Economic Crisis – Page 24 – artdiamondblog.com

FDR’s Treasury Secretary Morgenthau Concluded that Big Spending Stimulus “Does Not Work”

Henry Morgenthau, Jr.

Source of portrait: http://en.wikipedia.org/wiki/Henry_Morgenthau,_Jr.

Henry Morgenthau, Jr. was FDR’s Secretary of the Treasury from 1934-1945. In the following important quote, he admits that the big New Deal stimulus spending programs had failed.

(p. 2) We have tried spending money. We are spending more money than we have ever spent before and it does not work. And I have just none interest, and if I am wrong . . . somebody else can have my job. I want to see this country prosperous. I want to see people get a job, I want to see people get enough to eat. We have never made good on our promises. . . . I say after eight years of this administration we have just as much unemployment as when we started . . . . And an enormous debt to boot!

Source:
Folsom, Burton W., Jr. In New Deal or Raw Deal? How FDR’s Economic Legacy Has Damaged America. 4th ed. New York: Threshold Editions, 2008.
(Note: ellipses in Folsum’s version of the quotation.)

Folsum says that this statement was from testimony before the House Ways and Means Committee in May 1939; and can be found in Morgenthau’s Diary entry for May 9, 1939 at the Roosevelt Presidential Library.

Source of book image: http://www.flickr.com/photos/roscoe/3121498653/

Bailouts Damage “System Based on the Premise that Risk Can Bring Failure, as Well as Rewards”

Source of the cartoon: online version of the WSJ quoted and cited below.

(p. A8) William O. Perkins III says he turned a $1.25 million profit trading Goldman Sachs Group Inc. stock last week.

You would think that would count as a pretty good paycheck for the Houston energy trader. Instead, the experience left him so angry about the demise of capitalism that he says he has decided to spend his profits on advertisements attacking President George W. Bush’s planned $700 billion Wall Street bailout.
. . .
So he says he bought Goldman Sachs at $129 a share. The stock fell, so he bought more at $100 a share. It fell again, and he bought at $90. The next day it rallied and he sold out at an average price of $130 a share, for a net gain of about $1.25 million over three days of trading, he said.
Trouble was, the stock didn’t rally because of the fundamental strength of the company, Mr. Perkins said. It rallied because the federal government announced that it would rescue Wall Street from its own subprime follies, he said.
“The stock did OK because the government came in and said, ‘No one can fail,'” he said. “It’s capitalism on the way up and communism on the way down.”
His success left him furious, and he decided that someone had to speak out about the damage such a plan would cause to a system based on the premise that risk can bring failure, as well as rewards.

For the full story, see:

MICHAEL M. PHILLIPS. “Trader Makes a Quick $1.25 Million on Rescue, Then Slams It.” The Wall Street Journal (Weds., SEPTEMBER 24, 2008): A10.
(Note: ellipsis added.)

Rajan Foresaw Risks of Financial Disaster

“Raghuram Rajan, shown at 2005 symposium, warned of rising risks.” Source of caption and photo: online version of the NYT article quoted and cited below.

I praised Rajan’s analysis in a blog entry back in January 2008. Rajan deserves credit for seeing the situation earlier and more clearly than most other experts:

(p. A7) To outline his fears about the U.S. economy, Raghuram Rajan picked a tough crowd.

It was August 2005, at an annual gathering of high-powered economists at Jackson Hole, Wyo. — and that year they were honoring Alan Greenspan. Mr. Greenspan, a giant of 20th-century economic policy, was about to retire as Federal Reserve chairman after presiding over a historic period of economic growth.
Mr. Rajan, a professor at the University of Chicago’s Booth Graduate School of Business, chose that moment to deliver a paper called “Has Financial Development Made the World Riskier?”
. . .
He says he had planned to write about how financial developments during Mr. Greenspan’s 18-year tenure made the world safer. But the more he looked, the less he believed that. In the end, with Mr. Greenspan watching from the audience, he argued that disaster might loom.
Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly.
. . .
Mr. Rajan is now focused on coming up with ways to avoid a regulatory backlash akin to what happened during the Great Depression, when governments around the world threw up protectionist barriers and clamped down on financial markets.
Instead of heavy regulation, he says, the incentives of Wall Streeters need to change so that punishments for losing money are in line with rewards for earning it.
At the start of 2008, he suggested that bonuses that financial workers make during boom times should be kept in escrow accounts for a period of time. If the firm experienced big losses later, those accounts would be drained.
Facing withering criticism over the bonuses paid out in the boom, financial giant UBS and Wall Street firm Morgan Stanley have recently announced they’re adopting policies along the lines of what Mr. Rajan proposed.
Mr. Rajan also urges other safeguards. Along with Chicago colleagues Anil Kashyap and Harvard economist Jeremy Stein, he’s come up with a plan to create a form of financial-catastrophe insurance that firms would buy into.

For the full story, see:
JUSTIN LAHART. “Mr. Rajan Was Unpopular (But Prescient) at Greenspan Party.” The Wall Street Journal (Fri., JANUARY 2, 2009): A7.
(Note: ellipses added.)

Japan’s Stimulus Package Stimulated Debt, but Not Recovery

Source of graphs: online version of the NYT article quoted and cited below.

(p. A10) In the end, say economists, it was not public works but an expensive cleanup of the debt-ridden banking system, combined with growing exports to China and the United States, that brought a close to Japan’s Lost Decade. This has led many to conclude that spending did little more than sink Japan deeply into debt, leaving an enormous tax burden for future generations.

In the United States, it has also led to calls in Congress, particularly by Republicans, not to repeat the errors of Japan’s failed economic stimulus. They argue that it makes more sense to cut taxes, and let people decide how to spend their own money, than for the government to decide how to invest public funds. Japan put more emphasis on increased spending than tax cuts during its slump, but ultimately did reduce consumption taxes to encourage consumer spending as well.

For the full story, see:
MARTIN FACKLER. “Japan’s Big-Works Stimulus Is Lesson.” The New York Times (Fri., February 5, 2009): A1 & A10.

“The soaring Marine Bridge in Hamada, Japan, built as a public works project, was almost devoid of traffic on a recent morning.” Source of caption and photo: online version of the NYT article quoted and cited above.

“This is a Crisis of Excessive Debt”

Source of book image: http://ecx.images-amazon.com/images/I/41gD4n5UkHL._SL500_.jpg

Niall Ferguson has a recent book on money that has received a great deal of attention (but that I have not yet seen). Here are some of his views, as expressed at the 2009 World Economic Forum, in Davos, Switzerland:

(p. B4) “Even before Obama walked through the White House door, there were plans for $1 trillion of new debt,” said Niall Ferguson, a Harvard historian who has studied borrowing and its impact on national power. He now estimates that some $2.2 trillion in new government debt will be issued this year, assuming the stimulus plan is approved.

“You either crowd out other borrowers or you print money,” Mr. Ferguson added. “There is no way you can have $2.2 trillion in borrowing without influencing interest rates or inflation in the long-term.”
Mr. Ferguson was particularly struck by the new borrowing because the roots of the current crisis lay in an excess of American debt at all levels, from homeowners to Wall Street banks.
“This is a crisis of excessive debt, which reached 355 percent of American gross domestic product,” he said. “It cannot be solved with more debt.”
While Mr. Ferguson is a skeptic of the Keynesian thinking behind President Obama’s plan — rather than borrowing and spending to stimulate the economy, he favors corporate tax cuts — even supporters of the plan like Mr. Zedillo and Stephen Roach of Morgan Stanley have called on the White House to quickly address how it will pay for the spending in the long-term.

For the full story, see:
NELSON D. SCHWARTZ. “Global Worries Over U.S. Stimulus Spending.” The New York Times (Fri., January 29, 2009): B1 & B4.

The latest Ferguson book, is:
Ferguson, Niall. The Ascent of Money: A Financial History of the World. New York: Penguin Press, 2008.

Japan’s Huge Stimulus Spending Led to Economic Stagnation

(p. A2) Rep. Paul Ryan of Wisconsin, a young and economically astute Republican leader, has numerous problems with the economic-stimulus package working its way through Congress, but essentially they boil down to this: He fears the U.S. is repeating the mistakes Japan made trying to get out of its own economic ditch in the 1990s.
The Ryan critique is important in part because it’s popping up with increasing frequency among congressional Republicans.
. . .
Here’s the critique in a nutshell: Japan in the early 1990s, like the U.S. today, saw a real-estate bubble burst, spawning a banking and credit crisis that drove the whole economy down, hard. The Japanese then tried stimulating the economy with giant doses of government spending, which didn’t pep things up — but did bring on deficits that required tax increases later, dragging out Japan’s problems for years.

For the full commentary, see:
GERALD F. SEIB. “CAPITAL JOURNAL; Avoiding Japan’s Stimulus Miscues.” Wall Street Journal (Tues., FEBRUARY 2, 2009): A2.
(Note: ellipsis added.)

The Ad Hoc Growth of the Regulatory Snarl

Source of graphic: online version of the NYT article quoted and cited below.

(p. 9) Who’s to blame for the implosion of financial markets? The finger-pointing has gone in every direction, and it’s easy to see why: the regulatory structure points in every direction.

The apparatus that oversees the nation’s financial system is an ad hoc creation: every time there is a fiscal panic, new agencies are formed and existing ones receive new responsibilities.

For the full comment, see:
HANNAH FAIRFIELD. “Metrics; A Snarl of Regulation.” The New York Times, SundayBusiness Section (Sun., October 4, 2008): 9.

Financial Crisis Is “A Coming-Out Party” for Taleb and Behavioral Economists

(p. A23) My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.

Nassim Nicholas Taleb has been deeply influenced by this stream of research. Taleb not only has an explanation for what’s happening, he saw it coming. His popular books “Fooled by Randomness” and “The Black Swan” were broadsides at the risk-management models used in the financial world and beyond.

In “The Black Swan,” Taleb wrote, “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.” Globalization, he noted, “creates interlocking fragility.” He warned that while the growth of giant banks gives the appearance of stability, in reality, it raises the risk of a systemic collapse — “when one fails, they all fail.”

Taleb believes that our brains evolved to suit a world much simpler than the one we now face. His writing is idiosyncratic, but he does touch on many of the perceptual biases that distort our thinking: our tendency to see data that confirm our prejudices more vividly than data that contradict them; our tendency to overvalue recent events when anticipating future possibilities; our tendency to spin concurring facts into a single causal narrative; our tendency to applaud our own supposed skill in circumstances when we’ve actually benefited from dumb luck.

And looking at the financial crisis, it is easy to see dozens of errors of perception. Traders misperceived the possibility of rare events. They got caught in social contagions and reinforced each other’s risk assessments. They failed to perceive how tightly linked global networks can transform small events into big disasters.

Taleb is characteristically vituperative about the quantitative risk models, which try to model something that defies modelization. He subscribes to what he calls the tragic vision of humankind, which “believes in the existence of inherent limitations and flaws in the way we think and act and requires an acknowledgement of this fact as a basis for any individual and collective action.” If recent events don’t underline this worldview, nothing will.

For the full commentary, see:
DAVID BROOKS. “The Behavioral Revolution.” The New York Times (Tues., October 28, 2008): A31.

The reference to Taleb’s Black Swan book is:
Taleb, Nassim Nicholas. The Black Swan: The Impact of the Highly Improbable. New York: Random House, 2007.

Another review of Taleb’s book is:
Diamond, Arthur M., Jr. “Review of: Taleb, Nassim Nicholas. The Black Swan.” Journal of Scientific Exploration 22, no. 3 (Fall 2008): 419-422.

Stimulus Statement to President Obama that I Signed

Source of image of stimulus statement: http://www.cato.org/fiscalreality

My name appeared on the list of economists supporting an open statement addressed to President Obama questioning the wisdom of the huge government spending package recently passed by Congress. The statement was published in full-page ads paid for by the Cato Institute that ran on p. A11 of the Weds., Jan. 28, 2009 New York Times and on p. A14 of the Mon., Feb. 9, 2009 Wall Street Journal.

You can download a PDF of the statement, along with the initial list of signatories, at:
http://www.cato.org/special/stimulus09/cato_stimulus.pdf

Government Monetary Excess Caused Financial Crisis

Source of the book image: http://ecx.images-amazon.com/images/I/51-z6te6nKL._SS500_.jpg

Stanford economics professor John Taylor’s book Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis is scheduled to be published in late February 2009.

(p. A19) Many are calling for a 9/11-type commission to investigate the financial crisis. Any such investigation should not rule out government itself as a major culprit. My research shows that government actions and interventions — not any inherent failure or instability of the private economy — caused, prolonged and dramatically worsened the crisis.

The classic explanation of financial crises is that they are caused by excesses — frequently monetary excesses — which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.
Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. Researchers at the Organization for Economic Cooperation and Development have provided corroborating evidence from other countries: The greater the degree of monetary excess in a country, the larger was the housing boom.
. . .
The realization by the public that the government’s intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others and unclear, seemingly fear-based explanations of programs to address the crisis. What was the rationale for intervening with Bear Stearns, then not with Lehman, and then again with AIG? What would guide the operations of the TARP?
It did not have to be this way. To prevent misguided actions in the future, it is urgent that we return to sound principles of monetary policy, basing government interventions on clearly stated diagnoses and predictable frameworks for government actions.
Massive responses with little explanation will probably make things worse. That is the lesson from this crisis so far.

For the full commentary, see:

JOHN B. TAYLOR. “How Government Created the Financial Crisis.” Wall Street Journal (Tues., February 9, 2009): A19.
(Note: ellipsis added.)