The Corrosive Qualities of Inequality: The Roots of the Current Meltdown.

My article was just published in Challenge Magazine.

"The Corrosive Qualities of Inequality: The Roots of the Current Meltdown." Challenge, Vol. 51, No. 5 (September-October, 2008): pp. 40-64.

McCain’s Mortgage Subsidy: Incidence to Homeowners or to Bankers?

Mike Allen reports:

Sen. John McCain (R-Ariz.) made an overnight change in the homeowner bailout he proposed at Tuesday’s presidential debate, making it more generous to financial institutions and more costly for taxpayers. McCain's staff says it was always meant that way. When McCain sprung his surprise idea at the start of the debate in Nashville, his campaign posted details online of his American Homeownership Resurgence Plan, which would direct the government to buy up bad home mortgages, allowing strapped people to keep their property. The document posted and e-mailed by the McCain campaign on Tuesday night says at the end of its first full paragraph: “Lenders in these cases must recognize the loss that they’ve already suffered.” So the government would buy the mortgages at a discounted rate, reflecting the declining value of the mortgage paper. But when McCain reissued the document on Wednesday, that sentence was missing, to the dismay of many conservatives. That would mean the U.S. would pay face value for the troubled documents, which was the main reason Sen. Barack Obama (D-Ill.) gave for opposing the plan. A McCain campaign official explained the change: “That language was mistakenly included in the initial draft and it’s been corrected. It doesn’t reflect the intentions of the initiative, which necessitated the correction and the removal of the sentence. A simple mistake.” Obama Campaign Economic Policy Director Jason Furman said in the campaign statement opposing McCain's plan: "John McCain wants the government to massively overpay for mortgages in a plan that would guarantee taxpayers lose money, and put them at risk of losing even more if home values don’t recover. The biggest beneficiaries of this plan will be the same financial institutions that got us into this mess, some of whom even committed fraud."

When I posted this, Barkley suggested that the McCain proposal wasn’t quite so bad. He – like me – was assuming that most of the incidence of this subsidy would go to homeowners. Brad DeLong, however, seems to be saying that most of this subsidy would go “to the shareholders and managers of banks with troubled assets”. If that’s the case, I agree that this is a really bad proposal.

Voluntary Debt for Government Equity: the Mankiw-Paulson Bank Bailout Plan

Greg Mankiw wrote yesterday:

Some economists have proposed forcing these firms to go raise more capital from private sources. But how exactly can the government do that? It is not entirely clear how, as a legal matter, that can be accomplished. Perhaps regulators can twist the arms of the financial institutions. Call it the Tony Soprano approach. “Nice bank you have here. I wouldn’t want anything bad to happen to it.” Other economists have suggested that the government inject capital itself. That raises several questions. First, which firms? The government does not want to put taxpayer money into “zombie” firms that are in fact deeply insolvent but have not yet recognized it. Second, at what price should the government buy in? Third, isn’t this, kind of, like socialism? That is, do we really want the government to start playing a large, continuing role running Wall Street and allocating capital resources? I certainly don't. Here is an idea that might deal with these problems: The government can stand ready to be a silent partner to future Warren Buffetts. It could work as follows. Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date. This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control. Why would an undercapitalized financial firm take advantage of this offer? Because it would need to raise only half as much capital from private sources, that financing should be easier to come by. With Warren Buffetts in scarce supply, the government can in effect replicate them, by pigging backing on what they do.

Today, we learn:

The Bush administration is considering taking ownership stakes in certain U.S. banks as an option for dealing with a severe global credit crisis ... A decision to inject capital directly into financial institutions in return for ownership stakes would be similar to a plan announced Wednesday by Britain ... Treasury Secretary Henry Paulson told reporters that Treasury was moving quickly to implement the $700 billion rescue effort and he specifically mentioned reviewing ways to bolster the capital of banks.

My concern with Mankiw’s idea starts with the Akerlof demand for lemons problem where insiders may have information about the health of their company that the public or the government does not have (the asymmetric information problem). When this information is positive, they would be less likely to accept new equity infusion. Those willing to accept equity infusion may possess negative inside information about the health of their companies. The case against forced debt for equity swaps is not quite as air tight as Greg Mankiw suggests.

Villains and a Heroine

Today's Times has an article on Greenspan's role in the crisis, focusing on his rabid opposition to any regulation of derivatives. Along with Rubin and Summers, he shut down the attempt by Brooksley Born at the CFTC to do something. In retrospect, Rubin claims he wanted to regulate derivatives, but failed to do so because "the industry certainly didn't want any increase in these requirements. There was no potential for mobilizing public opposition." That's leadership, Bob! And Summers called Born and told her that trying to regulate would cause a financial crisis. When Congress finally made it official with Gramm taking the lead - as has been pointed out often-- the fix was already in, thanks to Rubin, Summers and Greenspan. Bipartisanship! An Obama administration should hire Brooksley Born and shun Summers and Rubin like the plague. For shame!

An Addition to Krugman’s Minimal Model

Paul Krugman has given us a first stab at a leverage-constrained intermediary-driven model of financial contagion. Its point is well-taken, but in my view it misses a very large piece.

I won’t reproduce the math (all basic algebra), but will make the argument verbally: Krugman’s model captures the effect that a falling asset price has on intermediaries’ portfolio capacity for this asset, assuming a fixed capital requirement: the price goes down, so holdings have to decline too in response to diminished equity. This assumes that the extent of leverage is externally imposed, for instance by a responsible regulator.

As we know, however, such regulators have been in short supply. Rather, desired leverage can be viewed as endogenous, a function of perceived risk. A falling asset price can therefore generate a potential double-whammy: for any given degree of leverage it reduces holdings, and it can also increase perceived risk exposure, reducing desired leverage still more.

If this is correct, one potential irony in renewed regulatory vigor (such as demanding more prudent policies on the part of institutions the government acquires an equity stake in) is that it intensifies deleveraging and puts further downward pressure on assets. Such an effect would not arise in interventions that touched a small corner of the global financial system, like Sweden’s in the early 90s, but it would have to be taken into account in the emerging global rescue. This would be an argument for public banking, as I’ve advocated here before, since such a system could be scaled up to whatever level of finance is deemed necessary, rather than relying on private sector willingness to lend and take positions.

Twenty-Five Years of Eight-Hour Propaganda

by the Sandwichman

"Why, of all possible immediate demands of the working class, was the eight-hour day chosen to be the special demand of labor's hosts on the from now on eventful May day?" Hubert Langerock asked in an article published in the May 1914 International Socialist Review.

Langerock, presumably a Marxist, had just spent six paragraphs dismissing what he referred to as the "simplism" and "bourgeois spirit" of Ira Steward's eight-hour theory. Without skipping a beat, he then delivered a panegyric to the demand for a reduction of hours as, "the only one which is not susceptible of a capitalistic interpretation." So which is it bourgeois simplism or unyielding revolutionary program?

It was not entirely on account of historical or national precedents but, because of all the demands which labor make under capitalism, a reduction of the hours of labor is the only one which is not susceptible of a capitalistic interpretation, the only one which unequivocally strikes at the root of the system. A reduction of the hours of labor embodies the experimental logic of facts and therefore it remains independent in its results from the words or formulas wherein it is expressed, it forces the most conservative craft-union man into an attitude which is revolutionary, whether he likes it or not.

No other demand of labor under capitalism is susceptible of the same interpretation, whether it be minimum-wage, or old-age pensions or unemployment benefits or feeding of school children or many more all such measures, unless backed up by a strong revolutionary feeling which makes them indisputable conquests of a forward-moving proletariat, become mere philanthropies of the bourgeois, surface measures of the master class. The bourgeois of today knows that he can recede from the orthodoxy of his old Manchesterianism without pecuniary loss, if he can prevent the birth of an efficient working class economic organization, which would cut the cost of his social emotionalism out of his profits.

Such was the reason for which eight hours became the specific demand of the marchers on May day.

Correction: Great Minds Think Simultaneously

On Oct. 3 I posted a piece that pointed out the similarities between my proposal for public banking and Andrew Feldstein’s. Not only was the general idea roughly the same, we both proposed the same figure for initial capitalization, $300B. Since my proposal appeared three days earlier, I harbored suspicions. I couldn’t find contact information for Feldstein, so I posted my doubts on the website of Joe Nocera, the New York Times columnist who was the source for AF’s proposal. After waiting for two days and not seeing any response, I went public about my suspicions here. I tried to make it clear that I had nothing to go on but coincidence, but in retrospect my writing could be interpreted as leaving a different impression.

What I’ve learned since: (1) Nocera and the Times are justifiably concerned about apparent accusations of plagiarism against one of their quoted sources. (I was contacted today.) (2) Feldstein privately communicated his proposal to Nocera on the same day I posted mine three minutes earlier. Talk about an idea being in the air!

So to set the record straight: the similarity and simultaneity of Andrew Feldstein’s suggestion and mine are entirely and remarkably coincidental. Whatever the truth content of my philosophical musings on the difference between academic and commercial conceptions of intellectual property, they do not apply in any way to this particular episode. And if Feldstein’s investment strategies are as farsighted as his policy proposals, you might want to take a look at his hedge fund.

McCain’s Expensive Mortgage Rescue Plan

Lauren Kornreich reports on McCain’s contradictory claims last night:

Does John McCain recommend a spending freeze to help stabilize the economy, or want the government to purchase bad mortgages from struggling homeowners? Well, according to his answers during Tuesday night’s debate, both. Early in the debate, McCain recommended that the federal government buy up bad mortgages from landowners and replace them with lower cost, fixed-rate mortgages, which he said would help keep Americans in their homes.

How expensive will this be? CalculatedRisk notes his own and the WSJ’s estimates of how many households have negative housing equity – something close to 12 million. He also notes what he calls a bad policy proposal from Glenn Hubbard and Chris Mayer. Whether or not the following proposal is a good idea or a bad one – it’s going to add to the Federal debt:

Housing starts are at their lowest level since the early 1980s, while there are more vacant houses than at any time since the Census Bureau started keeping such data in 1960. Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are accelerating. House prices continue to fall, weakening household balance sheets and the balance sheets of financial institutions. But this can stop. The price of a home is partially dependent on the mortgage rate -- a lower mortgage rate raises house prices. We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac.

Details of McCain's proposal can be found here:

The new mortgage would be an FHA-guaranteed fixed-rate mortgage at terms manageable for the homeowner. The direct cost of this plan would be roughly $300 billion, because the purchase of mortgages would relieve homeowners of “negative equity” in some homes.

Something tells me that this proposal would cost a LOT more than $300 billion. If anyone has a credible analysis of what this proposal would likely cost – that would be most appreciated.

Update: Brad DeLong places his estimate at only $100 billion but that’s because he views the McCain plan as not buying that many bad mortgages:
Democrats want to prevent depression and support the financial markets by investing taxpayer money in banks with troubled assets. Republicans want to give taxpayers money away to the shareholders and managers of banks with troubled assets.

Economic and Social Importance of the Eight-Hour Movement

"That the labor movement is a natural phase of modern society is too obvious for any careful observer of social phenomena and student of economic history to question."

There is nothing more conclusively demonstrated in the history of society than the fact that industrial reform is an inseparable part of social evolution. Activity is the evidence of life and discontent is the first indication of progress. The division of labor, and the specialization of economic functions constantly tend to make a readjustment of industrial and social relations necessary. The concentration of capital and the use of labor-saving and wealth-cheapening methods, which are the indispensable instruments of modern civilization, tend to produce two results. One is the division and concentration of industrial power; the other is the addition and diffusion of social and political power. The first tends to specialize and limit the laborer's economic function, and the latter to generalize and extend his social function. While the first tends to diminish his industrial individuality, the second tends to increase his social and political individuality. Thus, in proportion as the laborer becomes an economic automaton, and loses the power to employ himself, he becomes a social unit, and gains political power over his employer. Therefore, just n proportion as the division of labor, the concentration of capital, and wage conditions increases—which are the infallible evidence of progress—the laborer's social power becomes the chief means of promoting his industrial well-being.

Consequently, the labor movement, which is the organized social force of the laboring class, instead of being a relic of the simple conditions of the past, is an essential part of the complex social institution of the present. It is the natural outcome of the industrial growth of the present century, and can neither be coaxed nor coerced into silence. If wisely directed, it may be made an invaluable aid to progress; if perverted, it may become a perpetual menace to society.

Whether this movement shall become a help or a hindrance to progress, will largely depend upon the treatment it receives at the hands of the intellectual classes. If it is snubbed as an "alien intrusion," and its propositions refused a respectful hearing, it may be expected to incite passion and lead to class warfare. But if it is recognized as a legitimate phase of modern society, and its propositions treated with the careful consideration to which all vital problems are entitled, it may easily become the strong arm of national safety, social peace and progress. It is therefore no longer a question whether or no we shall have a labor movement, but whether by increasing the opportunities for developing the laborer's intelligence, and advancing his material well being, we shall promote social evolution, or whether by opposing the movement, we shall force it along the line of revolution.

The Fed Takes a Step Toward Public Banking

So now the Fed will directly purchase unsecured commercial paper, something a “real” financial institution does as a matter of course (except during a panic). Because even its resources are limited, it is acting on the liability side of the ledger as well, for the first time offering to pay interest on the deposits of commercial banks. (This also encourages banks to be less than fully lent, offsetting the credit creation implications of the Fed’s buying binge.)

If you put these two items together, you have the beginning of what I called Plan B in my earlier post on the subject. There is no need to bail out the private sector: it is possible to create a publicly owned and operated financial entity to carry on the normal tasks of issuing credit, pooling risk and supporting long-term investment. To go further down this road, the Fed would (a) expand the range of assets it would consider buying, and (b) offer competitive returns on deposits and shares of investment funds. Of course, it would be much better for this operation to be spun off to a new entity to avoid conflicts of interest and operational overload.

The overall situation is still in flux, and in particular it is not clear whether it will be possible to unfreeze private financial channels. It may be that, not only is public banking the best strategy—it may be the only one.

FED to Purchase Commercial Paper as an Offset to the Credit Crunch

Today’s 3-month LIBOR stands at 4.32% while yield on 3-month Treasury bills is less than 0.8%. While we thought Friday’s bail-out legislation would alleviate the credit crunch – the TED spread still exceeds 3.5%. Dean Baker says the FED has found a plan B:

It turns out that the Fed can buy commercial paper directly from non-financial corporations needing credit to maintain operations. This will keep the credit markets working even if the zombie banks aren't up to the task. In other words, the threat of a complete meltdown in the absence of a bailout was nonsense and the media once again got taken for a ride by the Bush administration.

The Federal Reserve reports interest rates both for 3-month nonfinancial commercial paper and for 3-month financial commercial paper. As of October 1 (latest date reported), the interest rate on the former (what Dean seems to be discussing) was only 2.27% while the interest rate on financial commercial paper was 3.81%.

The NY Times article that Dean relies on states:

The Fed plan is intended to renew the flow of credit on which the economy depends. Under its plan, the central bank would buy unsecured commercial paper, essentially short-term i.o.u.’s issued by banks, businesses and municipalities.

Given the spread between interest rates on financial commercial paper and nonfinancial commercial paper, it would be interesting to see which sector the FED’s plan B will focus on.

Crisis Commentary Overview

I have tried to integrate the commentaries into a coherent whole, before I go on to new ones.

Some people have complained about the Word format. I tried to use open office, but it lost all my formatting. Help will be appreciated

http://michaelperelman.wordpress.com/2008/10/07/crisis-commentary-overview/

Me on Italian TV

So, folks, just back from two conferences in Europe. The first one, in Urbino, Italy, on Dynamic Modeling in Economics and Finance, was held in honor of me turning 60. There was a report from it that appeared on Italian TV. The announcer described me as "volcanic," and the co-organizer described some of my early work on bubbles and crashes as relevant to the current situation (accurate). One of the participants, Frank Westerhoff from Germany, presented a model discussed last week in a NYTimes column by Mark Buchanan on Tobin taxes stabilizing speculative markets. The link to see about the conference and get to the video of the Italian TV story is
http://www.econ.uniurb.it/bischi/MDEF2008.html.

McCain’s Health Care for the Well To Do But Maybe Not for You

Paul Krugman makes one definitive claim and speculates on McCain’s plan for Medicare:

Conservative Republicans still hate Medicare, and would kill it if they could — in fact, they tried to gut it during the Clinton years (that’s what the 1995 shutdown of the government was all about). But so far they haven’t been able to pull that off. So John McCain wants to destroy the health insurance of nonelderly Americans instead. Most Americans under 65 currently get health insurance through their employers. That’s largely because the tax code favors such insurance: your employer’s contribution to insurance premiums isn’t considered taxable income, as long as the employer’s health plan follows certain rules. In particular, the same plan has to be available to all employees, regardless of the size of their paycheck or the state of their health. This system does a fairly effective job of protecting those it reaches, but it leaves many Americans out in the cold. Workers whose employers don’t offer coverage are forced to seek individual health insurance, often in vain. For one thing, insurance companies offering “nongroup” coverage generally refuse to cover anyone with a pre-existing medical condition. And individual insurance is very expensive, because insurers spend large sums weeding out “high-risk” applicants — that is, anyone who seems likely to actually need the insurance.

The speculation had to do with Palin’s closing remarks during the VP debate and her tribute to Ronald Reagan. Laura Meckler assures us that this speculation is well founded:

John McCain would pay for his health plan with major reductions to Medicare and Medicaid, a top aide said, in a move that independent analysts estimate could result in cuts of $1.3 trillion over 10 years to the government programs. The Republican presidential nominee has said little about the proposed cuts, but they are needed to keep his health-care plan "budget neutral," as he has promised. The McCain campaign hasn't given a specific figure for the cuts, but didn't dispute the analysts' estimate.

As a member of the deficit hawk wing of the Democratic Party, I think fiscal neutrality is a good thing. But I also think this type of a move is really bad policy from an income distribution perspective.

Update: Jonathan Cohn does a nice job of explaining how the McCain position has evolved over time:

First McCain said he would elimin[at]e the entire tax deduction for health insurance, in order to pay for his new tax credit. This would have paid for itself, but it would have done so by raising taxes on a lot of people. Then McCain decided he was keeping part of the deduction after all. While he would be raising taxes on a very few people, he'd be lowering them for most. Of course, that would also have meant running much bigger deficits. Now McCain is saying, no, no, he's not going to increase the deficit with his health care plan. Instead, he's going to pay for it by cutting Medicare and Medicaid--which, at the levels he's discussing, might seriously weaken the program. I can't wait to see what they come up with next.

The usual GOP playbook – playing fast and loose with how their fiscal proposals are supposed to be paid for (if at all).

Economic and Social Importance of the Eight-Hour Movement

The opposition of the employing class to this measure has not risen so much from an aversion to improving the laborer's condition as from a misconception of their economic relation to the community, and especially to the laboring classes.... For nearly a century the colleges have taught, and the employing classes have believed, that an increase of wages always means a decrease of profits—that their income moves inversely with that of the laborer's, or, in the language of the economic instructors, that "profits rise as wages fall, and fall as wages rise."

This proposition has been periodically discussed for more than three-quarters of a century. The characteristic feature of the controversy is that the measure has always been favored by the laboring class and their sympathizers, and as uniformly opposed by the statesmen, economists and employers. This opposition, however, is not, as is commonly assumed, all due to abnormal selfishness on the part of the employing class. The average employer is not more unsympathetic and indifferent to the welfare of society than is any other citizen. There is nothing in the mere fact of being an employer that necessarily destroys one's interest in the social well-being of others. The opposition of the employing class to this measure has not risen so much from an aversion to improving the laborer's condition as from a misconception of their economic relation to the community, and especially to the laboring classes. Nor are they responsible for this misconception; but as we have elsewhere shown, it is mainly due to the erroneous teachings of political economy. For nearly a century the colleges have taught, and the employing classes have believed, that an increase of wages always means a decrease of profits—that their income moves inversely with that of the laborer's, or, in the language of the economic instructors, that "profits rise as wages fall, and fall as wages rise." With this conviction it is not surprising that they should regard every effort to improve the laborer's economic and social condition— which always involves an increase of wages—as inimical to their interests.

From this point of view the more clearly it could be shown that a reduction of the hours of labor would tend to increase wages, the more imperative seemed the necessity for the employers to oppose it. This attitude has been further strengthened by the fact that hitherto the subject has been presented on sympathetic and philanthropic rather than economic grounds. Appeals to sentiment rather than to science have been made for it. The employing class have been asked to grant a reduction of the hours of labor, not as an act of wise statesmanship, but as a boon to the laborer, out of sympathy for the "unfortunate classes." To this they have with some degree of consistency replied, that "factories are business and not charitable institutions," and have accordingly resisted all efforts in this direction as an unwarranted attempt to compel them to make involuntary contributions to the laborers—to force them to give something for nothing—all of which they regard as a violation of their rights as free citizens. In short, through the influence of these conclusions they have come to regard the labor movement as an unwarranted agitation against the best interests both of the employing class and the whole community.

This view of the subject being generally shared by the leading journalists, essayists and statesmen, who reflect the teachings of the colleges—we naturally find the daily press, the magazines and the legislatures averse to every proposition for reducing the hours of labor. Among the objections usually urged against this measure are, that it would increase dissipation among the masses, that it would diminish production, and make smaller profits, and lower wages or higher prices inevitable, and thus be injurious alike to the employer, the laborer and the consumer. If these views were correct, the opposition which they incite to this measure would be entirely warranted, and the movement for the general establishment of an eight-hour system should be abandoned. But are they correct? In order to give a comprehensive answer to this question, the subject must be removed from the domain of philanthropy to that of philosophy, and science must be substituted for sentiment as the guide to action.