On Avoiding Politics

I've tried my best to avoid political discourse on this blog, as my goal has been and still is to learn about "economics".
However, it's getting harder and harder to do so. The more I read, the more I realize that economics are inextricably tied to politics. Political policy has a deep impact on economic problems and activity.
It turns out Paul Krugman went through this journey. Here's an article I found to be a fascinating read, sent to me by commenter CD. I've included a few select quotes, but I encourage you to read it in its entirety.

For the first twenty years of Krugman’s adult life, his world was divided not into left and right but into smart and stupid. “The great lesson was the low level of discussion,” he says of his time in Washington. “The then Secretary of the Treasury”—Donald Regan—“was not that bright, and you could have angry exchanges where neither side understood the policy.” Krugman was buoyed and protected in his youth by an intellectual snobbery so robust that distractions or snobberies of other sorts didn’t stand a chance. “When I was twenty-eight, I wouldn’t have had the time of day for some senator or other,” he says.

...

When Krugman first began writing articles for popular publications, in the mid-nineties, Bill Clinton was in office, and Krugman thought of the left and the right as more or less equal in power. Thus, there was no pressing need for him to take sides—he would shoot down idiocy wherever it presented itself, which was, in his opinion, all over the place. He thought of himself as a liberal, but he was a liberal economist, which wasn’t quite the same thing as a regular liberal. Until the late nineties, when he became absorbed by what was going wrong with Japan, he believed that monetary policy, rather than government spending, was all that was needed to avoid recessions: he agreed with Milton Friedman that if only the Fed had done its job better the Great Depression would never have happened. He thought that people who wanted to boycott Nike and other companies that ran sweatshops abroad were sentimental and stupid. Yes, of course, those foreign workers weren’t earning American wages and didn’t have American protections, but working in a sweatshop was still much better than their alternatives—that’s why they chose to work there. Moreover, sweatshops really weren’t the threat to American workers that the left claimed they were. “A back-of-the-envelope calculation . . . suggests that capital flows to the Third World since 1990 . . . have reduced real wages in the advanced world by about 0.15%,” he wrote in 1994. That was not nothing, but it certainly wasn’t anything to get paranoid about. The world needed more sweatshops, not fewer. Free trade was good for everyone. He felt that there was a market hatred on the left that was as dogmatic and irrational as government hatred on the right.

...

Certainly until the Enron scandal, Krugman had no sense that there was any kind of problem in American corporate governance. (He consulted briefly for Enron before he went to the Times.) Occasionally, he received letters from people claiming that corporations were cooking the books, but he thought this sounded so implausible that he dismissed them. “I believed that the market was enforcing,” he says. “I believed in the S.E.C. I just never really thought about it. It seemed like a pretty sunny world in 1999, and, for all of my cynicism, I shared a lot of that. The extent of corporate fraud, the financial malfeasance, the sheer viciousness of the political scene—those are all things that, ten years ago, I didn’t see.”
...
It was the 2000 election campaign that finally radicalized him. He’d begun writing his column the year before, and although his mandate at the outset was economic and business matters, he began paying more attention to the world in general. During the campaign, he perceived the Bush people telling outright lies, and this shocked him. Reagan’s people had at least tried to justify their policies with economic models and rationalizations. Krugman hadn’t believed the models would work, but at least they were there.
After the election, he began to attack Bush’s policies in his column, and, as his outrage escalated, his attacks grew more venomous. Krugman felt that liberals were unwilling to confront or even to acknowledge the anger on the right with some of their own, so he was going to have to do it.

...

People in the [Obama] Administration were sometimes frustrated by his criticisms. “Paul’s great strength is his pellucid clarity,” Summers says delicately. “The other side of it is that there’s a degree of complexity in the world that a President has to deal with that he sometimes misses in his search for clarity.” But Krugman could also be useful: if he supported something that the left was dubious about—the Senate health-care bill, for instance—he could bring a lot of people around. On the other hand, when, as was more often the case, it was conservatives who were holding out, he had no influence at all. “I was actually in the room when many of the final negotiations”—over the stimulus package—“were done, and there was no way that a larger package would have gotten sixty votes,” an Administration official says. “Regardless of whether he is academically correct, it just wasn’t in the cards.”

Reading

A few links:

• A good writeup on what Efficient Market Hypothesis really implies, along with an analysis of criticism of the idea.

  Prices may indeed contain "all relevant information" but this includes not just beliefs about earnings and discount rates, but also beliefs about "sentiment and emotion." These latter beliefs can change capriciously, and are notoriously difficult to track and predict. Prices therefore send messages that can be terribly garbled, and resource allocation decisions based on these prices can give rise to enormous (and avoidable) waste. Provided that major departures of prices from intrinsic values can be reliably identified, a case could be made for government intervention in affecting either the prices themselves, or at least the responses to the signals that they are sending.

• Hank Paulson calls for greater regulation:

  For example, the most recent proposal by the Obama administration — to bar big banks from trading driven by other than customer-related activity — would not have prevented the collapse of Fannie Mae, Freddie Mac, Lehman Brothers, American International Group, Washington Mutual, Wachovia or other institutions whose failure contributed to the crisis. Rather than dictating a set of rules that will become out of date as the markets evolve, policy makers should devise legislation that ensures that regulators have the authority to tackle the issue of size and all potential systemic risks.
  This calls for two vital changes. First, we must create a systemic risk regulator to monitor the stability of the markets and to restrain or end any activity at any financial firm that threatens the broader market. Second, the government must have resolution authority to impose an orderly liquidation on any failing financial institution to minimize its impact on the rest of the system.

• Roubini on a variety of topics, including Europe, the U.S., deficits, and fears of a double-dip recession. I quote a section on the US here:

  The US and Japan might be among the last to face the wrath of the bond-market vigilantes: the dollar is the main global reserve currency, and foreign-reserve accumulation – mostly US government bills and bonds – continues at a rapid pace. Japan is a net creditor and largely finances its debt domestically.
  But investors will become increasingly cautious even about these countries if the necessary fiscal consolidation is delayed. The US is a net debtor with an aging population, unfunded entitlement spending on social security and health care, an anemic economic recovery, and risks of continued monetization of the fiscal deficit. Japan is aging even faster, and economic stagnation is reducing domestic savings, while the public debt is approaching 200% of GDP.
  The US also faces political constraints to fiscal consolidation: Americans are deluding themselves that they can enjoy European-style social spending while maintaining low tax rates, as under President Ronald Reagan. At least European voters are willing to pay higher taxes for their public services.

• Wall Street's elder statesmen are teaming up to support Volcker, and are calling for more:

  Put aside for a moment the populist pressure to regulate banking and trading. Ask the elder statesmen of these industries — giants like George Soros, Nicholas F. Brady, John S. Reed, William H. Donaldson and John C. Bogle — where they stand on regulation, and they will bowl you over with their populism.
  ...Mr. Volcker, 82, signed up the support of nearly a dozen peers whose average age is north of 70 and whose pedigrees on Wall Street and in banking are impeccable. But while Mr. Volcker focuses on a rule that would henceforth prohibit a bank that takes deposits from also buying and selling securities for its own account — risking losses in the process — most of his prominent supporters see that as a starting point in a broader return to regulation. And most do not hesitate to speak up in interviews.

• Martin Wolf criticizing continuing calls for deficit reduction:

  So, yes, high-income countries face huge fiscal challenges. And yes, the crisis-hit countries start from grossly unsustainable fiscal positions. But the US is not Greece. Moreover, a massive fiscal tightening today would be a grave error. There is a huge risk – in my view, a certainty – that this would tip much of the world back into recession. The private sector must heal. That, not fiscal retrenchment, is the priority.

Still More On Boom-and-Bust

I've made a couple posts in the past talking about how we seem to operate in a boom-and-bust environment.
If you look at the first link, reader Wanna provided another comment supporting his position. I quote:

Wanna said...

Philosophically speaking boom and bust are a way of life and that is the way it should be. Fed should not try to anticipate a boom and nip it in its bud. How would the Fed know in advance that a bubble is going to happen. These things are evident only in hindsight (which of course is 20/20 for TV and market pundits). Fed's job as Greenspan and Bernanke have said before should be that of a mopper rather than a boom-breaker.

Wanna said...

http://blogs.forbes.com/streettalk/2010/02/02/death-taxes-and-market-crashes/?partner=dailycrux

Please see the above link (sent to me by someone else). Boom and bust are inevitable. If something is running very smooth its cause for concern as it might point to under-utilization of resources i.e. a smooth running economy almost by definition would not be utilizing its resources to the optimum.

"Boom and bust are inevitable". To some extent, I disagree. I think Wanna is right that philosophically, in the big picture, boom-and-bust is a fact of life. Nations rise and fall, etc. However, the assumption in his argument is that boom and bust on a smaller time-scale is a natural condition. In fact, there is nothing natural about our markets and economies: these are artificial, man-made constructs that we control. As such, their "natural" behavior is controlled by governments and societies and can thus be purposefully influenced.
For example, there is no economy in the world that optimally uses its resources (another argument used by Wanna to justify boom-and-bust). A simple example is that most countries, if not all, have a defense sector. Generally, contracts in this sector are handed out by governments to corporations within their jurisdiction, for security purposes. This inherently is a market that does not allow maximum competition, which usually leads to bloated contracts that are not at all optimal. Will this ever change? No. It is a security issue.
There are probably myriad other examples of how there truly is no such thing as a completely free-market society. Other than in the jungle, such an environment does not exist. We work in an artificially constructed system, and I don't think anyone wants to go to a Lord of the Flies society.

As such, I still hold to my view that we should work hard to improve government regulation and oversight of markets. I have admitted in the past that the government cannot do everything:

Not all bubbles can be prevented, not all idiocy can be controlled. However, the government has a responsibility to control what it can.

This includes viewing with suspicion markets that seemingly don't stop going up, and making sure that the mechanisms propelling them forward are not fundamentally unsound. This type of government regulation would likely not have done anything to prevent the dot com bubble we saw in the late 90's, as that seemed to be an issue of poor speculation by private investors without any serious underlying corruption. However, it could have mitigated the housing bubble in which triple-A ratings were given to fundamentally bad bundles of mortgages that banks then wildly speculated on. Curbing the boom would, I think, minimize the following bust, and I fail to see how that would be a bad thing. This would require that Bernanke not in fact be only a mopper, but instead an active regulator looking out for dangerous financial or economic activity.

Indeed, the final paragraph of the link Wanna provided speaks to my view:

Leverage, of course, just makes things worse. Or maybe that's not so obvious to everyone. The authors note that financial firms tend to blow up every 20 years or so, and that's to be expected given their high leverage and propensity to come up with innovative new products that nobody understands. The bankers' less imaginative counterparts, who make real things people can actually use, tend to carry less leverage. "In a sense, Corporate America seems smarter than the financial firms in managing its long-term risks," the authors write. Ah, but how can you earn a fat year-end bonus that way?

Technical Recovery

Larry Summers made a very interesting statement in a speech he gave at Davos, as reported by Martin Wolf at FT (emphasis mine):

Lawrence Summers, Mr Obama’s principal economic adviser, also stressed that “what we are seeing in the US and perhaps in other places, is a statistical recovery and a human recession”. In his view, the combination of high unemployment with “mercantilist policies” in parts of the world makes it hard to defend liberal trade politically or perhaps even intellectually. Unless the recovery proves far stronger than expected, high unemployment will persist in western countries, with all the political dangers it brings.

Today, news came out stating unemployment numbers may have been under-counted by 824,000 (!) since December 2007.

"There's certainly a disconnect between economists like myself who say the recession ended in May or June and the person on the street who says the recession hasn't ended," said John Canally, economist LPL Financial. "This report is only going to widen that gap."

I had mentioned, early in this blog's history, my fears of a double-dip recession. Those fears were fueled by some actual economists, of course. Reports such as this only increase that fear. It's also very interesting to see economists as prominent as Summers acknowledge that, despite evidence of a "statistical recovery", the fact is that for the average person, conditions are still pretty bad. Interestingly, Krugman pointed this out last July. If persistently high unemployment leads to politically-driven moves that go against free trade and in the direction of protectionism, we could be in for a very interesting decade. Note that I'm not making any claims about what would be good for jobs, because I have no idea. I'm simply pointing out that winds are blowing against liberal trade policies and efficient market theories.

On a side note, NY Attorney General Andrew Cuomo is accusing Bank of America of fraud:

The lawsuit contends that the bank's management team understated the losses at Merrill in order to get shareholders to approve the deal, then subsequently overstated the firm's willingness to terminate the merger to regulators weeks later in order to get $20 billion of additional aid from the federal government.
"Bank of America and its officials defrauded the government and the taxpayers at a very difficult and sensitive time," Cuomo said at a press conference Thursday, joined by federal bailout cop Neil Barofsky, whose office aided in the investigation. "I believe that Bank of America officials exploited this fear."

Along similar lines, Italy is also going after BoA, amongst others, in a fraud probe.

Corporate privateering in partnership with the state has been a perennial problem in developing nations, especially in South America and the western Pacific. But the economic hitmen are ranging further and wider these days, in search of greater profits and new fields of plunder, and in developed nations. Iceland and Greece are one thing, but if a G7 nation like the UK falls prey to the banks, the reaction may be severe.
This theme of national sovereignty versus corporatism will gain more traction over the next five to ten years.

Rent Seeking

Jesse's Cafe Americain points to an excellent piece written by James Rickards, former counsel to LTCM.

Emphasis in the quote below is mine:

Now consider another example of data mining, not done by retail firms, but by giant investment banks such as Goldman Sachs. These banks have thousands of customers transacting in trillions of dollars in stocks, bonds, commodities and foreign exchange daily. By using systems with anodyne names like SecDB, Goldman not only sees the transaction flows but some of the outright positions and whether they are bullish or bearish. Data mining techniques are just as effective for this market information as they are for Google, Amazon, Wal-Mart and others. ...

One need not be a market expert to imagine the power of this information. You can see which way the winds are blowing before the storm hits. ... This use of information is the ultimate type of insider trading because it does not break the law; you are not stealing the information, you own it.

So what do Goldman and others do with this mountain of market information? ...this mountain of immensely valuable market information is used mainly to power their giant proprietary trading desks allowing them to rack up consistent excess returns. Economists have a name for this also. It’s called “rent seeking,” which means taking value from others without any contribution to productivity. ... In nature, the name for a rent seeker is parasite.

The ideal existence for a parasite is symbiosis, or balance, where it offers some minimal service to the host, (some parasites devour insects which annoy the host), while extracting as much sustenance from the host as possible without killing it. But sometimes the symbiosis is disturbed and the parasite takes too much and actually destroys the host, which can end up destroying the parasite as well...

And that is the nature of Goldman. Gather up as many customers as possible, aggregate the available information to achieve a superior market view and then relentlessly extract rents from the marketplace. Better yet, tell yourself you’re smarter than everyone else and you’ve earned the rents from the symbiosis.

Ouch.
It's worth noting that the article isn't meant to just bash GS. Well okay, it mostly is, but does provide some justification:

We actually wouldn’t care about this if we weren’t subsidizing it. If Goldman wants to Hoover up information and their customers are willing to be used, that’s their business. We should mind that the taxpayers are supporting it. We should mind that Goldman has the ability to take government guaranteed deposits. We should mind that Goldman was bailed out in the AIG rescue and never even said thank you to working Americans who paid the bill.

Volcker Op-Ed

Paul Volcker published an Op-Ed in the NYT over the weekend, describing what he thinks we need to do about regulatory reform on banks. Summary:

• Prevent commercial banks from running hedge funds and proprietary trading desks.
• Create a government-run "Resolution Authority" that can intervene and safely shut down a bank that threatens the stability of the financial system, and make sure that stakeholders such as stock-owners, management, and bondholders pay the costs of the shut down (no more public safety net, reducing the moral hazard issue).
• No arbitrary size limits (an idea Simon Johnson has championed) that would artificially prevent an institution from becoming "too-big-to-fail". Instead, as noted above, institutions that fail would do so safely and not at public cost.

I quote the conclusion of the editorial:

I am well aware that there are interested parties that long to return to “business as usual,” even while retaining the comfort of remaining within the confines of the official safety net. They will argue that they themselves and intelligent regulators and supervisors, armed with recent experience, can maintain the needed surveillance, foresee the dangers and manage the risks.

In contrast, I tell you that is no substitute for structural change, the point the president himself has set out so strongly.

I’ve been there — as regulator, as central banker, as commercial bank official and director — for almost 60 years. I have observed how memories dim. Individuals change. Institutional and political pressures to “lay off” tough regulation will remain — most notably in the fair weather that inevitably precedes the storm.

The implication is clear. We need to face up to needed structural changes, and place them into law. To do less will simply mean ultimate failure — failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future.

UPDATE: Volcker vs. Volcker.