 was the historically large disparity between the rich and the rest of us.

This is, of course, an anathema to the supply side, whose notion is that giving more to one class will encourage them to produce more -- that class being the investing and entrepreneurial class, that is, the rich.

In fact, in a market economy, more equal income means more equal access to incentives. It also means a better economy. We'll get to Brad DeLong and the history note on this point in just a moment.

But one of the more intersting studies I can remember was one which surveyed self-reported happiness levels across different cultures. it turns out that it is not the absolute level of income that matters at all in self-reported well-being, but the relative wealth. If your hut has a bamboo mat on the floor and your neighbors have only dirt, you may report the same level of happiness as someone who has a Lexus in his garage when his neighbors have only Toyotas parked on the street.

Another, much more recent, study, demonstrated that excessive rewards may actually retard performance, as people stress too much and over think. We believe you see very poor moral performance when the stakes are high.

All of which leads us into today's history note and its author Brad DeLong. I found this in DeLong's U.S. Economic History lectures at Berkeley on iTunes.


Brad DeLong is professor of Economic History and chair of the Department of Political Economy at Berkeley. In the latter occupation he has been quite distracted since the Obama Administration shanghaied his department's Christina Romer and he lost David Romer in the transaction.

Why stop here? Some innovative researcher should examine the postwar United States. When economic equality was greatest -- in the 1950s and 1960's -- so too was prosperity and growth.

Robert Reich on the Public Option

Sums it up rather nicely
Tuesday, June 23, 2009
Why the Critics of a Public Option for Health Care Are Wrong

Without a public option, the other parties that comprise America's non-system of health care -- private insurers, doctors, hospitals, drug companies, and medical suppliers -- have little or no incentive to supply high-quality care at a lower cost than they do now.

Which is precisely why the public option has become such a lightening rod. The American Medical Association is dead-set against it, Big Pharma rejects it out of hand, and the biggest insurance companies won't consider it. No other issue in the current health-care debate is as fiercely opposed by the medical establishment and their lobbies now swarming over Capitol Hill. Of course, they don't want it. A public option would squeeze their profits and force them to undertake major reforms. That's the whole point.

Critics say the public option is really a Trojan horse for a government takeover of all of health insurance. But nothing could be further from the truth. It's an option. No one has to choose it. Individuals and families will merely be invited to compare costs and outcomes. Presumably they will choose the public plan only if it offers them and their families the best deal -- more and better health care for less.

Private insurers say a public option would have an unfair advantage in achieving this goal. Being the one public plan, it will have large economies of scale that will enable it to negotiate more favorable terms with pharmaceutical companies and other providers. But why, exactly, is this unfair? Isn't the whole point of cost containment to provide the public with health care on more favorable terms? If the public plan negotiates better terms -- thereby demonstrating that drug companies and other providers can meet them -- private plans could seek similar deals.

But, say the critics, the public plan starts off with an unfair advantage because it's likely to have lower administrative costs. That may be true -- Medicare's administrative costs per enrollee are a small fraction of typical private insurance costs -- but here again, why exactly is this unfair? Isn't one of the goals of health-care cost containment to lower administrative costs? If the public option pushes private plans to trim their bureaucracies and become more efficient, that's fine.

Critics complain that a public plan has an inherent advantage over private plans because the public won't have to show profits. But plenty of private plans are already not-for-profit. And if nonprofit plans can offer high-quality health care more cheaply than for-profit plans, why should for-profit plans be coddled? The public plan would merely force profit-making private plans to take whatever steps were necessary to become more competitive. Once again, that's a plus.

Critics charge that the public plan will be subsidized by the government. Here they have their facts wrong. Under every plan that's being discussed on Capitol Hill, subsidies go to individuals and families who need them in order to afford health care, not to a public plan. Individuals and families use the subsidies to shop for the best care they can find. They're free to choose the public plan, but that's only one option. They could take their subsidy and buy a private plan just as easily. Legislation should also make crystal clear that the public plan, for its part, may not dip into general revenues to cover its costs. It must pay for itself. And any government entity that oversees the health-insurance pool or acts as referee in setting ground rules for all plans must not favor the public plan.

Finally, critics say that because of its breadth and national reach, the public plan will be able to collect and analyze patient information on a large scale to discover the best ways to improve care. The public plan might even allow clinicians who form accountable-care organizations to keep a portion of the savings they generate. Those opposed to a public option ask how private plans can ever compete with all this. The answer is they can and should. It's the only way we have a prayer of taming health-care costs. But here's some good news for the private plans. The information gleaned by the public plan about best practices will be made available to the private plans as they try to achieve the same or better outputs.

As a practical matter, the choice people make between private plans and a public one is likely to function as a check on both. Such competition will encourage private plans to do better -- offering more value at less cost. At the same time, it will encourage the public plan to be as flexible as possible. In this way, private and public plans will offer one other benchmarks of what's possible and desirable.

Mr. Obama says he wants a public plan. But the strength of the opposition to it, along with his own commitment to making the emerging bill "bipartisan," is leading toward some oddball compromises. One would substitute nonprofit health insurance cooperatives for a public plan. But such cooperatives would lack the scale and authority to negotiate lower rates with drug companies and other providers, collect wide data on outcomes, or effect major change in the system.

Another emerging compromise is to hold off on a public option altogether unless or until private insurers fail to meet some targets for expanding coverage and lowering health-care costs years from now. But without a public option from the start, private insurers won't have the incentives or system-wide model they need to reach these targets. And in politics, years from now usually means never.

To get health care moving again in Congress, the president will have to be clear about how to deal with its costs and whether and how a public plan is to be included as an option. The two are intimately related. Enough talk. He should come out swinging for the public option.

Tuesday, June 23, 2009


The corporate takeover of the economy is no longer hypothetical. Perhaps they are well-meaning or simply deluded, but having to battle for every inch of progress means we are not going to get to the finish line in time.

America’s Socialism for the Rich
by Joseph E. Stiglitz

With all the talk of “green shoots” of economic recovery, America’s banks are pushing back on efforts to regulate them. While politicians talk about their commitment to regulatory reform to prevent a recurrence of the crisis, this is one area where the devil really is in the details – and the banks will muster what muscle they have left to ensure that they have ample room to continue as they have in the past.

The old system worked well for the bankers (if not for their shareholders), so why should they embrace change? Indeed, the efforts to rescue them devoted so little thought to the kind of post-crisis financial system we want that we will end up with a banking system that is less competitive, with the large banks that were too big too fail even larger.

It has long been recognized that those America’s banks that are too big to fail are also too big to be managed. That is one reason that the performance of several of them has been so dismal. Because government provides deposit insurance, it plays a large role in restructuring (unlike other sectors). Normally, when a bank fails, the government engineers a financial restructuring; if it has to put in money, it, of course, gains a stake in the future. Officials know that if they wait too long, zombie or near zombie banks – with little or no net worth, but treated as if they were viable institutions – are likely to “gamble on resurrection.” If they take big bets and win, they walk away with the proceeds; if they fail, the government picks up the tab.

This is not just theory; it is a lesson we learned, at great expense, during the Savings & Loan crisis of the 1980’s. When the ATM machine says, “insufficient funds,” the government doesn’t want this to mean that the bank, rather than your account, is out of money, so it intervenes before the till is empty. In a financial restructuring, shareholders typically get wiped out, and bondholders become the new shareholders. Sometimes, the government must provide additional funds; sometimes it looks for a new investor to take over the failed bank.

The Obama administration has, however, introduced a new concept: too big to be financially restructured. The administration argues that all hell would break loose if we tried to play by the usual rules with these big banks. Markets would panic. So, not only can’t we touch the bondholders, we can’t even touch the shareholders – even if most of the shares’ existing value merely reflects a bet on a government bailout.

I think this judgment is wrong. I think the Obama administration has succumbed to political pressure and scare-mongering by the big banks. As a result, the administration has confused bailing out the bankers and their shareholders with bailing out the banks.

Restructuring gives banks a chance for a new start: new potential investors (whether in equity or debt instruments) will have more confidence, other banks will be more willing to lend to them, and they will be more willing to lend to others. The bondholders will gain from an orderly restructuring, and if the value of the assets is truly greater than the market (and outside analysts) believe, they will eventually reap the gains.

But what is clear is that the Obama strategy’s current and future costs are very high – and so far, it has not achieved its limited objective of restarting lending. The taxpayer has had to pony up billions, and has provided billions more in guarantees – bills that are likely to come due in the future.

Rewriting the rules of the market economy – in a way that has benefited those that have caused so much pain to the entire global economy – is worse than financially costly. Most Americans view it as grossly unjust, especially after they saw the banks divert the billions intended to enable them to revive lending to payments of outsized bonuses and dividends. Tearing up the social contract is something that should not be done lightly.

But this new form of ersatz capitalism, in which losses are socialized and profits privatized, is doomed to failure. Incentives are distorted. There is no market discipline. The too-big-to-be-restructured banks know that they can gamble with impunity – and, with the Federal Reserve making funds available at near-zero interest rates, there are ample funds to do so.

Some have called this new economic regime “socialism with American characteristics.” But socialism is concerned about ordinary individuals. By contrast, the United States has provided little help for the millions of Americans who are losing their homes. Workers who lose their jobs receive only 39 weeks of limited unemployment benefits, and are then left on their own. And, when they lose their jobs, most lose their health insurance, too.

America has expanded its corporate safety net in unprecedented ways, from commercial banks to investment banks, then to insurance, and now to automobiles, with no end in sight. In truth, this is not socialism, but an extension of long standing corporate welfarism. The rich and powerful turn to the government to help them whenever they can, while needy individuals get little social protection.

We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed on others. And, if we don’t break them up, then we have to severely limit what they do. They can’t be allowed to do what they did in the past – gamble at others’ expenses.

This raises another problem with America’s too-big-to-fail, too-big-to-be-restructured banks: they are too politically powerful. Their lobbying efforts worked well, first to deregulate, and then to have taxpayers pay for the cleanup. Their hope is that it will work once again to keep them free to do as they please, regardless of the risks for taxpayers and the economy. We cannot afford to let that happen.

Sunday, June 21, 2009

Forecast charts and assumptions

The Pessimist Scenario assumes:
  • No change in the Big Banks First policy regarding the financial sector.

  • The commodities bubble now underway is not met at the pass by government countermeasures.

  • Health care reform is passed, but without the public option.

  • No new or significant fiscal stimulus.

The Baseline Scenario assumptions we've already gone over:
  • New significant stimulus, including help to states and localities

  • A viable public option in the health care reform package

  • Oil prices moderate, and the commodities bubble is short-lived

The Optimistic Scenario:
  • A full public option included in health care

  • Commodities bubble is short-lived

  • Full reform of the banking sector, including structuring markets to exclude government guarantees of derivatives and breaking up the big banks

  • Fiscal stimulus is paired with climate change alarm

  • Revenue is enhanced with carbon taxes and higher rates on the wealthy

All assume
  • The consumer economy is buried under the rubble of the crash of the financial markets.

  • An end to the Great Recession has to come on the back of public goods

Of no concern to us is:
  • Strength or weakness in financial markets. Lower stocks will lower effective borrowing rates. Strength in stocks will gin up confidence.

  • Dollar weakness or strength. Dollar weakness mirrors strength in the price of commodities, particularly oil. Although we have argued for a decade that the trade imbalance eventually means a weaker dollar, that is not so true in the short term in an economic crisis.

  • Budget deficit. The larger the deficit the more fiscal stimulus is likely to have been administered, but also the more pressure builds to raise interest rates and resist needed reforms.

Friday, June 19, 2009

The Health Care War: Robert Reich

Indeed, I hope you caught his blog post. If not, here it is:

The Health Care War is Now Official
by Robert Reich
June 12, 2009

Yesterday [June 11 - ah] the American Medical Association came out against a public option for health care. And yesterday the President reaffirmed his support for it. The next weeks will show what Obama is made of -- whether he's willing and able to take on the most formidable lobbying coalition he has faced so far on an issue that will define his presidency.

And make no mistake: A public option large enough to have bargaining leverage to drive down drug prices and private-insurance premiums is the defining issue of universal health care. It's the only way to make health care affordable. It's the only way to prevent Medicare and Medicaid from eating up future federal budgets. An ersatz public option -- whether Kent Conrad's non-profit cooperatives, Olympia Snowe's "trigger," or regulated state-run plans -- won't do squat.

The last president to successfully take on the giant health care lobbies was LBJ. He got Medicare and Medicaid enacted because he weighed into the details, twisted congressional arms, threatened and cajoled, drew lines in the sand, and went to war against the AMA and the other giant lobbyists standing in the way. The question now is how much LBJ is in Barack Obama.

The big guns are out and they're firing. All major lobbying firms in Washington -- many of them brimming with ex-members of Congress -- are now crawling all over the Hill. Lots of money is on the table. AMA's political action committee has contributed $9.8 million to congressional candidates since 2000, and its lobbying arm is one of the most formidable on the Hill. Meanwhile, Big Insurance and Big Pharma are increasing their firepower. The five largest private insurers and their trade group America's Health Insurance Plans spent a total of $6.4 million on lobbying in the first quarter of this year, up more than $1 million from the first quarter last year, and are spending even more now. United Health Group spent $1.5 million in the first quarter, up 34 percent from the $1.1 million it spent in the first quarter last year. Aetna spent $809,793 between January and the end of March, up 41 percent from last year. Pfizer, the world's biggest drugmaker, spent more than $6.1 million on lobbying between January and March, more than double what it spent last year. It also spent nearly $3.3 million lobbying in the fourth quarter of 2008. Every one of them is upping their spending.

Some congressional Democrats are willing and able to stand up to this barrage. Many are not. They need cover from the White House.

The President can't do this alone. You must weigh in and get everyone you know to weigh in, too. Bombard your senators and representatives. Organize and mobilize others. And let the White House know how strongly you feel. This is one of those battles that define a presidency. But more importantly, it's one of those battles that define the state of American democracy.

And another, earlier piece:

The Latest Public Option Bamboozle, and How to Recognize the Real Thing
by Robert Reich
June 11, 2009

Here's the latest contortion from Senate Dems trying to win over a few Republicans to a "public option:" Let nonprofits create health-care cooperatives, and call them the public option. Kent Conrad came up with this bamboozle. Finance chair Baucus is impressed, and some Republicans -- even Grassley -- seem interested. Watch your wallets.

Nonprofit health-care cooperatives won't have any real bargaining leverage to get lower prices because they'll be too small and too numerous. Pharma and Insurance know they can roll them. That's why the Conrad compromise is getting a good reception from across the aisle, just as Olympia Snowe's "trigger" (whereby no public option until some time down the pike, and only if Pharma and Insurance don't bring down and extend coverage a tad) is also gaining traction.

The truth is that there's only one "public option" that will truly bring down costs and premiums -- one that's national in scale and combines its bargaining power with Medicare, and is allowed to negotiate lower drug prices and lower doctor and hospital fees. And that's precisely what Pharma and Insurance detest, for exactly the same reason.

Whatever it's called -- public option or chopped liver -- it has to be able to squeeze Pharma, Insurance, and the rest of the medical-industrial complex. And the more likely it is to squeeze them, the more they'll fight it. And the greater the opposition from Republicans, and from Dems who either believe any bill has to have some Republican support or who have sold themselves out to the medical biggies.

As long as single payer is off the table, then we need a real public option. Don't be fooled by labels. Demand the real thing.

Thursday, June 18, 2009

Geithner and Summers make their case

From the Washington Post. Since we had Administration lead on health care Peter Orzag yesterday, let's offer the center-right duo of Summers and Geithner, still at the center of Obama's economic team, today.
A New Financial Foundation

By Timothy Geithner and Lawrence Summers
Monday, June 15, 2009

Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world.

We have taken extraordinary measures to help put America on a path to recovery. But it is not enough to simply repair the damage. The economic pain felt by ordinary Americans is a daily reminder that, even as we labor toward recovery, we must begin today to build the foundation for a stronger and safer system.

This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.

Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.

That is why, this week -- at the president's direction, and after months of consultation with Congress, regulators, business and consumer groups, academics and experts -- the administration will put forward a plan to modernize financial regulation and supervision. The goal is to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess.

In developing its proposals, the administration has focused on five key problems in our existing regulatory regime -- problems that, we believe, played a direct role in producing or magnifying the current crisis.

First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.

The administration's proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system.

Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

The administration's plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.

The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of "over the counter" derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.

Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products -- from credit cards to annuities.

Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.

Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve's lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term.

To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.

Fifth, and finally, we live in a globalized world, and the actions we take here at home -- no matter how smart and sound -- will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.

The discussion here presents only a brief preview of the administration's forthcoming proposals. Some people will say that this is not the time to debate the future of financial regulation, that this debate should wait until the crisis is fully behind us. Such critics misunderstand the nature of the challenges we face. Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.

By restoring the public's trust in our financial system, the administration's reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses. Now is the time to act.

Timothy Geithner is secretary of the Treasury. Lawrence Summers is director of the National Economic Council.

Wednesday, June 17, 2009

Peter Orzag on the Obama health care proposal

A plan to boost America’s fiscal health

By Peter Orszag

Published: June 15 2009 19:26 | Last updated: June 15 2009 19:26

As the healthcare debate picks up in the US, there has been much discussion about how to pay for it. Coinciding with this debate are vocal concerns about the country’s underlying fiscal position – which some have suggested as a reason to delay healthcare reform.

What this argument ignores is that healthcare is central to the long-term fiscal and economic prospects of the US. If costs per enrollee in Medicare and Medicaid grow at the same rate over the next four decades as they have over the past four, those two programmes will increase from 5 per cent of gross domestic product today to 20 per cent by 2050.

Healthcare cost growth dwarfs any of the other long-term fiscal challenges the US faces. Nothing else we do on the fiscal front will matter much if we fail to address rapidly rising healthcare costs.

The US spends almost 50 per cent more per person on healthcare than the next most costly nation, but our health outcomes lag those of most industrialised countries. For families, after adjusting for inflation, health insurance premiums have increased 58 per cent while wages have risen only 3 per cent since 2000. For states, rising healthcare costs are squeezing their budgets, leading to cuts in essential services and tax rises. And for the economy as a whole, if healthcare costs grow at the rate they are now, healthcare will consume one-fifth of GDP by 2017.

That is why Barack Obama is committed to undertaking healthcare reform this year. Based on estimates by Dartmouth College and others, the US spends about $700bn (£428bn, €505bn) a year on healthcare that does nothing to improve Americans’ health outcomes.

Reducing the number of tests, procedures and other medical costs that do not improve health presents an enormous opportunity. Our fiscal future is so dominated by healthcare that if the US can slow the rate of cost growth by just 15 basis points a year (0.15 percentage points), the savings for Medicare and Medicaid would equal the impact from eliminating Social Security’s entire 75-year shortfall. If we slow the rate of healthcare cost growth by 1.5 percentage points per year, by 2030 we could reduce the federal budget deficit by 2.5 per cent of GDP, which is about $350bn relative to today’s economy.

So what must be done? As he made clear in his speech to the American Medical Association on Monday, Mr Obama is firmly committed to making healthcare reform deficit neutral over the next decade, using real savings or revenue proposals that can be scored by the Congressional Budget Office. The offsets are not theoretical; they are specific proposals determined by outside, impartial arbiters such as the CBO to cut spending or raise revenue.

In particular, Mr Obama has put forward in his budget proposals to generate $635bn for healthcare reform with roughly half coming from Medicare and Medicaid efficiencies (such as reducing Medicare overpayments to private insurers) and half from tax provisions limiting the itemised deduction rate for the wealthiest Americans to what it was when Ronald Reagan was president. On Saturday, Mr Obama also proposed an extra $313bn in Medicare and Medicaid savings proposals including a proposal that will generate about $106bn in savings over 10 years by reducing payments that help hospitals with the cost of treating patients without insurance because as we expand coverage, the need for such payments is reduced. Taken together, these “pay-fors” total about $950bn over 10 years, an amount that puts us in a good position to fully fund health reform in a deficit neutral way.

We must also address the forces making the healthcare system unaffordable and inefficient. The system creates incentives for doctors and hospitals to provide more care, not the best care. A lack of information on what works leads to huge variations in the quality of care and its cost. As Atul Gawande has described in the New Yorker, there are cities such as McAllen, Texas, that spend close to twice the national average on healthcare and do not get better results than lower cost, high-quality cities even in their own state or region.

The US must move towards a higher-quality, lower-cost system in which best practices are universal – rather than concentrated only in some parts of the country. The administration has therefore put forward initiatives such as health IT, research into what works, prevention and wellness, and changes in provider incentives. We must also change the process of policymaking so that policy can keep pace with a dynamic health market, for example by expanding the role of bodies such as the Medicare Payment Advisory Commission.

It is partially because of the unnecessarily high costs of our system that too many Americans lack insurance and are exposed to big financial and health risks. Mr Obama has said that healthcare reform must reduce costs and expand coverage since doing the latter without the former is fiscally unsustainable.

This is not the end of our commitment to fiscal responsibility. Once healthcare reform is in place, the US can then focus on other aspects of fiscal sustainability, including Social Security reform. But the bottom line is that healthcare reform is a necessity both for millions of American families and the long-term fiscal and economic health of the nation.

Tuesday, June 16, 2009

Full text of Roubini comment on Latvia

News mentioned the Latvia crisis and Nouriel Roubini.
Here is a full version of Roubini's piece from the Financial Tiems

Latvia’s currency crisis is a rerun of Argentina’s
By Nouriel Roubini
June 10, 2009

After a recent failed public debt auction, the authorities in Latvia are desperately trying to prevent a depreciation of the currency, the lat. The country’s predicament is similar to the one that faced Argentina in 2000-01: a severe recession driven by global financial shocks, a sudden drying up of capital inflows and the need to reduce a large external deficit worsened by an unsustainable currency peg.

As in Argentina, the International Monetary Fund initially went along – somewhat uncomfortably – with the authorities’ strong preference for not letting the currency depreciate, in spite of its significant overvaluation. But a real exchange rate depreciation is necessary to restore the country’s competitiveness; in its absence, a painful adjustment of relative prices can occur only via deflation and a fall in nominal wages that will take too long and exacerbate the recession.

Draconian cuts in public spending will be required if Latvia is to improve the current account. But this is becoming politically unsustainable. And while fiscal consolidation is needed – as Argentina found in 2000-01 – it will make the recession more severe in the short run. So it is a self-defeating strategy as long as the currency remains overvalued.

Of course, as in Argentina, letting the currency depreciate would lead to massive negative balance-sheet effects. The large foreign liabilities of households, companies and banks are in foreign currency; the real value in local currency of such debts would increase sharply after a devaluation. Devaluation may therefore lead to default by many private sector agents – and as the country’s banks are local subsidiaries of Swedish banks, a financial meltdown in Latvia could prove damaging for its neighbours.

Nonetheless, devaluation seems un­avoidable and the IMF programme – which ruled it out – is thus inherently flawed. The IMF or the European Union could increase financial support for Latvia but, as in Argentina, this would be throwing good money after bad. International resources are better used to mitigate the collateral damage of depreciation.

An introduction of the euro immediately after devaluation could help prevent the exchange rate from overshooting, although it would require the eurozone to admit a country that does not yet satisfy the formal criteria for membership. Euroisation after depreciation is a more credible strategy for Latvia than dollarisation would have been for Argentina, as Latvia was on its way to membership and its business cycle is highly correlated with that of the EU. Euroisation without depreciation will not work, as a real depreciation is necessary to restore competitiveness. Of course, any depreciation – with or without euroisation – will make many foreign currency debts unsustainable and will require a forced debt restructuring, as in the case of Argentina.

To minimise the risk of contagion, the best strategy may be: depreciate the currency, euroise after depreciation, restructure private foreign currency liabilities without a formal “default”, and augment the IMF plan to limit the financial fallout. It is a risky strategy but – as in Buenos Aires nine years ago – when plan A does not work it is time to move to plan B sooner rather than later. Delaying plan B would only cause a bigger blowout when the unavoidable currency crisis eventually occurs. It is to be hoped the lessons of Argentina in 2001 have been learnt.

Latvia’s authorities are trying desperately to prevent depreciation by intervening in the foreign exchange market. While the very thin interbank market slows down the rate at which domestic and foreign financial institutions can short the Latvian currency and put pressure on the central bank reserves, the country is bleeding forex reserves at an alarming rate. Only a miracle or some draconian and credible fiscal adjustment (that does not exacerbate the recession) could restore the peg’s credibility and lead to a growth recovery.

At this point, a currency and financial crisis is pretty much unavoidable; the issue is how to minimise the domestic and international costs of the needed change in the policy regime. As the experience with Argentina suggests, procrastinating will make the unavoidable crash – and the regional contagion – even more ­dramatic and costly.

The writer is a professor of economics at New York University’s Stern School of Business and chairman of RGE Monitor

Compensation: Why not just raise top marginal income tax rates?

Gene Sperling of the President's team identifies some factors on executive compensation. A more economically practical, but likely politically impossible, way to do this is through the front door. A new top marginal rate of 90 percent would match that in the boom years of the 1950s. Over say $2.5 million. I mean, how much money do you need?

At a minimum, the rate above $100,000 should be increased by 15% to reflect the payroll tax phase-out.

If you think higher taxes on the rich are contractionary, it ain't necessarily so. The rich spend less of their income than the government.

June 11, 2009

Gene Sperling, Counselor to the Secretary of the Treasury, Opening Statement before the U.S. House of Representatives Committee on Financial Services

Chairman Frank, Ranking Member Bachus, Members of the Committee, I appreciate the opportunity to testify before you on this important topic of systemic risk and executive compensation.

Each of us involved in economic policy has an obligation to fully understand the factors that contributed to this financial crisis and to make our best effort to find the policies that minimize the likelihood of its recurrence. There is little question that one contributing factor to the excessive risk taking that was central to the crisis was the prevalence of compensation practices at financial institutions that encouraged short-term gains to be realized with little regard to the potential economic damage such behavior could cause not only to those firms, but to the financial system and economy as a whole. As Secretary Geithner said yesterday, too often "incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage." Compensation structures that permitted key executives and other financial actors to avoid the potential long-term downsides of their actions discouraged a focus on determining long-term risk and underlying economic value, while reducing the number of financial market participants with an incentive to be a "canary in the coal mine."

After one large investment bank suffered large losses, it acknowledged – properly reflecting on what it should have done differently – that it had skewed its employees' incentives by simply measuring bonuses against gross revenue after personnel costs, with "no formal account taken of the quality or sustainability of those earnings." And the potential harm caused by compensation arrangements based on short-term results with little account for long-term risks went beyond top executives. Indeed, across the subprime mortgage industry, brokers were often compensated in ways that placed a high premium on the volume of their lending without regard to whether borrowers had the ability to make their payments. As a result, lenders, whose compensation normally did not require them to internalize long-term risk, had a strong incentive to increase volume by targeting riskier and riskier borrowers – and they did, contributing to the problems that spurred our current crisis.

As we work to restore financial stability, the focus on executive compensation at companies that have received governmental assistance is appropriate and understandable. But what is most important for our economy at large is the topic of this hearing: understanding how compensation practices contributed to this financial crisis and what steps we can take to ensure they do not cause excessive risk-taking in the future. And while the financial sector has been at the center of this issue, we believe that compensation practices must be better aligned with long-term value and prudent risk management at all firms, and not just for the financial services industry.

Yesterday, Secretary Geithner laid out a set of principles for moving forward with compensation reforms. Our goal is to help ensure that there is a much closer alignment between compensation, sound risk management and long-term value creation for firms and the economy as a whole. Our goal is not to have the government micromanage private sector compensation. As Secretary Geithner said yesterday, "We are not capping pay. We are not setting forth precise prescriptions for how companies should set compensation, which can often be counterproductive." We also recognize these principles may evolve over time, and we look forward to engaging in a discussion with this Committee, the Congress, supervisors, academics and other compensation experts, shareholders and the business community about the best path. We begin this conversation recognizing that the reforms we put in place must be based not only on our best intentions, but also a clear-eyed understanding of the need to minimize unintended consequences. But we think these principles offer a promising way forward.

1. Compensation plans should properly measure and reward performance

There is little debate that compensation should be tied to performance in order to best align the incentives of executives with those of shareholders. But even compensation that is nominally performance-based has often rewarded failure or set benchmarks too low to have a meaningful impact.

There is increasing consensus in the expert community that performance-based compensation must involve a thoughtful combination of metrics that is indexed to relative performance as opposed to just following the ups and downs of the market. Performance pay based solely on stock price can on the one hand, "confuse brains for a bull-market" and in the other scenario, fail to recognize exceptional contributions by executives in difficult times. A thoughtful mix of performance metrics could include not only stock prices, but individual performance assessments, adherence to risk management and measures that account for the long-term soundness of the firm.

2. Compensation should be structured in line with the time horizon of risks

As I mention above, much of the damage caused by this crisis occurred when people were able to capture excessive and immediate gains without their compensation reflecting the long-term risks they were imposing on their companies, their shareholders, and ultimately, the economy as a whole. Financial firms offered incentives to invest heavily in complex financial instruments that yielded large gains in the short-term, but presented a "tail risk" of major losses. Inevitably, these practices contributed to an overwhelming focus on gains – as they allowed the payout of significant amounts of compensation today without any regard for the possible downside that might come tomorrow.

That is why we believe companies should seek to pay both executives and other employees in ways that are tightly aligned with the long-term value and soundness of the firm. One traditional way of doing so is to provide compensation for executives overwhelmingly in stock that must be held for a long period of time – even beyond retirement. Such compensation structures also reduce the risk that executives might walk away with large pay packages in one year only to see their firms crumble in the next year or two. In these cases, the dramatic decline in stock price would effectively "claw back" the previous year's pay. Other firms keep bonuses "at risk," so that if large profits in one year are followed by poor performance in the next, the bonuses will be reduced.

Yet, as Harvard Professor Lucian Bebchuk has written, compensation packages based on restricted stock are not a fool-proof means of ensuring alignment with long-term value, as such pay structures can still incentivize well-timed strategies to manipulate the value of common equity or take "heads I win a lot, tails I lose a little" bets depending on the capital structure and degree of leverage of the firm.

3. Compensation practices should be aligned with sound risk management

Ensuring that compensation fosters sound risk-management requires pay strategies that do not allow market participants to completely externalize their long-term risk, while also ensuring that those responsible for risk management receive the compensation and the authority within firms to provide a check on excessive risk-taking. As the Financial Stability Forum recently stated, "staff engaged in financial and risk control must be independent, have appropriate authority, and be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the firm."

This authority and independence is all the more important in times of excessive optimism when consistent – though unsustainable – asset appreciation can temporarily make the reckless look wise and the prudent look overly risk-averse. Former Federal Reserve Chairman William McChesney Martin Jr. once said that "The job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting." Likewise, risk managers must have the independence, stature and pay to take the car keys away when they believe a temporary good-time may be creating even a small risk of a major financial accident down the road.

Yet there are several reports showing the degree to which risk managers lacked the appropriate authority during the run-up to this financial crisis. Accounts of one Wall Street firm discuss how risk managers who once roamed the trading floors to gain a better understanding of how the company worked and where weaknesses might exist were denied access to that necessary information and discouraged from expressing their concerns.

That is why we believe that compensation committees should conduct and publish a risk assessment of whether pay structures – not only for top executives, but for all employees – incentivize excessive risk-taking. As part of this process, committees should identify whether an employee or executive experiences a penalty if their exceptional performance is based on decisions that ultimately put the long-term health of the firm in danger. At the same time, managers should also have direct reporting access to the compensation committee to enhance their impact.

I should also note that in the rule we released yesterday concerning executive compensation for recipients of assistance through the Troubled Asset Relief Program, we put forward – as the Administration called for on February 4th – a requirement that compensation committees not only provide a full risk assessment for their compensation, but that they do so in a narrative form that explains the rationale for how their pay structure does not encourage excessive risk. We believe such a requirement not only increases transparency, but forces firms to think through the basic risk logic of their compensation plans, and we hope it will help begin an important discussion between shareholders, directors and risk managers about the relationship between compensation and risk.

4. We should reexamine whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders

While golden parachutes were created to align executives' interests with those of shareholders during mergers, they have expanded in ways that may not be consistent with the long-term value of the firm, and – as of 2006 – were in place at over 80 percent of the largest firms. Likewise, supplemental retirement packages that are intended to provide financial security to employees are too often used obscure the full amount of "walkaway" pay due a top executive once they leave the firm. Indeed, Lucian Bebchuk and Jesse Fried have shown that there is substantial evidence that "firms use retirement benefits to provide executives with substantial amounts of `stealth compensation' -- compensation not transparent to shareholders – that is largely decoupled from performance."[1]

Examining these practices is all the more important because when workers who are losing their jobs see the top executives at their firms walking away with huge severance packages, it creates the understandable impression that there is a double-standard in which top executives are rewarded for failure at the same time working families are forced to sacrifice. As Secretary Geithner said yesterday, "we should reexamine how well these golden parachutes and supplemental retirement packages are aligned with shareholder interests, whether they truly incentivize performance and whether they reward top executives even if their shareholders lose value."

5. We should promote transparency and accountability in setting compensation

Many of the excessive compensation practices in place during the financial crisis likely would have been discouraged or reexamined if they had been implemented by truly independent compensation committees and were transparent to a company's owners – its shareholders. Companies often hire compensation consultants who also provide the firm millions of dollars in other services – creating conflicts of interest. According to one Congressional investigation, the median CEO salary of Fortune 250 companies in 2006 that hired compensation consultants with the largest conflicts of interest was 67 percent higher than the median CEO salary of the companies that did not use consultants with such conflicts of interest.[2]

That is why we hope to work with Chairman Frank and this committee to pass "say on pay" legislation, requiring all public companies to hold a non-binding shareholder resolution to approve executive compensation packages. We believe that "say on pay" will place a greater check on boards to ensure that their compensation packages are aligned with the interest of shareholders. Indeed, in Britain, where "say on pay" was implemented in 2002, it has – according to a study by Professor Stephen Davis at Yale's Millstein Center for Corporate Governance and Performance – been associated with greater communication between boards and shareholders, while a recent paper by Fabrizio Ferri and David Maber of Harvard Business School has found that say on pay made CEO compensation more sensitive to negative results.[3] As a result, the resolutions have gained more and more support, with 76 percent of Chartered Financial Analysts now in favor of say on pay.[4]

In addition, we want to work with this committee and the Congress to pass legislation directing the SEC to put in place independence rules for compensation committees analogous to those required for audit committees as part of the Sarbanes-Oxley Act. Our goal is to move compensation committees from being independent in name to being independent in fact. Under this proposal, not only would committee members be truly independent, but they would also be given the authority to appoint and retain compensation consultants and legal counsel, along with the funding necessary to do so. This legislation would also instruct the SEC to create standards for ensuring the independence of compensation consultants, providing shareholders with the confidence that the compensation committee is receiving objective, expert advice.

I am pleased today to be testifying here alongside my colleagues from the SEC and the Fed. We are encouraged by the efforts of the SEC to seek greater transparency and disclosure on compensation, and by the commitment of the Federal Reserve and other bank supervisors to ensure compensation practices are consistent with their fundamental duty to promote the safety and soundness of our financial system. As Secretary Geithner announced yesterday, we also hope to work further with other agencies on this issue by asking the President's Working Group on Financial Markets to provide an annual review of compensation practices to monitor whether they are creating excessive risks.

As we move to repair our financial system, get our economy growing again and pursue a broad agenda of regulatory reform, we must ensure that the compensation practices that contributed to this crisis no longer put our system and our economy at risk. I commend the committee for holding these hearings, and I look forward to approaching this difficult issue with a degree of seriousness, reflection and humility – seriousness over the harm excessive risk-taking has caused for so many innocent people; reflection over the lessons we have already learned; and humility in recognizing the complexity of this issue, its potential for unintended consequences, and the importance of testing each of our ideas against the most rigorous analysis.

Forecast I -- We begin the extension of the Demand Side forecast

The low-tech forecast from Demand Side

All the high-flying forecast models have broken down. The Demand Side forecast does better than the Bull Chips.

Not by brilliance, but because we are looking in the right direction.

It is not that there is any particular sophistication in our forecast that it has done so well in difficult times, it is just that the forecast adopts the demand side perspective.

We'll get to the details on the next podcast. Today the theory.

Waiting for profits to increase before the economy can turn around, a canard repeated by last week's Idiot of the Week, is ass-backwards. The prospect of profit must increase, not the fact of profit.

The difference is the crucial difference.

Prospect is forward-looking and involves investment. Entrepreneurs identify a need and fill it. The investment is important. it is the beginning of the business cycle, such as it exists.

The fact of profit means the investment is paying off, not that any new investment is required. In fact, companies habitually maintain this profit by discouraging investment from competitors by one means or another. Continued profits may mean a good investment has been made in the past, but it may equally mean a protected industry or the aging of the business cycle.

When we use the word investment, we are not referring to buying stocks, but in real investment. Equities and debt issues from companies do not necessarily mean a new plant or better mousetrap -- or more jobs. They are purchases of existing investment and may very well be made for defensive purposes or to take advantage of a market advantage or some other reason. Financial investments, in particular, are -- as we have discovered to our dismay -- not jobs-producing investment.

We use the concept of business cycle not because we put much stock in it as a prime descriptor of what is going on, but because it is familiar. The concept is much more useful when applied to segments of the economy, the sectors, than it is when applied to the economy as a whole. The entrepreneur is always looking forward, hence there is no particular reason for demand to fade unless the profits portion is too large or concentrated in cohorts that do not spend or invest. Such unbalanced profits distribution simply drains the multiplier.

The past two recessions, for example, were brought on by speculative financial bubbles. This is not a business cycle. It is demand alternately stimulated and crushed by perceptions of wealth, as paper values of stocks and houses rise and fall. It may stimulate investment, but because these perceptions are in a bubble, that investment is inevitably distorted.

One might argue that the investment boom of the late 1990s actually ameliorated the downturn in the 2000's. The real improvements in productivity reducing, perhaps, the decline in perceived wealth. Be that as it may, and it is only speculation:

Demand creates the prospect of profit. But what creates demand? One might foresee that a water shortage will increase the demand for water, and so invest in that commodity. But it must be effective demand. You will not make a profit if people cannot create effective market demand by having the income to purchase.

In our current case, what creates demand is government spending and investment, and its translation into private investment.

One of the great calamities afflicting young economists is segregating C + I + G + NX. Consumption plus investment plus government spending plus net exports. On one hand, it is an accurate description of output, since it covers all the bases. On the other hand, it is simply a labeling exercise which often gets its tags wrong. C includes consumer durables, some education and health care. G includes a lot of education, health care, infrastructure spending and activities such as national defense. All of this might be better thought of as investment in a real form. The I includes only investment by businesses and residential housing. Business inventory may include chewing gum.

Not to beat this horse too long, but the return on education per dollar is about six times that of residential investment,

What creates demand? Investment. Government spending. But it is also released by economic security.

You heard our simple modeling of the various stimulus packages where we highlighted the falling consumption function. The consumption function is the proportion of new income that is spent. In good times, with stable prospects, more of one's income may be spent. In bad times, with uncertain prospects, the tendency is to save. You can see the savings rate spiking right now. Private pullback has more than offset public stimulus. We'll have a comment on the savings rate and the flagellation of the American consumer in an upcoming podcast.

But let's walk around this point a bit.

What is so important economically about the health care fix? It will create security and return confidence in consumers. So serious has been the body blow to the balance sheet of households that confidence will not return without a tangible reason. Universal health care can be one reason. Secondarily it will reduce the many types of burdens of profit-first health care delivery on the budgets of households, government and business.

What destroys demand? Withdrawal of investment and government spending -- and a falling consumption function.

All other things equal, one would use government spending to balance a drop in investment spending such as we have seen since 2007 with the drop in residential and business investment. This has not happened. Not only has there been the pull-back in the household and business sector we noted above, but the contraction in state and local government spending has also offset much of the federal expansion. The financial collapse and credit crunch piled on an enormous subtraction in investment and employment far above what might have occurred in the expiration of a housing bubble absent the blunders in securitization, mortgage innovation and derivatives.

We could go on.

But to the forecast.

As we've said, our baseline forecast assumes policy advances at the federal level in three areas:

(a) Removing the zombie banks from the economic field and reforming the financial sector,

(b) Fiscal stimulus, and

(c) Improvements in social insurance and homeowners' assistance.

We did not mention homeowners assistance this time, until now, but it is important not only to stabilize the consumption function but also to stabilize the housing market. These clearly are not in place to the level we imagined, but neither have policymakers exhausted their allotment of time. The response may come as the facts make themselves more clear.

Prospects going forward are uncertain to the degree that we are going to break out the forecast into optimistic, baseline, and pessimistic scenarios. The differences are based entirely on government policy choices. We recognize that economics is a science of human behavior. The behavior of millions aggregated is, however, more predictable than that of a few in government or powerful corporations that may have idiosyncratic incentives.

You've heard some of the assumptions for the baseline. We'll go into the details, including the numbers in the next podcast.