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So what lies ahead in 2009? Is the worst behind us or ahead of us? To answer these questions, we must understand that a vicious circle of economic contraction and worsening financial conditions is underway.

The United States will certainly experience its worst recession in decades, a deep and protracted contraction lasting about 24 months through the end of 2009. Moreover, the entire global economy will contract. There will be recession in the euro zone, the United Kingdom, Continental Europe, Canada, Japan, and the other advanced economies. There is also a risk of a hard landing for emerging-market economies, as trade, financial, and currency links transmit real and financial shocks to them.

In the advanced economies, recession had brought back earlier in 2008 fears of 1970’s-style stagflation (a combination of economic stagnation and inflation). But, with aggregate demand falling below growing aggregate supply, slack goods markets will lead to lower inflation as firms’ pricing power is restrained. Likewise, rising unemployment will control labor costs and wage growth. These factors, combined with sharply falling commodity prices, will cause inflation in advanced economies to ease toward the 1% level, raising concerns about deflation, not stagflation.

Deflation is dangerous as it leads to a liquidity trap: nominal policy rates cannot fall below zero, so monetary policy becomes ineffective. Falling prices mean that the real cost of capital is high and the real value of nominal debts rise, leading to further declines in consumption and investment – and thus setting in motion a vicious circle in which incomes and jobs are squeezed further, aggravating the fall in demand and prices.

As traditional monetary policy becomes ineffective, other unorthodox policies will continue to be used: policies to bail out investors, financial institutions, and borrowers; massive provision of liquidity to banks in order to ease the credit crunch; and even more radical actions to reduce long-term interest rates on government bonds and narrow the spread between market rates and government bonds.

Today’s global crisis was triggered by the collapse of the US housing bubble, but it was not caused by it. America’s credit excesses were in residential mortgages, commercial mortgages, credit cards, auto loans, and student loans. There was also excess in the securitized products that converted these debts into toxic financial derivatives; in borrowing by local governments; in financing for leveraged buyouts that should never have occurred; in corporate bonds that will now suffer massive losses in a surge of defaults; in the dangerous and unregulated credit default swap market.

Moreover, these pathologies were not confined to the US. There were housing bubbles in many other countries, fueled by excessive cheap lending that did not reflect underlying risks. There was also a commodity bubble and a private equity and hedge funds bubble. Indeed, we now see the demise of the shadow banking system, the complex of non-bank financial institutions that looked like banks as they borrowed short term and in liquid ways, leveraged a lot, and invested in longer term and illiquid ways.

As a result, the biggest asset and credit bubble in human history is now going bust, with overall credit losses likely to be close to a staggering $2 trillion. Thus, unless governments rapidly recapitalize financial institutions, the credit crunch will become even more severe as losses mount faster than recapitalization and banks are forced to contract credit and lending.

Equity prices and other risky assets have fallen sharply from their peaks of late 2007, but there are still significant downside risks. An emerging consensus suggests that the prices of many risky assets – including equities – have fallen so much that we are at the bottom and a rapid recovery will occur.

But the worst is still ahead of us. In the next few months, the macroeconomic news and earnings/profits reports from around the world will be much worse than expected, putting further downward pressure on prices of risky assets, because equity analysts are still deluding themselves that the economic contraction will be mild and short.

While the risk of a total systemic financial meltdown has been reduced by the actions of the G-7 and other economies to backstop their financial systems, severe vulnerabilities remain. The credit crunch will get worse; deleveraging will continue, as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus causing more price falls and driving more insolvent financial institutions out of business. A few emerging-market economies will certainly enter a full-blown financial crisis.

So 2009 will be a painful year of global recession and further financial stresses, losses, and bankruptcies. Only aggressive, coordinated, and effective policy actions by advanced and emerging-market countries can ensure that the global economy recovers in 2010, rather than entering a more protracted period of economic stagnation.

Nouriel Roubini is Professor of Economics at the Stern School of Business, New York University and Chairman of RGE Monitor (www.rgemonitor.com), an economic and financial consultancy.

Economists are good at identifying underlying forces, but they are not so good at timing. The dynamics are, however, much as anticipated. America is still on a downward trajectory for 2009 – with grave consequences for the world as a whole.

For example, as their tax revenues plummet, state and local governments are in the process of cutting back their expenditures. American exports are about to decline. Consumer spending is plummeting, as expected. There has been an enormous decrease in (perceived) wealth, in the trillions, with the decline in house and stock prices. Besides, most Americans were living beyond their means, using their houses, with their bloated values, as collateral. That game is up.

America would be facing these problems even if it were not simultaneously facing a financial crisis. America’s economy had been supercharged by excessive leveraging; now comes the painful process of deleveraging. Excessive leveraging, combined with bad lending and risky derivatives, has caused credit markets to freeze. After all, when banks don’t know their own balance sheets, they aren’t about to trust others’.

The Bush administration didn’t see the problems coming, denied that they were problems when they came, then minimized their significance, and, finally, panicked. Guided by one of the architects of the problem, Hank Paulson, who had advocated for deregulation and allowing banks to take on even more leveraging, it was no surprise that the administration veered from one policy to another – each strategy supported with absolute conviction, until minutes before it was abandoned for another. Even if confidence really were all that mattered, the economy would have sunk.

Moreover, what little action has been taken has been aimed at shoring up the financial system. But the financial crisis is only one of several crises facing the country: the underlying macroeconomic problem has been made worse by the sinking fortunes of the bottom half of the population. Those who would spend don’t have the money, and those with the money aren’t spending.

America, and the world, is also facing a major structural problem, not unlike that at the beginning of the last century, when productivity increases in agriculture meant that a rapidly declining share of the population could find work there. Nowadays, increases in manufacturing productivity are even more impressive than they were for agriculture a century ago; but that means the adjustments that must be made are all the greater.

Not long ago, there was discussion of the dangers of a disorderly unwinding of the global economy’s massive imbalances. What we are seeing today is part of that unwinding. But there are equally fundamental changes in the global balances of economic power: the hoards of liquid money to help bail out the world lie in Asia and the Middle East, not in West. But global institutions do not reflect these new realities.

Globalization has meant that we are increasingly interdependent. One cannot have a deep and long downturn in the world’s largest economy without global ramifications. I had long argued that the notion of decoupling was a myth; the evidence now corroborates that view. This is especially so because America has exported not just its recession, but its failed deregulatory philosophy and toxic mortgages, so financial institutions in Europe and elsewhere are also confronting many of the same problems.

Many in the developing world have benefited greatly from the last boom, through financial flows, exports, and high commodity prices. Now, all of that is being reversed. Indeed, it is the ultimate irony that money is now flowing from poor and well-managed economies to the US, the source of the global problems.

The point of reciting these challenges facing the world is to suggest that, even if Obama and other world leaders do everything right, the US and the global economy are in for a difficult period. The question is not only how long the recession will last, but what the economy will look like when it emerges.

Will it return to robust growth, or will we have an anemic recovery, à la Japan in the 1990’s? Right now, I cast my vote for the latter, especially since the huge debt legacy is likely to dampen enthusiasm for the big stimulus that is required. Without a sufficiently large stimulus (in excess of 2% of GDP), we will have a vicious negative spiral: a weak economy will mean more bankruptcies, which will push stock prices down and interest rates up, undermine consumer confidence, and weaken banks. Consumption and investment will be cut back further.

Many Wall Street financiers, having received their gobs of cash, are returning to their fiscal religion of low deficits. It is remarkable how, having proven their incompetence, they are still revered in some quarters. What matters more than deficits is what we do with money; borrowing to finance high-productivity investments in education, technology, or infrastructure strengthens a nation’s balance sheet.

The financiers, however, will argue for caution: let’s see how the economy does, and if it needs more money, we can give it. But a firm that is forced into bankruptcy is not un-bankrupted when a course is reversed. The damage is long-lasting.

If Obama follows his instinct, pays attention to Main Street rather than Wall Street, and acts boldly, then there is a prospect that the economy will start to emerge from the downturn by late 2009. If not, the short-term prospects for America, and the world, are bleak.

Joseph E. Stiglitz, professor of economics at Columbia University, and recipient of the 2001 Nobel Prize in Economics, is co-author, with Linda Bilmes, of 'The Three Trillion Dollar War: The True Costs of the Iraq Conflict'.

Last year's "8 for '08" were fairly accurate on six counts: the world would continue to dither as Iran's nuclear program advanced, the "consensus" on global warming would start to crumble, Cuba would sail into rough waters, Hugo Chavez would wear thinner, the Cold War would return and the economy would replace Iraq as the top news story.

We were too sanguine, however, about the economy's ability to avoid recession and a little early in predicting a reassessment of the Bush presidency. We were also disappointed a Nobel Prize didn't go to Japanese and American researchers who found a way to turn regular human skin cells into the equivalent of embryonic stem cells.

Now, this year's outlook:

1. A Less Safe Homeland?

One of the Bush Administration's key reasons for letting the National Security Agency listen to communications between the U.S. and al-Qaida contacts was that the special courts set up by the Foreign Intelligence Surveillance Act often work too slowly to prevent terrorist operations. As current CIA director and former NSA director Gen. Michael Hayden put it, "it's a quicker trigger . . . it allows us to be as agile as operationally required to cover these targets."

Given this success, will Barack Obama as president follow the wishes of many of his fellow Democrats in Congress and dilute this indispensable tool that has helped keep us safe since the 9/11 attacks?

Will he end the CIA's so-called "black prisons" program, in which tough interrogations were used on key terrorist detainees in foreign locations, to extract information about future attack plans?

Will he take the heat from the left of his own party and boldly use his constitutional authority as president to go the extra mile in protecting the country, as George W. Bush has?

Will he view victory as imperative in both Iraq and Afghanistan, recognizing them as fronts in the war on terror?

We'll see. Promising to get Osama bin Laden sounds great in a campaign; governing requires more than catchphrases.

2. Stimulus Pushes Deficit To $1 Tril

Late in 2008, talk centered around a deal involving up to $800 billion in new spending, focused mainly on infrastructure and so-called Green Jobs. Tax cuts of $150 billion or more will focus on the middle class. Under Obama, those who no longer pay any taxes will surge from 44 million currently to more than 50 million, as those in the top 5% of incomes shoulder a greater share of the tax burden.

Obama' s stimulus, along with the nearly $2 trillion in outlays for 2008's financial and auto bailout, will push the deficit to more than $1 trillion — 7% of GDP, the biggest deficit since 1946.

The gush of red ink will alarm fiscal conservatives of both parties, who will have to grapple with soaring entitlement costs and a huge price tag for Obama's stimulus and infrastructure programs. The GOP will try to make it a wedge issue in congressional elections of 2010.

With Democrats firmly in control of both houses of Congress and the presidency, businesses may start feeling left out. A cut in corporate income taxes, at 35% now among the highest in the developed world, may make it through Congress, but only as part of a bigger deal that would raise taxes on those with incomes over $250,000.

And Democrats will fight Republican efforts to cut capital gains taxes, calling it a giveaway to the rich, even though such cuts have in the past led to strong economic and job growth.

3. China Falls Into Recession

After decades of stunning 10% GDP growth, China's economy stumbled late in 2008. It will continue to slow in 2009 — and possibly beyond. The main trigger for their slump: Soaring energy prices during early 2008, and a steep decline in U.S. demand for China's goods.

In 2007, China posted a $262 billion trade surplus, most of it rung up with the U.S., which ran a $709 billion trade deficit the same year. China has a pile of nearly $1.8 trillion in reserves, thanks mainly to its persistent trade surpluses. But that might shrink as its economy moves into a slowdown and China invests money overseas.

This will have a major impact. Already 20 million people a year leave farms and rural areas of China to find work and a better life in the big cities. If China grows by 5% or less over the next year or so, it won't create enough jobs and will face serious social pressures that could break into open violence. In 2007, China experienced at least 85,000 acts of rebellion, usually put down quickly and brutally.

Despite its rapid growth, China still only ranks No. 81 on the U.N.'s human development index, a gauge that combines health, education and income. Things are far worse for the more than half of China's 1.3 billion people who live in rural areas. If they tire of communist rule and endemic corruption, things could get very ugly.

Given China's dilemma, its best hope might lie with Wal-Mart.

4. Recovery In The U.S.?

Contrary to predictions of gloom and doom lasting into 2010, the U.S. economy will pull out of its recession as a massive home inventory overhang is worked off, oil prices stay low, trillions of dollars in stimulus and bailout funds are put to work and Fed interest-rate cuts kick in. Banks and finance companies will start lending again, and rising demand will push companies to hire. By the end of 2009, some people will be voicing concern about a new threat — inflation.

Cheaper energy helps. The weekly average cost of a gallon of gasoline plunged from $4.05 at its peak in mid-July to $1.59 in the last week of 2008. According to Nariman Behravish, chief economist of Global Insight, each 10-cent drop in gas prices is equal to a $12 billion tax cut. So the U.S. will get a "silent" tax cut of about $295 billion.

This means the bear market in stocks — which are one of the economy's best leading indicators — should be drawing to a close. This bear is now in its 15th month, and most don't last more than 15 or 16. Nine to 10 is more like it.

Most economists look for a 1% drop in GDP in 2009 as unemployment heads for 8%. But a strong second-half rebound means the U.S. economy might grow in 2009 — and once again pull the rest of the world out of recession with it.

5. Energy Fever, Climate Change Cool Off

The cooling trend that began in 1998 will continue as solar activity remains dormant. Last year was the coolest year in a decade.

As the evidence grows, more scientists will join the list of climate "deniers," as protests arise in Europe and the U.S. over expensive alternate-energy schemes that slow global economic recovery.

But as long as crude remains below $70 a barrel — the make-or-break level for many energy projects and alternative energy — Congress will continue to drag its feet on drilling for more oil and gas in the U.S. Obama might try to introduce a cap-and-trade system passed by Congress. If he can't, he'll let the Environmental Protection Agency limit companies' output of carbon-based emissions.

Meanwhile, congressional Republicans, many of whom are skeptical of extreme claims made by global warming advocates, may cut a deal with Democrats that would raise taxes on all forms of carbon-based energy in exchange for deep cuts in income and payroll taxes.

World demand for oil will fall, as it did in 2008. Global economic growth of 4.6% a year from 2003 to 2007 was the fastest in decades, pushing up energy use. But the boom's over. Petrobullies like Russia's Putin, Venezuela's Chavez and Iran's Ahmadinejad will find their ambitions curbed as oil earnings plunge.

6. Big Labor Fights For Relevance

Organized labor made a big deal about its $400 million in campaign spending to win the election for Democrats in 2008. Elated by its success, it vowed to put its agenda front and center.

But as 2009 rolls in, all that cash is starting to look less like power projection and more like a last-gasp bid to go for broke.

The big problem is that in a weak economy, the union agenda is incompatible with economic growth. Businesses can't grow and create jobs in an atmosphere where workers are forced into unions and free trade is restricted. Given the choice of a recovering economy or a satisfied union base, Obama is likely to tilt toward saving the economy, if only for the sake of his own political viability.

That said, after spending that much money, unions want to show they still matter after watching their share of the U.S. work force shrink from 31.4% in 1960 to less than 12% today.

Two possibilities stand out in 2009: One is to fight head-on for legislation like "card-check," a change to the National Labor Relations Act that would eliminate secret ballots to make organizing new unions easier. But businesses will strongly fight "card check."

On trade, unions will oppose pending free-trade pacts with Colombia, South Korea and Panama and make new demands for protection against China. If Obama agrees to this, exports, a key spur to U.S. growth, will suffer.

7. Obama Seeks Health Care Reform

Even health care experts sympathetic to Obama's goals argue the president-elect understates his plan's costs. Obama's plan of near universal coverage means "a $100 billion infusion of new health care spending" that "would actually increase the rate of health care inflation and ultimately create an imperative for more draconian government intervention in the health care markets," says Health Policy and Strategy Associates President Robert Laszewski.

Featuring Medicaid and SCHIP expansions and huge new burdens for businesses, ObamaCare's massive new spending will be a tough political sell, especially with taxpayers already footing the bill for bailouts of banks and the auto sector, and millions of Americans losing their jobs — which is where Tom Daschle comes in. The HHS secretary-designate was Democratic leader in the U.S. Senate.

Daschle knows plenty of senators on both sides of the aisle personally and appears regularly around the country on a health care "listening tour," hoping to gather a mandate for an entirely new system.

If, as expected, President Obama insists that a big government health care reform is imperative for economic recovery, this shrewd legislative warrior will be his general, in charge of imposing the kind of socialized medicine found in France, Britain and Canada, where waiting lists and substandard quality are the norm.

8. India Gets Assertive

India's citizens have gained a lot from their opening to the world in 1991 and they aren't about to give it up. But threats remain from the global economic downturn and terror attacks out of Pakistan.

Elections by May could bring the return of the BJP Hindu nationalists to government. The ruling Congress Party's cautious response to November's terror attack in Mumbai and the sharp economic downturn have left voters unhappy. India's 9%-plus GDP growth rate is expected to slip to 6.5% in 2009. Still, India's 1 billion-plus people have tasted prosperity and want to keep it going.

It all points to a need for assertiveness, no matter who wins. Fiscal stimulus is on the plate, and possibly more defense spending. The government may tighten its alliance with the U.S. to modernize its military. Though Pakistan is the big problem, India is unlikely to risk nuclear warfare. But it may assert itself in forums like the U.N.

As a large market, India will forge closer trade ties with markets like the U.S., Japan, and EU. India will help fight pirates in the Indian Ocean because it's vulnerable to them blocking key sea lanes.

India has one thing going for it: optimism. Its public still believes in markets and the country's future.

9. Israel Gets Rid Of Iran's Nuclear Threat

Will Israel use its altercation with the Iranian-backed Hamas as a stepping stone toward a strike on Iran's nuclear facilities? The signs are that an Obama Administration, committed to "tough diplomacy," will be less likely to let Israel take matters into its own hands and strike Tehran as it did Iraq's Osirak nuclear reactor in 1981.

Lack of U.S. support would make such airstrikes more difficult, and leave Israel even more vulnerable politically on the world stage. With the Jewish state just this week sending warplanes to annihilate Hamas terrorists, defying heavy international pressure for a cease-fire, it seems clear Israel won't hesitate to defend itself.

Should Bibi Netanyahu and the Likud Party return to power in coming elections, Hamas — and its patron, Iran — might be in bigger trouble. Israel might be tempted to go for broke, taking out Iran's burgeoning nuclear threat rather than letting Tel Aviv go up in a mushroom cloud.

Home prices in the United States, as measured by the Standard & Poor’s/Case-Shiller Home Price Indices, have plummeted more than 40% in real inflation-adjusted terms in some major cities since the peak around the beginning of 2006. Nationally, including all cities, the fall is over 25%.

The futures market at the Chicago Mercantile Exchange is now predicting declines of around 15% more before the prices bottom out in 2010. These are the market’s forecasts – and it is not a very liquid market. But those who make these forecasts are implying real declines, from peak to trough, of more than 50% in some places.

Why are we seeing such big price drops? And why does the housing market in so many other countries now reflect similar conditions? The answer has both proximate and underlying causes.

The proximate answer for the US is that a decline in lending standards helped people buy houses at ever-increasing prices before 2006. Freer lending meant that people were freer to bid up prices of homes to ridiculous levels. Shacks were selling for a million dollars.

After the peak, lenders tightened their standards. When buyers find it difficult to finance home purchases, sellers have to cut the asking price.

The up and down of lending represents a credit cycle, and credit cycles have played a major role in economic fluctuations for centuries. In his 1873 book Lombard Street , Walter Bagehot, the British businessman and editor of The Economist , described these cycles perfectly. The boom just before the depression of the 1870’s that he described sounds a lot like what happened just before the current crisis. When credit expands, he wrote, “The certain result is a bound of national prosperity; the country leaps forward as if by magic. But only part of that prosperity has a solid reason…this prosperity is precarious.”

But the credit cycle was not the ultimate cause of the 1870’s depression or the crisis we are seeing today. Ultimately, one must always ask why lending standards were loosened and then tightened. The credit cycle is an amplification mechanism. The instability in the lending sector is always there, and the crisis manifests itself only if some precipitating factor triggers it.

Moreover, the extreme weakening and then tightening of credit standards seems particularly prominent only in the US, while the housing boom-bust cycle is prevalent throughout much of the world.

The precipitating factor that led to the current situation has to do with our evolving world culture, spread rapidly through enhanced media outlets and the Internet, and its perceptions of the markets.

It has to do with the deep admiration of markets that has developed during the boom, in line with the “efficient markets theory” in academic finance. It became widely believed that financial markets are such sublime poolers of information that they represent a collective judgment that transcends that of any mere mortal. James Surowiecki’s bestselling 2004 book, with the outrageous title The Wisdom of Crowds , pressed this idea forward at the very height of the real estate boom.

The boom in the world’s housing markets and stock markets between 2003 and 2006 was caused by this faulty idea, and the idea that investments in homes and equities are a sure route to wealth. It had become an article of faith that the value of both types of assets only goes up in the long run, and that it is foolish to try to “time the market.” It was sincerely believed, and supported by deep intuitive judgment, that interruptions in this upward trajectory could only be small and transient. People seemed to think that rapid appreciation in these markets had become a universal constant, like the speed of light.

Nothing else ultimately explains lenders’ immense willingness, in the boom up to 2006, to lower their credit standards on home mortgages, regulators’ willingness to let them do it, rating agencies’ willingness to rate mortgage securities highly, and investors’ willingness to gobble them up.

There is no theory in economics that provides a reason to think that prices in these markets can only go up. On the contrary, economic theorists have been puzzled by the historical rate of increase in the stock market, which they call “the equity premium puzzle.” They do not have a corresponding name for the behavior of the housing market, because, historically, its prices (correcting for inflation) have not generally gone up very much on average, until the post-2000 bubble.

The booms in these markets can be traced substantially to the growth of the idea that one should always continually hold as many of these assets as possible, just as that you should drink green tea or eat dark chocolate every day for antioxidants. Such ideas create artificial demand – but only for a while. After all, we no longer smoke cigarettes to prevent infections.

People will believe many things if they have the impression that the rich and famous believe them, too. But their belief can suddenly be disrupted if plainly visible events contradict it. That is what is happening now, and 2009 will shape up as a year of even more profound disenchantment.

Robert Shiller is professor of economics at Yale University, chief economist at MacroMarkets LLC and author of 'Subprime Solution: How The Global Financial Crisis Happened and What To Do About It'.

There is a widely held belief that financial risk is easily measured – that we can stick some sort of riskometer deep into the bowels of the financial system and get an accurate measurement of the risk of complex financial instruments. Such misguided belief in this riskometer played a key role in getting the financial system into the mess it is in.

Unfortunately, the lessons have not been learned. Risk sensitivity is expected to play a key role both in the future regulatory system and new areas such as executive compensation.

Origins of the Myth

Where does this belief come from? Perhaps the riskometer is incredibly clever – after all, it is designed by some of the smartest people around, using incredibly sophisticated mathematics.

Perhaps this belief also comes from what we know about physics. By understanding the laws of nature, engineers are able to create the most amazing things. If we can leverage the laws of nature into an Airbus 380, we surely must be able to leverage the laws of finance into a CDO.

This is false. The laws of finance are not the same as the laws of nature. The engineer, by understanding physics, can create structures that are safe regardless of what natures throws at them because the engineer reacts to nature but nature does not generally react to the engineer.

The Problem Is Endogenous Risk

In physics, complexity is a virtue. It enables us to create supercomputers and iPods. In finance, complexity used to be a virtue. The more complex the instruments are, the more opaque they are, and the more money you make. So long as the underlying risk assumptions are correct, the complex product is sound. In finance, complexity has become a vice.

We can create the most sophisticated financial models, but immediately when they are put to use, the financial system changes. Outcomes in the financial system aggregate intelligent human behaviour. Therefore attempting to forecast prices or risk using past observations is generally impossible. This is what Hyun Song Shin and I called endogenous risk (Danielsson and Shin 2003).

Because of endogenous risk, financial risk forecasting is one of the hardest things we do. In Danielsson (2008), I tried what is perhaps the easiest risk modelling exercise there is – forecasting value-at-risk for IBM stock. The resulting number was about +/- 30% accurate, depending on the model and assumptions. And this is the best case scenario. Trying to model the risk in more complicated assets is much more inaccurate. +/- 30% accurate is the best we can do.

Applying the Riskometer

The inaccuracy of risk modelling does not prevent us from trying to measure risk, and when we have such a measurement, we can create the most amazing structures – CDOs, SIVs, CDSs, and the entire alphabet soup of instruments limited only by our mathematical ability and imagination. Unfortunately, if the underlying foundation is based on sand, the whole structure becomes unstable. What the quants missed was that the underlying assumptions were false.

We don’t seem to be learning the lesson, as argued by Taleb and Triana (2008), that “risk methods that failed dramatically in the real world continue to be taught to students”, adding “a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis.”

When complicated models are used to create financial products, the designer looks at historical prices for guidance. If in history prices are generally increasing and risk is apparently low, that will become the prediction for the future. Thus a bubble is created. Increasing prices feed into the models, inflating valuations, inflating prices more. This is how most models work, and this is why models are often so wrong. We cannot stick a riskometer into a CDO and get an accurate reading.

Risk Sensitivity and Financial Regulations

One of the biggest problems leading up to the crisis was the twin belief that risk could be modelled and that complexity was good. Certainly the regulators who made risk sensitivity the centrepiece of the Basel 2 Accord believed this.

Under Basel 2, bank capital is risk-sensitive. What that means is that a financial institution is required to measure the riskiness of its assets, and the riskier the assets the more capital it has to hold. At a first glance, this is a sensible idea, after all why should we not want capital to reflect riskiness? But there are at least three main problems: the measurement of risk, procyclicality (see Danielsson et. al 2001), and the determination of capital.

To have risk-sensitive capital we need to measure risk, i.e. apply the riskometer. In the absence of accurate risk measurements, risk-sensitive bank capital is at best meaningless and at worst dangerous.

Risk-sensitive capital can be dangerous because it gives a false sense of security. In the same way it is so hard to measure risk, it is also easy to manipulate risk measurements. It is a straightforward exercise to manipulate risk measurements to give vastly different outcomes in an entirely plausible and justifiable manner, without affecting the real underlying risk. A financial institution can easily report low risk levels whilst deliberately or otherwise assuming much higher risk. This of course means that risk calculations used for the calculation of capital are inevitably suspect.

The Financial Engineering Premium

Related to this is the problem of determining what exactly is capital. The standards for determining capital are not set in stone; they vary between countries and even between institutions. Indeed, a vast industry of capital structure experts exists explicitly to manipulate capital, making capital appear as high as possible while making it in reality as low as possible.

The unreliability of capital calculations becomes especially visible when we compare standard capital calculations under international standards with the American leverage ratio. The leverage ratio limits the capital to assets ratio of banks and is therefore a much more conservative measure of capital than the risk-based capital of Basel 2. Because it is more conservative, it is much harder to manipulate.

One thing we have learned in the crisis is that banks that were thought to have adequate capital have been found lacking. A number of recent studies have looked at the various calculations of bank capital and found that some of the most highly capitalised banks under Basel 2 are the lowest capitalised under the leverage ratio, an effect we could call the financial engineering premium.

As Philipp Hildebrand (2008) of the Swiss National Bank recently observed “Looking at risk-based capital measures, the two large Swiss banks were among the best-capitalised large international banks in the world. Looking at simple leverage, however, these institutions were among the worst-capitalised banks”

The Riskometer and Bonuses

We are now seeing risk sensitivity applied to new areas such as executive compensation. A recent example is a report from UBS (2008) on their future model for compensation, where it is stated that “variable compensation will be based on clear performance criteria which are linked to risk-adjusted value creation.” The idea seems laudable – of course we want the compensation of UBS executives to be increasingly risk sensitive.

The problem is that whilst such risk sensitivity may be intuitively and theoretically attractive, it is difficult or impossible to achieve in practice. One thing we have learned in the crisis is that executives have been able to assume much more risk than desired by the bank. A key reason why they were able to do so was that they understood the models and the risk in their own positions much better than other parts of the bank. It is hard to see why more risk-sensitive compensation would solve that problem. After all, the individual who has the deepest understanding of positions and the models is in the best place to manipulate the risk models. Increasing the risk sensitivity of executive compensation seems to be the lazy way out.

This problem might not be too bad because UBS will not pay out all the bonuses in one go, instead, “Even if an executive leaves the company, the balance (i.e. remaining bonuses) will be kept at-risk for a period of three years in order to capture any tail risk events.” Unfortunately, the fact that a tail event is realised does not by itself imply that tail risk was high, and conversely, the absence of such an event does not imply risk was low. If UBS denies bonus payments when losses occur in the future and pays them out when no losses occur, all it has accomplished is rewarding the lucky and inviting lawsuits from the unlucky. The underlying problem is not really solved.

Conclusion

The myth of the riskometer is alive and kicking. In spite of a large body of empirical evidence identifying the difficulties in measuring financial risk, policymakers and financial institutions alike continue to promote risk sensitivity.

The reasons may have to do with the fact that risk sensitivity is intuitively attractive, and the counter arguments complex. The crisis, however, shows us the folly of the riskometer. Let us hope that decision makers will rely on other methods.

References
1. Danielsson, Jon and Hyun Song Shin, 2003, “Endogenous Risk”, chapter in Modern Risk Management: A History.

2. Danielsson, Jon, Paul Embrechts, Charles Goodhart, Con Keating, Felix Muennich, Olivier Renault and Hyun Song Shin (2001) “An Academic Response to Basel II”, 2001.

3. Danielsson, Jon (2008) “Blame the models”, VoxEU.org, 8 May 2008

4. Hildebrand, Philipp M. (2008) “Is Basel II Enough? The Benefits of a Leverage Ratio”, Financial Markets Group Lecture, London School of Economics .

5. Taleb, Nassim Nicholas and Pablo Triana (2008) “Bystanders to this financial crime were many” Financial Times December 7.

6. UBS (2008) “Compensation report: UBS’s new compensation model”

Jon Danielsson is a Reader in Finance at the London School of Economics.

When a jury nullifies a law, the men and women of the jury assert their power to judge the law as well as the actions of the defendant relative to the law. Although they may find that the defendant broke the law, they may refuse to convict, and thereby “nullify” the law. Nullification is rare, and historical examples usually apply to specific situations. Though controversial and potentially a source of abuse, nullification allows the people, in the form of a jury, to be the final arbiter of justice and acts as a check on the power of government.

In a similar fashion, economic nullification recognizes that we the people have the authority and the duty to render a final judgment on whether or not the government’s transfer of money to a company is just, or is an unjust taking from the American people. For example, if through special pleadings and influence, a company persuades the President and Congress to use the power of government to take money from millions of Americans and give it to them, the refusal of the American people to do business with such an entity would more than offset any supposed benefit of the taking and potentially reduce that company’s future political power as well.

Consider the case of GM and Chrysler. Faced with a shortage of cash accentuated by the economic downturn, the managements of these two companies realized that they would not for long be able to meet all of their commitments, including the contracts with their dealers, bondholders, banks, and the union representing their workers. Under the law, they, and any other company or individual in a similar situation, can enter into the supervision of a judge to sort out their financial affairs by declaring bankruptcy.

However, the managements of GM and Chrysler, with the support of the United Auto Workers, chose instead to use their political influence to get a special $13.4 billion “bridge loan” from the federal government with the possibility of another $4 billion in February, all designed to give these two automakers until the end of March time to figure out a plan that would assure their “viability.” To put this gambit in perspective, GM and Chrysler this year will sell about 4.5 million cars in the U.S. A $17.4 billion loan therefore amounts to more than $10,000 per car that we, the American people, are being forced to lend these two companies to keep them afloat for less than 4 months.

In other words, GM and Chrysler used their political power to accomplish what they apparently could not achieve through voluntary means. Instead of filing for bankruptcy, they were able to compel the American people to lend them this money through the force of government. The government loans to GM and Chrysler represent an involuntary transfer of resources from the American people for the private use of the shareholders and employees of these two companies. As such, these loans constitute an unjust taking.

The appropriate response, therefore, is economic nullification. If enough of us refuse to buy, lease or rent a GM or Chrysler product until they have repaid the loans, then the consequent fall-off in sales and market share will thwart the current strategy of seeking private benefit at the expense of the American people. If, as a consequence, these companies go bankrupt and are unable to repay the loans, so be it. The principle of liberty rises above the dollars at stake. In addition, they may have failed anyway – but after billions more were taken from the American people. Finally, economic nullification in this case would act as a deterrent to all future would be perpetrators of the unjust use of political power.

GM and Chrysler are the poster children for this essay. But, the possibilities for economic nullification are growing as fast as the list of companies seeking a bailout. For example, if a financial institution receives a capital infusion because it was “too big to fail,” then economic nullification would cause it to shrink to a point that it could be allowed to fail. At that point, this institution once again would be subject to the discipline of the market.

In some cases, engaging in economic nullification will be easy; in others, inconvenient. In still others, it may be more expensive. In the most difficult cases – especially for those entrusted with the success of a business -- it may require a special effort and take time to find a new supplier or customer. But if companies know that the cost of being a recipient of government largess is a dramatic loss of business, they will be far less likely to gain through the exercise of political power what they were unable to achieve in the market. Over time, that will lead to less government intrusion in markets, less government spending, and more opportunity for those in the private sector to prosper.

The practice of economic nullification will transfer significant power from politicians to the private sector. The exercise of our power as consumers to effectively overturn the unjust taking of resources from the American people for benefit of those with special access and political influence can help restore the role of government to the protector, rather than the abrogator, of our liberty. And, the beautiful thing is this: all economic nullification requires is for individual Americans to say “enough,” and act accordingly.

Is it directly attending to the pressing needs of the people by making sure that none are permitted to have more until all are assured enough? Mao Zedong might score high on that test.

Woody Allen came closest when he quipped that eighty percent of success is showing up. Most Democracies throughout history invariably stopped doing that. Until we arrived on the scene, democracies had a tendency to degenerate into tyranny or dissolve in civil war, disappearing in the blink of an eye compared to the long-lived dynasties that ruled since Mesopotamians argued politics over clay mugs of beer.

Our founders were keenly aware of how badly history’s odds were stacked against them. They racked their brains to invent techniques that might forestall Democracy’s natural decay, seeking to avoid “trading one tyrant three thousand miles away for three thousand tyrants a mile away.”

They got something right and we got a couple of centuries to build a nation unlike any that had come before.

The pioneers who forged our country, aided by immigrants that flocked to join this bold experiment, received little help from the modest government they created. When our hearty ancestors stumbled, and they stumbled often, they picked themselves up and tried again. Through fits and starts they built the longest running Democracy humanity has ever achieved. So far.

Do you get the sense lately that we have lost our way? What transformed us into a nation predisposed to demand help from others when the going got tough, whether we are CEOs or factory workers or homeowners struggling with mortgage payments? Do we really believe that the universe owes us the highest standard of living simply because we are Americans?

Does it pass the sniff test of history to ask the Chinese to financially underwrite a wanton profligacy we refuse to address? Are we so eager to indenture ourselves to them, handing off the baton of world leadership passed to us a mere generation ago by the British?

The Chinese are an ancient people with an infant government still recovering from a horrible experiment gone awry. They have not yet decided whether to embrace our form of democracy or run from it in fear. What instructive example are we setting?

When the British relinquished their role as leaders of the free world, they had the excuse of exhaustion brought on by their struggle to defeat the Nazis. What's our excuse? We built too many McMansions?

We are the world leaders in diversity, incorporating a range of attitudes, values, and lifestyles into a culture as varied as the racial and ethnic stock that makes up our citizenry. The resulting tapestry enriches our lives as it refreshes our genes. But why is diversity a virtue when applied to, say, cultural practices or sexual preferences yet socially unacceptable when it comes to the attendant outcomes of fundamental economic behaviors?

The core freedoms our founders gave us rest on the power of choice. And choices have consequences. Take away the consequences and you inevitably erode the freedoms.

Some people prefer safe, steady jobs that pay modest incomes. Others take huge risks seeking outsized rewards. And some try not to work at all. While none begrudge caring for those unfortunate few who can’t provide for themselves through no fault of their own, is it Democracy's job to thwart the outcomes of economic choices made by the rest of us?

Some people prefer to sacrifice today to save for a better tomorrow. Many live like the lilies of the field, looking to Providence to meet their future needs. What happens when the machinery of Democracy gets hijacked by the spenders of today to grab the savings others made yesterday, and will be forced to make tomorrow, so our nation can continue consuming more than we produce?

If we go down this road, and it looks like we might, we have no one to blame for the inevitable outcome but ourselves.

The United States of America has been in existence a whopping one half of one percent of all the years since the first sovereigns set up shop to face the challenges of governing. It’s going to take a lot of perseverance and a thoughtful return to our founding principles to build a record that even deserves mention by the time the pyramids double in age.

That’s because the true test of democracy is avoiding self destruction.

Maybe any tax cut is better than no tax cut, but a clear view of what the incoming Obama administration has planned raises serious concerns.

Not surprisingly, considering the class-warfare rhetoric of his campaign, the next president has fallen into the politics-driven trap that has plagued so many of his fellow Democrats: being unable to support a plain old across-the-board cut because "the rich" might get to keep more of their money.

So instead of simply accepting the wisdom of the big Bush across-the-board tax cuts on income and investment, he'll propose what you could call "outcome-based tax-cutting": You're getting a tax cut because Uncle Sam wants a certain thing to happen, like a failed business to unfail.

That philosophy of government micromanagement of the private sector cannot work.

First, there's the glaring flaw that the Obama business tax plan gives a one-year tax credit for companies that generate new jobs or back off on layoffs.

The idea is to give them some relief while they're under strain, like handing a cup of Gatorade to a long-distance runner. But no one can run a marathon without food in his stomach and a road without obstacles.

Businesses need the certainty of low taxes in the long-term future to get past the financial crisis and do well, not the fiscal policy equivalent of a performing seal being rewarded with a sardine from its master.

Then there's Obama's proposed expansion of the write-off for businesses from the current $175,000 to as much as $250,000 for the next two years. This rewards firms who have done badly and may even encourage losses in the future.

Businesses that have done well get no such bonus. It's like applying the failed thinking behind welfare — cash handouts from the government for those who fail — to industry.

What's more, this would superimpose more complexity onto an already burdensome tax code. For accountants, the New Year's Eve party may have only just begun.

Finally, for run-of-the-mill taxpayers, there's Obama's "Making Work Pay" program. It begins with yet more rebates, which — as the Bush administration discovered twice — does little if anything to stimulate the economy.

Sending out nice, fat checks from the U.S. Treasury is an idea that goes back at least to the failed presidential campaign of George McGovern in 1972. But for a tax cut to have any real stimulative effect on productivity, it must serve to reward that productivity: the more you produce (i.e., earn), the bigger your tax cut.

Barack Obama may soon be saying in every speech he makes as president that he enacted the biggest tax cut in history — citing the mind-boggling figure of $300 billion.

But cash from Washington for people who don't pay income taxes, and for businesses that don't work, is not tax-cutting. Instead, it's exactly what Obama the candidate promised Joe the Plumber: wealth redistribution.

While Jaguar’s sleek styling never disappeared during its nationalized years, the quality of its cars surely did. For anyone who knew Jaguar owners during the ‘70s and early ‘80s, their comments were pretty much uniform: great look and great interior, but the car always needs repairs.

Anecdotally, this writer remembers that Sierra Leasing, a Glendale, CA-based firm that leases luxury automobiles, strongly recommended that its customers avoid Jaguars altogether. With the cars constantly breaking down, it wasn’t worth the hassle and low levels of customer satisfaction for Sierra to secure the automaker’s products for clients.

Jaguar’s demise was easily explainable. Freed from basic market pressures imposed by consumers with regard to quality, Jaguar could foist unreliable cars onto the marketplace without worry. While private companies face bankruptcy if they regularly fail customers, Jaguar’s access to the funds of hapless taxpayers made consumer satisfaction irrelevant.

And though the quality of its cars never fell to the level of East Germany’s Trabant, the auto of “choice” for citizens of the communist bloc of countries, Jaguar’s brand gradually plummeted. Indeed, no advertizing campaign could make up for frequent Jaguar sightings at auto-repair bays wherever the car was sold.

In later years, after Thatcher’s aforementioned privatization program, Jaguar owners would hasten to explain their purchase of same with assurances that they’d purchased their model after the British government had returned the brand to the private sector. And to the extent that models made between 1975-84 remained in working condition, this was frequently thanks to replacement of the original engine with one not produced by Jaguar.

Fast forward to today, over the past few weeks Chrysler has begun a new ad campaign. Spending money presumably provided by America’s similarly hapless taxpayers, Chrysler CEO Bob Nardelli has taken out full-page ads in major U.S. newspapers thanking “America” for “investing in Chrysler.”

Could Nardelli really be this naïve? Indeed, if we ignore the basic truth that many Americans looked askance at the government’s rescue, did it ever occur to him that the very government help that he and GM CEO Richard Wagoner deemed essential was in fact a brand killer?

The regular protest from Wagoner and Nardelli with regard to bankruptcy had to do with what the latter would mean for sales. Supposedly consumers wouldn’t buy the products of a bankrupt firm despite polls suggesting otherwise, not to mention the greater reality that post 9/11, Americans regularly flew bankrupt airlines. Circuit City filed for bankruptcy in the fall, but this didn’t keep it from shelving its existing ad campaign, nor did it keep customers out of its stores.

The question not asked by Messrs. Nardelli and Wagoner had to do with how consumers would view firms explicitly on the federal dole. Wouldn’t this itself kill sales given the many Americans not pleased with the bailout? And to the extent that the bailout doesn’t offend the sensibilities of all potential car buyers, wouldn’t acceptance of federal money on its face signal to consumers that the brands in question aren’t worth the risk?

Most importantly, and with Jaguar’s history in mind, aren’t nationalized entities (think Amtrak, landline telcos in Europe, Aeroflot in Soviet Russia) notorious for offering low-quality products inefficiently? Given the British government’s “successful” oversight of Jaguar’s demise, are Nardelli and Wagoner really so gullible as to believe that U.S. politicians and bureaucrats, not to mention a future car “czar”, will somehow be more effective?

And for the various “green” politicians who see a nationalized U.S. auto industry as the path toward ubiquitous hybrids, their stridency may well be environmentalism’s Vietnam. Whatever the truth about “global warming”, one sure way to turn voters off when it comes to the theory of climate change will be for our nationalized carmakers to produce green cars that constantly need repairs.

So while the bailout of GM and Chrysler was unfortunate for the continued waste of physical, human and financial capital, it can’t be stressed enough that its biggest victims will be its supposed beneficiaries. History, from the Trabant to the Jaguar, reveals the ineffective nature of government control over anything.

And if Americans looked askance at the bailout of firms known at the very least for making passable cars, just wait for the certain outcry that will materialize when the products of our nationalized carmakers come off the assembly line. If Americans are already mad, their anger is a quiet preview of what lies ahead.

In exchange for Venezuelan oil at a 40% discount, Kennedy would enhance Hugo Chavez's reputation and shame private oil companies for not getting involved.

And that he did. Joe blanketed television stations across the U.S. for over three years as Chavez's pitchman, urging the poor to sign up for Chavez's cheap oil. Call 1-877-Joe4Oil, he said, begging them to take it. Kennedy said he fueled 400,000 households in first 16 and then finally 23 states, praising Chavez's "generosity."

But behind the pretty image was an odious dictatorship that's devastated democracy in Venezuela, multiplied poverty and forged military ties with America's enemies. That's why having a shill or two in the U.S. to praise Chavez as a "humanitarian" is always useful, at least while the money lasts.

But it didn't. On Monday, a distraught Kennedy announced he had been cut off by Chavez with no warning, leaving him with 90% less fuel to give away this winter. He had to lay off 20 employees.

Worse, he faced angry recipients from Alaska to Maine who'd been counting on him for all that cheap oil. Chavez wasn't on the hook for that — Joe was. Kennedy said he'd try to change the dictator's mind and urged recipients to write him letters.

But even Joe had to know that with falling oil prices, the party was over. Chavez was flat busted after squandering $600 billion in oil earnings around the world in such giveaways.

For Joe, all that remains was sullied family honor and no fuel. He'd been used by Chavez during the boom, thrown overboard as excess baggage during the bust, and finally realized it Monday.

There are ways to deliver cheap oil, if that's the aim, and one doesn't need dictators to do it. Raising money is one. Although it's harder than dictator cash, it's honorable and its results last. Chavez's profligate spending and mercurial policies should have been a warning, because anything too good to be true, usually is.

Now left cold, Joe can contemplate what happens when a deal is made with a dictator: Like the devil, he eventually gets his due.

George Soros' recent book on the credit crisis is a good example of this line of thinking. He even suggests that established financial theory is obsolete. His view, in essence, means that the current financial crisis is the final proof that markets do not process information efficiently. If this is true, we are closer to John Maynard Keynes' view of the market as a casino than to Friedrich von Hayek's view of it as a marvelous mechanism for processing dispersed information.

For example, the recent spike in oil prices would have been driven by an irrational frenzy in futures markets. Market operators would have miscalculated systematically, been overconfident about their information and overreacted to news. I believe, however, that there is another explanation for these phenomena, which is based on rational calculation and information processing by institutions and traders.

The problems we see in the financial markets have very much to do with lack of good information, misaligned incentives, and, in fact, rational responses to the environment. When information is scarce and unevenly distributed, prices may well depart from the reality of fundamentals.

We see this when new technologies arrive on the scene. The Internet bubble is the most recent example, but a similar phenomenon occurred with the construction of railways more than a century ago. It can be argued that the sophisticated loan packages created by banks in recent years are, likewise, a new and unknown product, so information and experience to aid pricing has been scarce and dispersed.

In such circumstances, prices may well move far from the fundamentals as assessed by a hypothetical collective wisdom that would pool all information in the market. Trading on the momentum of price movements may then become a rational activity that becomes self-fulfilling, as investors decide to "ride the bubble" while it lasts. The bubble is inflated further by the asymmetry between those who bet that prices will rise and buy, and those who forecast a fall, but stay out because to sell short is too costly.

This means that important and relatively persistent departures of prices from fundamental values are possible, and even likely, when information is dispersed — but that a correction to align them with reality will always follow. Eventually, stock prices do reflect the fundamentals of the economy. This explains why the market can look like Keynes's casino in the short term and like Hayek's marvel in the long term.

So how does this explain the overexposure of many institutions to subprime mortgage risk and the collapse of the interbank market? Were banks that chose to securitize sub-prime loans instead of keeping them on their balance sheets behaving irrationally? Again, informational asymmetries and misaligned incentives are at the heart of what happened.

Keeping those loans on the books would have meant that a bank would have had to incur a large capital adequacy provision and monitor the loans' performance, at a cost to itself. Securitization avoided such costs and placed the new product advantageously — with the complicity of rating agencies, which stood to profit from investors' inexperience and lack of information. Executives collected generous bonuses, and equity holders were protected by limited liability.

A probable cause of the collapse of the interbank market is precisely informational failure. This is a well-known phenomenon; indeed the study of the market for automotive "lemons" won George Akerlof the Nobel Prize. Banks still don't trust each other, since each wonders how many skeletons the other has in its closet. There is no irrationality here.

The debate over the irrationality of financial markets is no mere academic argument. If we believe that economic actors are irrational, then we will enact paternalistic policies aimed at controlling behavior or bailing out failed agents and institutions, which could be self-defeating and even dangerous. This may include restrictions on investments by institutions and individuals and intrusive regulation that limits, or dictates, their conduct in the market.

The calls to curb speculation in derivatives markets or short sales have this flavor. If, on the other hand, we believe that economic actors will respond rationally to incentives and information, then we can usefully reform regulatory frameworks with well-targeted measures, including restrictions on off-balance sheet vehicles, tougher disclosure requirements and controls on rating agencies' conflicts of interests.

Xavier Vives is a professor of economics and finance at IESE Business School and author of "Information and Learning in Markets".

Memories are short in government, however, and a decade later, when the American economy was again slowing, governors, mayors and legislatures began hiking taxes again, sparking the next tax revolt. One of the most visible victims of this uprising was New Jersey Gov. Jim Florio, who faced a $3 billion budget deficit in 1991 and promptly asked for $2.8 billion in new taxes--at the time the largest single-year tax increase ever imposed by a state. Although Jersey had been, as recently as the 1960s, one of the country’s most lightly taxed states, Florio’s tax increases, the culmination of a series of rises over the years, helped push the state and local tax burden in Jersey to 11.6 percent of total income — one of the highest in the nation. Since the Garden State didn’t have (and still doesn’t) California-style initiative and referendum, taxpayers displayed their ire by handing control of the state legislature to Republicans in mid-term elections and then dumping Florio two years later — the first sitting governor to be defeated in a reelection bid since Jersey had adopted its modern constitution in 1947.

In other states, meanwhile, the early 1990s tax revolt took the form of ballot initiatives to cap state spending levels, such as Amendment I in Colorado, which required that new tax increases be approved directly by voters.

Today, 44 states are facing budget woes that amount to a projected $90 billion in collective deficits in the coming fiscal year. Again, many governors and legislatures are pondering tax increases even as unemployment rises and people try to work themselves out of debt. New York tops the list with a whopping 88 new taxes and fees proposed by Gov. David Paterson, but he’s not alone. After raising taxes by about $1.1 billion in 2006, New Jersey Gov. Jon Corzine is hinting at new tax increases. California, Florida, Kentucky, Maryland, Nevada and Oregon are just some of the states that have either raised taxes or are considering such a move. The stage would seem to be set, in other words, for the next tax revolt in the states.

But the political climate has also changed dramatically since the early 1990s, and the next year or so may show whether state and local tax revolts are even possible anymore. Opponents of tax revolts—especially public sector unions, social service advocacy organizations that rely on government funds, and other groups that consume government resources—have grown much more powerful, and much savvier at fighting back efforts to trim the growth of government. After voters recalled California Gov. Gray Davis in 2003, startled public sector unions mobilized to derail a set of voter initiatives supported by his successor, Arnold Schwarzenegger, including one that would have limited the growth of the state’s budget. Public sector unions spent north of $50 million in the 2005 campaign against the initiatives, with the state’s teachers’ union alone kicking in $41.8 million.

In New Jersey that same year, public unions worked to derail a budding taxpayer revolt when they used their clout in the state legislature to water down a bill that would have created a constitutional convention to enact property tax reform. Under union pressure, legislators approved the convention but barred it from addressing government spending, which rendered a potential gathering useless.

In New York State, unions have been running ominous radio ads warning of sharp declines in services unless Albany raises taxes. Such ads can be devastatingly effective. A similar advertising campaign by health care interests in 1999, which warned of massive hospital closings unless the state increased aid to health care institutions, prompted worried New Yorkers to barrage hospitals with phone calls asking if they were about to shut their doors and provoked the head of one hospital association to accuse other health care groups in the state of employing scare tactics to further their goals.

Meanwhile, state politicians have quietly been working to make the initiative process tougher and thus limit the number of radical proposals like Proposition 13 that ever make it on the ballot. In 2007 alone, according to Governing Magazine, states enacted some 33 bills regulating the initiative process. In Florida, 60 percent of voters must now vote in favor of a ballot initiative in order for it to become law. In other states, those who gather signatures supporting ballot initiatives must now go through state-mandated training. Such rules will make in more difficult for ad hoc taxpayer groups that arise in response to political developments to be effective.

Still, one gets the feeling that most state politicians would not like to test the new, tougher systems that they’ve put in place. They’d rather have a President Obama come to their aid with direct federal funding for hard-pressed budgets, such as higher reimbursements for Medicaid, increases in federal dollars for local law enforcement, and more aid for K-through-12 education. Obama has, at one time or another in his run for the presidency, promised all of the above, although that was before the federal government committed $700 billion to bail out financial institutions. Recently Obama has offered states stimulus in the form of more infrastructure spending, which will do little to bolster budgets in the coming year.

So the stage may be set for a series of face-offs between beleaguered taxpayers and tax-eaters. If so, we’ll learn just how much the landscape has shifted since the last wave of tax revolts.

And if goverment economic statistics aren’t misleading investors about the health of the economy, they’re frequently telling us long after the fact what has actually happened.

Trade deficit. Probably the best place to start is the alleged trade deficit given that it’s arguably the least understood economic statistic. It should be said plainly that there is no such thing as a trade deficit. It is a myth. For one, countries don’t trade; instead people trade. When we consider it in that light we must conclude that rather than deficits, individuals are constantly exchanging what they deem personal surplus for something they don’t have but want.

The best way to look at trade is to view it in an individual context. As individuals we run trade deficits with our landlords, our grocery stores, and restaurants we frequent. But are we in deficit? Hardly. We’re able to maintain those supposed deficits in trade thanks to the work we engage in elsewhere. In the end all trade balances due to the basic truth that we can’t buy from anyone unless someone’s purchased something from us of equal value first.

The question then becomes why the government produces statistics suggesting we’re in “deficit” on a monthly basis? The answer lies in what they define as “trade.” When Americans buy shoes, socks and shirts that are made in China, those purchases accrue to the deficit. Conversely, the Chinese are big purchasers of our equities, land and debt. None of those purchases count in the alleged “trade” balance because they are “capital” assets. But we export opportunities to invest in our generally booming economy in exchange for goods that are not in our economic interest to make.

The reality is that trade deficits are a sign of economic health. And while GDP figures are highly misleading (more on that later), periods when our GDP has grown the most have regularly correlated with rising trade “deficits.”

Savings rate. In his classic book The Wealth of Nations, Adam Smith wrote that “Capitals are increased by parsimony, and diminished by prodigality and misconduct.” This is important when we consider the savings rate, because the basic truth is that without savings, there is no wealth.

The paradox here is that the government regularly reports that the savings rate in the United States is nil, or often times negative. This is so despite the fact that the Federal Reserve frequently reports on total wealth in the U.S., and the number of late has hovered in the $50 trillion dollar range. If we allegedly don’t save, how is it that we’re so rich?

The answer to this question lies in how this statistic is computed. When the government measures our savings, it measures it in terms of our monthly income versus our monthly spending. And there lies the problem with this statistic. The savings rate first of all can’t distinguish between spending on a vacation or spending for instance on home Internet access that would in theory lead to higher income.

The reality that Americans as a whole have historically invested some of their income at some point greatly distorts the whole savings picture. That is so because the savings rate does not account for capital gains. What this means is that if someone bought 1000 shares of Dell Computer back in 1994 only to see those shares split six times, this person might not appear as a saver in the government’s calculation. Thanks to six splits, that individual might sell shares on occasion to fund all manner of purchases, so despite the fact that this person would be wealthy by any definition, the extra spending wrought by past parsimony would often eclipse that person’s savings rate thanks to the spending of capital gains.

In short, the broad prosperity experienced by Americans over the last twenty five years has created enormous capital gains that were attained by savings but, in the ultimate paradox, have driven our savings rate lower. To find a time when the savings rate was high, one would have to go back to 1982 when stocks and housing were both down at the same time. With no capital gains to access, Americans rightly saved a great deal of income. Far from a sign of prosperity, this signaled a weak economic outlook.

In short, the notion that Americans don’t save is yet another myth.

Durable goods orders. Former Fed Chairman Alan Greenspan has frequently pointed out that while the aggregate output of the United States is five times greater in real terms than it was in 1950, the output weighs the same. Greenspan’s observation deserves special attention considering all the attention given to the durable goods number produced by the federal government. When the durable goods number comes in below expectations, economists and commentators frequently key on it as evidence that the economy is not very sound.

But as the late Warren Brookes wrote in his 1982 book, The Economy In Mind, “the thing that is most responsible for keeping the United States competitive in the world market has relatively little to do with physical assets.”

To understand what Brookes meant, we need only look at the composition of the S&P 500 upon its inception in 1957 compared to today. Fifty years ago, steel, aluminum, chemical, paper, and mining companies made up half the value of the S&P, whereas today those sectors account for only 12 percent of the index’s value.

Conversely, the technology, health-care, and financial sectors now account for nearly one-half of the S&P, compared to 6 percent fifty years ago. So while many still concentrate on statistics measuring investment in new plant and equipment, the actual U.S. economy has evolved in such a way that these measures are far less impactful to our overall economic well-being.

The durable goods number is rooted in the past given its reliance on heavy equipment. But we are once again an economy of the mind, so when commentators suggest a poor number here is indicative of poor economic health, they’re engaging in thinking that mattered in the past, but that has very little relevance to the present.

Unemployment. Probably the most watched economic statistic each month on Wall Street is the unemployment number. It is assumed that the level of employment is an indicator of health—thus the attention—but it seems the major reason unemployment gets so much press is that the Fed watches the number owing to its counterproductive obsession with employment levels.

The reality is that the level of employment or job creation is very much a function of population. When populations grow, so do job levels. In this sense, unemployment is somewhat of a misnomer. People aren’t not working so much due to lack of jobs as they don’t work owing to a failure to supply their labor at a rate that attracts employers.

So barring government restrictions on employment, jobs are always being created and destroyed at the same time. Indeed, the computer is arguably the greatest destroyer of jobs in world history, but the efficiencies wrought by its broad use freed up all sorts of human and financial capital that led to the creation of higher paying jobs.

Notably, when we read about “high” levels of unemployment in some of the European countries, it’s important to not take them very seriously either. Due to high rates of taxation, many workers seek to hide their employment from the government. At the same time, restrictions on firing most notably in France have fostered a high level of unemployment there that is belied by strong stock-market returns in that country over the years. Through temping and other ways around the rules, businesses continue to hire.

And while it is correctly said that lots of jobs were created during the Reagan and Clinton years, it’s also true that percentage job growth under Jimmy Carter was the highest of any president post WWII, not to mention that job growth has been very impressive under President Bush. No one would mistake the Carter/Bush economies for those enjoyed under Reagan/Clinton, but if you measured them purely in terms of employment, they might all look very similar.

Instead, it’s better to look at the quality of jobs and economic dynamism forever revealed by the stock market. In that case, jobs were plentiful and good under Reagan/Clinton in ways that the Carter/Bush eras have not measured up too. In short, employment is a factor in our economic health, but not a reliable one.

Consumer price index. The Consumer Price Index, or CPI, is probably the most backward-looking government statistic of them all. That is so most prominently because prices are sticky. All one need do is go to a bookstore to figure this out. Most books are priced in U.S. and Canadian dollars, and the despite the looney’s near parity with the dollar, books are usually priced 50% higher in the Canadian currency.

Another example showing the misleading nature of consumer prices involves Dreyer’s Grand Ice Cream. Rather than raise the price of a tub of Cookies & Cream, Dreyer’s has recently shrunk the size of each ice-cream container from one holding 1.75 quarts to a smaller one holding 1.5 quarts. Given the infinite inputs producers consider in reaching a market price, it’s undeniably difficult for government bureaucrats to reliably factor in those same inputs.

It should also be said that prices change all the time for reasons unrelated to the value of the currency. Outsourcing and the growing efficiency of computer makers has led a sharp drop in computer prices, while the memory contained in a $300 iPod would have cost you $10,000 ten years ago. CPI cannot account for productivity either; the very productivity that has at least in the short-term mitigated the rising costs of goods that would result from a weaker unit of account.

Looked at today, despite a stupendous drop in the dollar which has shown up in the price of gold along with every major foreign currency, government measures of inflation stateside are largely quiescent. But we shouldn’t be fooled, and if this is doubted, we need look no further than the countries whose currencies have crushed the dollar in recent years, and that are experiencing multi-year highs in terms of consumer-price inflation.

In the end, consumer prices organize the market economy, and in doing so they account for all manner of inputs that have nothing to do with the value of the unit of account. Since inflation is purely monetary in nature, it’s important to remember this in light of the consumer prices relied on by the Bureau of Labor Statistics to divine inflationary pressures.

Gross domestic product. This economic measure is perhaps what Brenner was alluding to most prominently in proclaiming macroeconomics a myth. Certainly no national measure of production could ever be definitive evidence of broad economic health, or weakness for that matter. All one need do to confirm this is make the short drive from New York City to Newark, New Jersey.

Furthermore, one region or city’s productivity in one country is surely a function of foreign productivity that lies outside the scope of what is a national calculation. Silicon Valley thrives not just for its human capital based in northern California, but also booms thanks to the productivity of workers on the other side of the world.

Even if we ignore the limiting nature of border-specific calculations, we must remember that while the trade deficit’s economic reality is one of capital and goods inflows that are a reward for our productivity, a large deficit in trade subtracts from our GDP growth. Conversely, while government spending is by definition an economic retardant for capital being removed from the private sector for immediate government consumption, when it comes to GDP, this adds to the number.

Furthermore, GDP in the ’70s actually grew more than it did in the ’50s; this despite the fact that the ’70s are correctly known for economic malaise rather than vitality. If one solely used GDP as a measure of economic health, one would be unaware that the S&P 500 rose a mere 17 percent in the allegedly high-growth ’70s versus a 255 percent gain in the ’50s. The economy in GDP terms grew all four years of Jimmy Carter’s presidency and has grown impressively under George W. Bush, but the S&P rose only 30% under Carter and has had negative returns under Bush.

What these numbers tell us is that rather than using government statistics to understand our economic situation, we would do better to reference market prices. Market prices serve as the world’s great voting booth when it comes to the health and direction of the economy.

Economists and commentators alike will continue to try and draw economic pictures based on the misleading and backward looking statistics. But Wainwright research will continue to draw a more accurate picture; one informed by the wisdom of infinite individual decisions that government statisticians could never hope to harness.

If we live in a global economy, and I think everyone would agree that we do, don’t some of the planet’s inhabitants need to be savers? If no one saved, where would the capital come from for future growth? Is there some magic percentage of income above which savings becomes a vice rather than a virtue? If so, who should decide what that percentage should be? Hank Paulson? Ben Bernanke?

American policy makers just can’t seem to come to grips with the fact that it is the US that caused this problem. It was not caused by Asians saving too much or because the Chinese held down the value of their currency. It wasn’t a savings glut that pushed interest rates down and drove investors toward riskier assets. It was caused by the obvious, if sometimes unofficial, policy of the US government. The Fed held interest rates artificially low while the Treasury pursued a weak dollar. The result was savings and investment being redirected to real assets such as housing and commodities in an attempt to preserve purchasing power. With savings and investment diverted from more productive uses, it should not be surprising that we now face a nasty recession.

Americans are now saving more and some interpret that to mean the recession will be extended since in their view it is consumption that drives growth. These pundits have it exactly backwards. The fact that Americans save more during recessions is what makes US recessions shorter than would otherwise be the case. Others are trotting out the old canard about the “paradox of saving”, but frugality is not a virtue only when practiced by a small number and is suddenly transformed into a vice when more people participate.

Savings today is the fuel for growth tomorrow. Families that are saving more are merely shifting their time preference. Due to circumstances and fear of the future, they are foregoing consumption today in favor of consumption tomorrow. The Fed is doing everything it can, by suppressing interest rates, to counter that shift, but that is a losing game for the Fed. Individuals will do the right thing regardless of Fed policy. Luckily, the dollar has risen during the crisis which should give Americans even more reason to save and invest in productive assets.

This focus on the short term reveals the Fed as the political entity that it has always been. Politicians who must face voters periodically have no incentive to enact economic policies that are in the long-term interest of the nation. Theoretically, the Fed should be able to ignore these short term pressures and set monetary policy in a way that is beneficial to the long-term health of the economy. The reality is obviously different as the Fed governors must please the political masters who appoint and confirm them. The Fed and Treasury Department have always been used by politicians to avoid making the hard choices that are required for long-term growth and price stability. Manipulating interest rates and exchange rates are not substitutes for good policy.

This week the Obama administration released some details of its stimulus plan, which is now being touted as heavy on “tax cuts”. But the “good policy” within is notable only by its absence. These “tax cuts” are not tax cuts in the traditional sense.

The largest of the business tax cuts will allow companies to use current losses to offset profits as far back as five years. There are even proposals to provide tax “rebates” to companies that have never turned a profit (think ethanol). Thus, companies that have lost money recently will be rewarded while those who managed their businesses profitably will be forced to support their competitors. Accelerated depreciation is also part of the package and will allow companies to shorten the schedule for investments made over the next two years. This has been tried before and had little effect on investment. The temporary nature of the cut renders it ineffective. Companies will just use the cut to expense already planned expenditures. Changing the depreciation schedule permanently could have an effect on long-term investment, but that isn’t being considered.

Most of the other “tax cuts” are actually tax credits that should be classified as income subsidies. While there may be social benefits to a negative income tax and it is certainly more efficient than traditional forms of welfare, tax credits shouldn’t be confused with anything that will drive future economic performance. It is just another attempt to prop up consumption at the expense of savings.

Higher taxes on the most productive will be used to supplement the income of the less productive. Money is merely transferred from those with a high propensity to save to those with a high propensity to consume. It is just another attempt to borrow from the future to fund consumption in the present. We may forestall a deeper recession today, but only at the expense of a weaker economy in the future.

And those who believe that only government spending can save us can’t even bring themselves to embrace these limited, temporary and ineffective tax cuts. Paul Krugman has already taken to the pages of the New York Times to wonder aloud whether Obama is depending too much on tax reductions:

"I don’t know yet. But news reports this morning certainly raise questions.

Let’s lay out the basics here. Other things equal, public investment is a much better way to provide economic stimulus than tax cuts, for two reasons. First, if the government spends money, that money is spent, helping support demand, whereas tax cuts may be largely saved. So public investment offers more bang for the buck. Second, public investment leaves something of value behind when the stimulus is over."

Recent studies have shown that tax cuts are actually more stimulative than deficit financed government spending. Deficit financed government spending shocks produce an effect similar to tax hikes. The taxes to pay for the spending may be in the future, but the effect is felt today as people adjust their behavior to prepare for those higher future taxes. Any stimulus from the spending is mostly offset by the expectation of higher future taxes.

With a deficit financed tax cut, even if it is saved to Krugman’s doubtless horror, at least people will have the dollars to pay higher future taxes and the present change in behavior is limited. And does Krugman really believe that if the tax cuts are saved (and therefore fund private investment) there is no benefit? Why is it that only “investments” made by his preferred politicians produce returns?

The actions of the Federal Reserve and soon the actions of the new Obama administration amount to punishing the victims of the financial crisis. The victims are the everyday Americans who saved and invested their hard earned dollars and didn’t consume beyond their means, but who will be forced to pay the tab for those who did.

Other victims are the companies that managed their businesses conservatively, only to be forced to subsidize companies that were managed recklessly. The victims are the retired Americans who must try to survive on interest rates that are artificially suppressed to rescue those who overindulged.

The question at this point is when will the prudent be rewarded? When will creditors be treated with the same deference as debtors? When will we get economic policy that is effective rather than just politically correct? When will we again trust the market to sort winners from losers rather than allowing politicians to rescue the well connected?

Well, 28 years ago Ronald Reagan said government was the problem, not the solution. Dealing with a bad recession like this one, the Gipper lowered taxes and domestic spending. Obama on the other hand has offered an $800 billion package, with plenty of infrastructure spending that alleges to create three million jobs.

Nobody really believes infrastructure spending will end the recession or create permanent new jobs. However, it’s interesting just how much the Obama plan has changed since the election. The size has been roughly constant. But the mix of tax cuts and spending increases is now totally different.

Instead of $100 billion worth of tax credits, there are now $300 billion worth of tax cuts. This includes a big new piece for business, more cash-expensing for small-business investment, and a restoration of the five-year tax-loss carry-back, which will especially help banks and homebuilders. It might even result in tax refunds for businesses, and might also allow banks to rid themselves of toxic assets, since the losses will now be spread over many years.

So what we have now is an $800 billion stimulus package with $300 billion of so-called tax cuts which could infer less spending than before -- maybe only $500 billion worth.

Obama’s economic advisers are bragging to me about their new tax-cut package. They say they’re very pro-growth. And you know what? I acknowledge it. People like Larry Summers, Austan Goolsbee, Christy Romer, and Tim Geithner are no left-wing big-government whackos. They may not be hard-core supply-siders. But in terms of the economics profession, I would call them center-right.

And they absolutely understand the importance of private business and investment in the job-creating economic-growth process. And I think they’re views are the main reason for the reshaping of the Obama package between the campaign trail and the eve of inauguration.

The problem is that they’re not reducing marginal tax rates on large and small businesses or individuals. Their tax credits will be two-year’s worth, not permanent. There will be no incentive effects to maximize growth. And many of the tax cuts are refundable credits, which really are a form of government spending.

So it’s not a supply-side package. However, I’ve really never met a tax cut I didn’t like. And any tax cut is better than a spending increase since private companies and individuals will at least get the money instead of government.

This is the interesting part of the Obama plan. Somewhere in there the tax cuts will have a small positive economic effect. I would have designed it differently, but then again Team Obama won the election. I guess I could say it could have been worse.

Of course, Team Obama will have to contend with the sticker shock of a $1.2 trillion deficit for 2009, just printed by the Congressional Budget Office. And that’s before the Obama stimulus plan. But I don’t think Republicans really have a leg to stand on with the deficit argument -- or for that matter the spending argument.

Yes, Obama is raising the ante, and the new numbers are just about over the edge. But a lot of that new deficit is TARP money that should be scored as investment -- not real spending. And in view of all the economic pessimism out there, I doubt if the public is very worried about deficits.

What’s most regrettable is that congressional Republicans have yet to make the alternative case. They haven’t pressed for marginal tax-rate cuts as an option to Obama’s credits. So far, the GOP is me-too. They’ve offered an echo instead of a choice.

Meanwhile, polls now say the public favors Obama’s plan by 55 to 65 percent. His personal approval rating is even higher. And he’s being politically astute by reaching out to Republicans. He has virtually removed partisan rhetoric. Simply put, Obama is in the driver’s seat right now.

Sure, the Democratic Congress may mangle Obama’s plan. They might even repeal the Bush tax cuts this year. So there is considerable uncertainty about the details of the final package. But I must say, a crafty Obama is doing his best top employ his version of the Reagan tax-cut plan. Obama talks big government. But so far his program actually reduces the government-spending share and increases the private tax-cut share.

Very interesting.

During the primaries and the general election, not to mention the presidential transition, Obama has weaved from the far left to the moderate center, blurring himself into a seeming enigma. But now we can see the outlines of how he will govern, and it is a combination of the far left and the center—the worst kind of combination. He will act on the ideas of the far left, while presenting them under a moderate, conventional, non-ideological cover.

The danger of Barack Obama's presidency is not that he will act openly on the old dogmas of the left. Indeed, during his transition he has largely attempted to meld into the Washington woodwork by hiring only the most conventional Beltway insiders. Instead, the danger is that he has been so steeped in leftist dogma for his entire life that he will accept the left's attitudes implicitly and automatically, without even realizing it.

All of which brings us to the main content of Obama's speech, which was an attempt to sell us a half-trillion-dollar program of government spending. This is, of course, money that the federal government does not have, so Obama has admitted that the budget deficit will explode to more than $1 trillion.

The money will be thrown around to all of the conventional pork-barrel recipients, from roads and bridges to "alternative energy," which is perpetually in need of government subsidies. But that is less important than the overall effect this spending will have. Given the current contraction in private credit—which will be further withdrawn by the government's vastly increased borrowing—an enormous amount of the money flowing through the economy will now be government money. An increasing amount of economic activity will be directed, not by the private marketplace, but by the government.

Not to worry, Obama tells us. His administration will "launch an unprecedented effort to eliminate unwise and unnecessary spending." They "won't just throw money at our problems—we'll invest in what works." And if you believe that, brother, then I'd like to sell you a can't-lose investment in one of Bernie Madoff's funds.

In fact, this spending has to be wasted, because it is being directed by a thinly disguised form of government central planning. Obama tells us that "instead of politicians doling out money behind a veil of secrecy, decisions about where we invest will be made transparently, and informed by independent experts wherever possible." What does this mean?

Elsewhere, Obama has indicated that he will create an "economic recovery oversight board." According to the Associated Press, "Obama's proposed Economic Recovery Accountability and Transparency Board is to include members the administration deems relevant to helping the country rebound from the year-old recession." Why just have an Economic Recovery Board—why not elevate it to a cabinet-level position? The Federal Department of Economic Recovery would really capture the whole flavor of this scheme.

This is a new central planning board for the American economy, in which a collection of politically connected experts will be empowered to decide which industrial enterprises are worthy of investment and which are not. This is already the policy of the Bush administration, of course, with Treasury Secretary Henry Paulson empowered to act as the economic dictator of the financial industry, deciding which financial institutions are to be supported by freshly printed government dollars and which are to be dismembered and sold. You can see all around you the evidence of how well that worked, and now Obama wants to expand this system to the whole economy.

This new scheme for central planning is an attempt to revive the most discredited idea of the creaky Old Left—but Obama is dressing it up in conventional centrist bromides. I thought that this one was particularly rich:

If we hope to end this crisis, we must end the culture of anything goes that helped create it—and this change must begin in Washington. It is time to trade old habits for a new spirit of responsibility. It is time to finally change the ways of Washington so that we can set a new and better course for America.

How is it "changing the ways of Washington" to propose expanding government power and an explosion in deficit spending? Those are the ways of Washington.

But that's not all. Comically, after proposing hundreds of billions of dollars in new spending and a trillion-dollar deficit, Obama tell us that "government at every level will have to tighten its belt." This "belt-tightening" takes the form of a federal bailout for state governments so that they can "avoid harmful budget cuts."

In this series of evasions and deceptions, there is one item that was not, alas, originated by Obama. He boasts that the hundreds of billions of dollars in new federal spending will be "free from earmarks and pet projects…. This must be a time when leaders in both parties put the urgent needs of our nation above our own narrow interests."

The "small-government conservatives" deserve this one. For decades, the ineffectual advocates of "small government" have directed all of their anger toward earmarks, which in total constitute less than one tenth of one percent of federal spending. Earmarks are small government; it's the rest of the budget that's big. And Barack Obama is now borrowing this conservative argument to justify making big government a whole lot bigger.

The biggest evasion of Obama's speech is that he is hiding what is essentially an ideological program—a resurrection of the ghost of socialism—as a rejection of ideology. He warns us that we must not "rely on the worn-out dogmas of the past" (by which he means free-market economics) and he calls on both parties (by which he means Republicans) "to put good ideas ahead of the old ideological battles."

Yet it is not easy to guess Obama's own basic ideological commitment: that "only government can provide the short-term boost necessary to lift us from a recession this deep and severe. Only government can break the vicious cycles that are crippling our economy."

Obama's premise is that only government can guide and manage economic activity. Only a Federal Department of Economic Recovery can bring back prosperity. This is the most ideological of ideological positions, an "ism." The name for it is "statism," a belief in the central role of the state in controlling the economy.

A consensus now exists that America's recession – already a year old – is likely to be long and deep, and that almost all countries will be affected. I always thought that the notion that what happened in America would be decoupled from the rest of the world was a myth. Events are showing that to be so.

Fortunately, America has, at last, a president with some understanding of the nature and severity of the problem, and who has committed himself to a strong stimulus programme. This, together with concerted action by governments elsewhere, will mean that the downturn will be less severe than it otherwise would be.

The United States Federal Reserve, which helped create the problems through a combination of excessive liquidity and lax regulation, is trying to make amends – by flooding the economy with liquidity, a move that, at best, has merely prevented matters from being worse. It's not surprising that those who helped create the problems and didn't see the disaster coming have not done a masterly job in dealing with it. By now, the dynamics of the downturn are set, and things will get worse before they get better.

In some ways, the Fed resembles a drunk driver who, suddenly realising that he is heading off the road starts careening from side to side. The response to the lack of liquidity is ever more liquidity. When the economy starts recovering, and banks start lending, will they be able to drain the liquidity smoothly out of the system? Will America face a bout of inflation? Or, more likely, in another moment of excess, will the Fed over-react, nipping the recovery in the bud? Given the unsteady hand exhibited so far, we cannot have much confidence in what awaits us.

Still, I am not sure that there is sufficient appreciation of some of the underlying problems facing the global economy, without which the current global recession is unlikely to give way to robust growth – no matter how good a job the Fed does.

For a long time, the US has played an important role in keeping the global economy going. America's profligacy – the fact that the world's richest country could not live within its means – was often criticised. But perhaps the world should be thankful, because without American profligacy, there would have been insufficient global aggregate demand. In the past, developing countries filled this role, running trade and fiscal deficits. But they paid a high price, and fiscal responsibility and conservative monetary policies are now the fashion.

Indeed, many developing countries, fearful of losing their economic sovereignty to the IMF – as occurred during the 1997 Asian financial crisis – accumulated hundreds of billions of dollars in reserves. Money put into reserves is income not spent.

Moreover, growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can't spend it all.

The world's unending appetite for oil, beyond its ability or willingness to produce, has contributed a third factor. Rising oil prices transferred money to oil-rich countries, again contributing to the flood of liquidity. Though oil prices have been dampened for now, a robust recovery could send them soaring again.

For a while, people spoke almost approvingly of the flood of liquidity. But this was just the flip side of what Keynes had worried about – insufficient global aggregate demand. The search for return contributed to the reckless leverage and risk-taking that underlay this crisis.

America's government will, for a time, partly make up for the increasing savings of US consumers. But if America's consumers go from their near-zero savings to a modest 4% or 5% of GDP, then the depressing effect on demand (in addition to that resulting from declines in investment, exports and state and local government expenditures) will not be fully offset by even the largest government expenditure programmes. In two years, governments, mindful of the huge increases in the debt burden resulting from the mega-bailouts and the mind-boggling deficits, will be under pressure to run primary surpluses (where government spending net of interest payments is less than revenues).

A few years ago, there was worry about the risk of a disorderly unwinding of "global imbalances". The current crisis can be viewed as part of that, but little is being done about the underlying problems that gave rise to these imbalances. We need not just temporary stimuli, but longer-term solutions. It is not as if there was a shortage of needs; it is only that those who might meet those needs have a shortage of funds.

First, we need to reverse the worrying trends of growing inequality. More progressive income taxation will also help stabilise the economy, through what economists call "automatic stabilisers". It would also help if the advanced developed countries fulfilled their commitments to helping the world's poorest by increasing their foreign-aid budgets to 0.7% of GDP.

Second, the world needs enormous investments if it is to respond to the challenges of global warming. Transportation systems and living patterns must be changed dramatically.

Third, a global reserve system is needed. It makes little sense for the world's poorest countries to lend money to the richest at low interest rates. The system is unstable. The dollar reserve system is fraying, but is likely to be replaced with a dollar/euro or dollar/euro/yen system that is even more unstable. Annual emissions of a global reserve currency (what Keynes called Bancor, the IMF calls SDRs) could help fuel global aggregate demand and be used to promote development and address the problems of global warming.

This year will be bleak. The question we need to be asking now is, how can we enhance the likelihood that we will eventually emerge into a robust recovery?

Joseph Stiglitz is professor of economics at Columbia University.

But if taxpayers really do have to shell out all that money as they see their neighbors — or even themselves — getting laid off and being foreclosed on, they should at least see how the money's spent.

The incoming Obama administration can improve on this by pushing for more transparency and accountability. But will it?

So far, Hank Paulson's Treasury Department hasn't revealed how the bailout funds are being spent. It may be there's such a sense of urgency at the federal level that action takes precedence over prudence. It's not hard to understand why. Bush noted in his press conference Monday that he had "chucked" free-market principles because of fears the economy could fall into depression.

However, one of the key principles of those who want to shrink government, lower taxes and promote capitalism is that the people should know what government spends their taxes on.

If the purpose of the money given to banks was to ease foreclosures, then such strings should have been attached to the cash in the Treasury's original strategy. It wasn't.

On the other hand, if letting banks spend it as they wished was desirable, then Treasury should let it be known and defend it.

Instead of being straight up about things, however, we find Treasury answering questions from the Congressional Oversight Panel in a manner so tight-lipped that one would think the panel's enquiries had been delivered to the National Security Agency by mistake.

This is not terrorist e-mails at issue; the government has little excuse for secrecy with so much tax money at risk.

The banks, too, have been tight-lipped about how they're using the money. Given the amounts, this is not satisfactory.

One way or another, changes are on the way. President-elect Obama said Monday that he'll seek stricter rules and more transparency in spending the remaining $350 billion of the $700 billion under the Troubled Assets Relief Program (TARP).

"I think many of us have been disappointed with the lack of clarity, the absence of transparency," Obama said, after formally requesting that Bush ask Congress for the remaining $350 billion.

Already, Obama's Treasury Secretary-designate Tim Geithner is working with Lawrence Summers, who'll head the White House National Economic Council, to reshape TARP. They're seeking to give the federal government a greater stake in financial firms, and to tie federal assistance explicitly to limits on executive pay.

House Banking Committee Chairman Barney Frank, D-Mass., whose advocacy of forcing banks to be instruments of social justice helped cause the mess we're in, is also pushing TARP reforms that would impose "the most stringent nontax executive compensation restrictions" — including forbidding golden parachute payments to executives and applying executive pay limits retroactively.

Unfortunately, this is what the lack of transparency and no clear strategy for exactly how the rescue money would be used has set us up for: The micromanaging from Washington of the biggest financial institutions.

We wonder: How many other businesses will Uncle Sam end up setting executive pay for, outside the wishes of the shareholders?

There's a very harsh lesson here. The TARP program came into being for the best of reasons. But it came up short when it comes to transparency. We're glad Obama wants to make TARP better.

More transparency will surely help, but letting the federal government — which caused the problem in the first place — tighten its control over our financial system will bring us no good and may help slow our recovery.

This is certainly the case now. November's $40.4 billion gap was the smallest in five years and the fourth monthly decline in a row. Both exports and imports fell — a sign of global recession.

So the deficit is shrinking — but don't cue the applause.

Contrary to what some assert, a smaller deficit isn't a "drag" on the economy. Nor is it a sign of economic health.

Just look at recent history. From the end of the recession in 2001 to 2006, a time of solid economic growth in the U.S. economy, the trade deficit surged to record levels.

But, as economist David Malpass of Encima Global has noted, during that time the U.S. created some 9.3 million jobs. Japan, by comparison, created just 360,000 new jobs, and Europe — excluding Spain — created just 1.1 million.

(Like the U.S., Spain ran big deficits. It created 3.6 million new jobs — more than three times the rest of the Euro zone combined.)

This isn't new. As trade economist Dan Griswold of the Cato Institute noted in a 2007 study, there's an inverse relationship between trade deficits and the economy. The faster the economy grows, the greater the trade deficit. And vice versa.

"In those years since 1980 in which the current account (the broadest measure of trade) deficit actually shrank as a share of GDP, real GDP growth averaged 1.9%," Griswold noted. But when the trade gap grew 0.5% or more, he added, real GDP growth averaged 4.1%.

This means the economy grew roughly twice as fast when the trade deficit was getting "worse" than when it was getting "better."

By the way, the last time we ran a trade surplus for a full 12 months was 1991 — a recession year. Anyone who still believes that surpluses are good must be longing for the good old days of the Depression. Thanks to plunging consumer spending and the Smoot-Hawley tariffs, the U.S. ran trade surpluses in nine of the 10 years of the 1930s.

Yes, critics say, but we're falling deeper and deeper into debt as we run up our national credit card to buy goods overseas. We now owe the rest of the world trillions of dollars, thanks to our insatiable hunger for foreign-made things. Where will it all end?

But this too shows a misunderstanding of how things really work.

The mirror-image of a trade deficit isn't debt; it's a capital surplus. That is, dollars that go overseas for foreign goods don't just sit there as "debt." They are either saved, spent on U.S. goods or reinvested here. Mostly it's the latter.

As a 1999 Joint Economic Committee report notes, "a trade deficit will occur when the U.S. economy is offering investors such attractive options that foreigners are investing more in the United States — buying more assets — than Americans are investing abroad."

That's been happening for years.

When dollars come back as investment, we often mistakenly call it "debt." True enough, it's debt if the money buys U.S. Treasurys. But if it's an investment in the stock market, do we really owe someone something?

And if the trade surpluses other countries rack up with us are spent on U.S. real estate, are we worse off? Is that a debt?

And if the money returns as investment in factories and businesses, don't we come out ahead?

The answers are: No, no and yes.

In fact, a lot of that money comes back as direct investment.

This a good thing. As economist Matthew Slaughter of Dartmouth University recently noted, foreign companies in 2005 employed nearly 5.1 million Americans, or roughly 4.4% of the labor force. Compensation per worker for the foreign companies was $66,042, 32% higher than for the average private sector job.

Foreign investments — recycled trade deficits — have made our economy stronger by boosting productivity and lifting demand for labor here. Those investments are made possible by our deficits.

Virtually all economists agree: The more and freer trade, the better. Trade doesn't make us poorer; it makes us richer — a far cry from the misconceptions that pundits have been peddling, and most of the public has been buying, for years.

In its investigations, the Times relied partially on government disclosure documents that the Bush Department of Labor had introduced a few years earlier, which require labor organizations to give more detail about how they spend members’ money. The new forms require all unions with annual receipts larger than $250,000 to offer their members details on everything from fundraising expenditures to political campaign outlays to donations to what it costs to run the union’s annual convention.

While most of the revelations weren’t as explosive as those uncovered by the Times, the disclosure forms filed by other big labor groups provided grist for controversy. The National Education Association’s initial disclosure forms, for instance, showed that it made a whopping $65 million in gifts and donations to groups, including many to organizations whose mission has little to do with K-through-12 education, such as the Human Rights Campaign, which lobbies for "lesbian, gay, bisexual and transgender equal rights." Among those education groups that did get funding, many had a decidedly narrow political mission, such as Protect Our Public Schools, a Washington-state based group that was opposing the school choice movement with help from a $500,000 grant from the NEA.

Unions heavily supported Barack Obama in his presidential bid, and much of their support hinged on his backing of labor-friendly initiatives, most especially the controversial Employee Free Choice Act, which would eliminate secret ballots for union elections. When she went before Congress for confirmation hearings, Obama’s choice to head the Department of Labor, California Congresswoman Hilda Solis, was grilled about her position on EFCA and other laws of interest to the labor movement.

But significant changes in White House policy can occur administratively as well as legislatively. Our cabinet-level departments, in particular, wield important administrative powers, and often what is done, or undone, by a new cabinet officer without the slightest legislative initiative is as significant as what gets debated and passed in Congress.

The new disclosure rules fall into that category. Since organized labor spent about $100 million of members’ dues helping to elect Obama and supporting Democrats in Congress, the AFL-CIO and other unions have provided Obama with a lengthy list of things they would like done for them in Washington. And high on that list is undoing some of the disclosure requirements put in place during the Bush years. Without any debate in Congress, an Obama Labor Department could rescind them. Of it could simply not enforce them. As any investigative reporter will tell you, businesses and nonprofit groups often fail to file their required documents without being held accountable.

How the Obama administration treats the disclosure requirements will say a lot about what kind of Labor Department it will run. The Bush administration liked to accuse the DOL of becoming the Department of Organized Labor during the Clinton years because of its pro-union rulings. Union groups, by contrast, accused the Bush DOL of acting like a tool of big business.

Left out of this debate were the interests of ordinary workers. One could argue about whether the EFCA or minimum wage legislation serves the ordinary worker or not. But it’s difficult to question the importance of the Department of Labor’s transparency regulations in allowing ordinary union members to see more clearly how their money is being spent, without in any way affecting the balance of power between unions and businesses.

How the Obama administration handles the transparency regulations will tell us more about its government philosophy than any legislation it puts before Congress. Will Obama run a Department of Labor for the benefit of all workers, or a Department of Organized Labor that curries favor with those who run unions, even if it’s at the expense of their rank and file members? We will know shortly.

We don’t have the answers to these questions, in part because the consequences will depend on what actions policymakers take. The right responses will ensure that the world economy can begin to recover by late 2009. Poor policy choices, on the other hand, will at best delay recovery and at worst do permanent damage. Here is a list of things to watch for.

Will the US response be “bold” enough?

Barack Obama has promised that it will be, echoing at least part of Franklin D. Roosevelt’s famous call for “bold, persistent experimentation” at the height of the Great Depression in 1932. Obama has a first-rate group of economists on his side, which ensures that he will not do anything silly. But America’s circumstances are sufficiently exceptional that he will need advisers who are willing to try new, untested ideas — in other words, experimentation à la FDR.

In particular, he will need to go beyond Keynesian fiscal-stimulus policies to heal the deep wounds to economic confidence that lie at the root of the current crisis. So far, confidence-building measures have been limited to financial markets, through public guarantees, liquidity support, and capital injections.

But workers who worry about being laid off are unlikely to go spend, regardless of how much money fiscal stimulus puts in their pockets. Just as banks are hoarding cash, households will try to preserve wealth by increasing their saving. So incentives targeted directly at preserving employment will have to be part of the solution.

Will Europe get its act together?

This could have been Europe’s moment. After all, the crisis originated in the US and left American policy focused on its domestic troubles, opening up room for global leadership by others. Instead, the crisis demonstrated the deep divisions within Europe — on everything from financial regulation to the requisite policy response.

Germany has dragged its feet on fiscal stimulus, stymieing what should have been the second leg of a globally coordinated fiscal action plan. If Europe wants to pull its weight on the global stage, it will have to act with greater unity of purpose and shoulder a greater share of responsibility. Alas, the best that can be hoped for at this stage is that Europe will not undermine the global fiscal stimulus that even the International Monetary Fund, the guardian of fiscal orthodoxy, regards as absolutely essential.

Will China hold together?

Even though a weak US response is the biggest risk on the economic side, what happens in China may well have deeper and more lasting consequences on the broader historical canvas. For China is a country of enormous hidden tensions and cleavages, and these may erupt into open conflict in difficult economic times.

Experts on China differ on the rate of economic growth needed to create employment for the millions of Chinese who flock into the country’s cities every year. But it is virtually certain that China will fall short of this threshold in 2009. This explains the almost continuous stream of measures that emanate from Beijing these days: increased public spending, monetary easing, pressure on state enterprises to expand activity, subsidies to exporters, partial convertibility of the remninbi to spur trade with neighboring countries, and so on. But will this do enough to stem the slowdown in an economy that has become hooked on external demand in recent years?

If social tensions rise, China’s government is likely to respond with greater repression, which will bode ill both for its relations with the West and for its medium-term political stability. Experience shows that democracies hold the edge over authoritarian regimes when it comes to handling the fallout from crises. It was democratic India (in 1991) and South Korea (in 1997-1998) that turned around their economies quickly, while Pinochet’s Chile (in 1983) and Suharto’s Indonesia (in 1997-98) fell into deeper quagmires.

Authoritarian regimes lack the institutions of conflict management that democracies provide. So tensions spill over into the streets and take the form of riots and protests. However the Chinese leadership responds, future generations may remember 2009 less for its global economic and financial crisis than for the momentous transformation that it caused in China.

Will there be enough global economic cooperation?

When domestic needs become paramount, global economic cooperation suffers. But the costs of protectionism in trade and finance are especially large at moments like these. The Great Depression was aggravated by the trade barriers that countries imposed to protect domestic employment. This will be a temptation this time around as well. And banks — whether explicitly nationalized or not — will be under pressure to prioritize domestic borrowers.

So far, the IMF has reacted with newfound vigor, establishing a much-needed short-term lending facility, which may well need to be expanded if emerging markets come under greater pressure. The World Trade Organization, meanwhile, has wasted valuable time on the irrelevant Doha round. It should have focused its efforts on monitoring and implementing the G-20’s commitment not to raise trade barriers.

Policymakers need to shed received wisdom and forget useless dichotomies such as “markets versus government” or “nation-state versus globalization.” They need to come to grips with the reality that national regulations and international markets are inextricably linked with — and in need of — each other. The more pragmatically and creatively they act, the more quickly the world economy will recover.

Dani Rodrik is professor of political economy at Harvard University.

The global economy will recover, but the timing and strength of the recovery are highly uncertain. Government policy responses around the world will be critical determinants of the speed and vigor of the recovery. Today I will offer some thoughts on current and prospective policy responses to the crisis in the United States, with a particular emphasis on actions by the Federal Reserve. In doing so, I will outline the framework that has guided the Federal Reserve's responses to date. I will also explain why I believe that the Fed still has powerful tools at its disposal to fight the financial crisis and the economic downturn, even though the overnight federal funds rate cannot be reduced meaningfully further.

The Federal Reserve's Response to the Crisis

The Federal Reserve has responded aggressively to the crisis since its emergence in the summer of 2007. Following a cut in the discount rate (the rate at which the Federal Reserve lends to depository institutions) in August of that year, the Federal Open Market Committee began to ease monetary policy in September 2007, reducing the target for the federal funds rate by 50 basis points.1 As indications of economic weakness proliferated, the Committee continued to respond, bringing down its target for the federal funds rate by a cumulative 325 basis points by the spring of 2008. In historical comparison, this policy response stands out as exceptionally rapid and proactive. In taking these actions, we aimed both to cushion the direct effects of the financial turbulence on the economy and to reduce the virulence of the so-called adverse feedback loop, in which economic weakness and financial stress become mutually reinforcing.

These policy actions helped to support employment and incomes during the first year of the crisis. Unfortunately, the intensification of the financial turbulence last fall led to further deterioration in the economic outlook. The Committee responded by cutting the target for the federal funds rate an additional 100 basis points last October, with half of that reduction coming as part of an unprecedented coordinated interest rate cut by six major central banks on October 8. In December the Committee reduced its target further, setting a range of 0 to 25 basis points for the target federal funds rate.

The Committee's aggressive monetary easing was not without risks. During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation. These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities. The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations. However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. Committee members expected that, at some point, global economic growth would moderate, resulting in slower increases in the demand for commodities and a leveling out in their prices--as reflected, for example, in the pattern of futures market prices. As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation has already declined significantly and appears likely to moderate further.

The Fed's monetary easing has been reflected in significant declines in a number of lending rates, especially shorter-term rates, thus offsetting to some degree the effects of the financial turmoil on financial conditions. However, that offset has been incomplete, as widening credit spreads, more restrictive lending standards, and credit market dysfunction have worked against the monetary easing and led to tighter financial conditions overall. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Thus, in addition to easing monetary policy, the Federal Reserve has worked to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector. In doing so, as I will discuss shortly, the Fed has deployed a number of additional policy tools, some of which were previously in our toolkit and some of which have been created as the need arose.

Beyond the Federal Funds Rate: The Fed's Policy Toolkit

Although the federal funds rate is now close to zero, the Federal Reserve retains a number of policy tools that can be deployed against the crisis.

One important tool is policy communication. Even if the overnight rate is close to zero, the Committee should be able to influence longer-term interest rates by informing the public's expectations about the future course of monetary policy. To illustrate, in its statement after its December meeting, the Committee expressed the view that economic conditions are likely to warrant an unusually low federal funds rate for some time.2 To the extent that such statements cause the public to lengthen the horizon over which they expect short-term rates to be held at very low levels, they will exert downward pressure on longer-term rates, stimulating aggregate demand. It is important, however, that statements of this sort be expressed in conditional fashion--that is, that they link policy expectations to the evolving economic outlook. If the public were to perceive a statement about future policy to be unconditional, then long-term rates might fail to respond in the desired fashion should the economic outlook change materially.

Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy. As I will elaborate, I find it useful to divide these tools into three groups. Although these sets of tools differ in important respects, they have one aspect in common: They all make use of the asset side of the Federal Reserve's balance sheet. That is, each involves the Fed's authorities to extend credit or purchase securities.

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to sound financial institutions. Over the course of the crisis, the Fed has taken a number of extraordinary actions to ensure that financial institutions have adequate access to short-term credit. These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed's discount window.3 For example, since August 2007 we have lowered the spread between the discount rate and the federal funds rate target from 100 basis points to 25 basis points; increased the term of discount window loans from overnight to 90 days; created the Term Auction Facility, which auctions credit to depository institutions for terms up to three months; put into place the Term Securities Lending Facility, which allows primary dealers to borrow Treasury securities from the Fed against less-liquid collateral; and initiated the Primary Dealer Credit Facility as a source of liquidity for those firms, among other actions.

Because interbank markets are global in scope, the Federal Reserve has also approved bilateral currency swap agreements with 14 foreign central banks. The swap facilities have allowed these central banks to acquire dollars from the Federal Reserve to lend to banks in their jurisdictions, which has served to ease conditions in dollar funding markets globally. In most cases, the provision of this dollar liquidity abroad was conducted in tight coordination with the Federal Reserve's own funding auctions.

Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers. In the case of currency swaps, the foreign central banks are responsible for repayment, not the financial institutions that ultimately receive the funds; moreover, as further security, the Federal Reserve receives an equivalent amount of foreign currency in exchange for the dollars it provides to foreign central banks.

Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confidence, financial institutions will be able to meet the resulting demands for cash without resorting to potentially destabilizing fire sales of assets. Moreover, backstopping the liquidity needs of financial institutions reduces funding stresses and, all else equal, should increase the willingness of those institutions to lend and make markets.

On the other hand, the provision of ample liquidity to banks and primary dealers is no panacea. Today, concerns about capital, asset quality, and credit risk continue to limit the willingness of many intermediaries to extend credit, even when liquidity is ample. Moreover, providing liquidity to financial institutions does not address directly instability or declining credit availability in critical nonbank markets, such as the commercial paper market or the market for asset-backed securities, both of which normally play major roles in the extension of credit in the United States.

To address these issues, the Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets. Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds. In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve's credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a "haircut" and the Treasury is providing $20 billion of capital as supplementary loss protection. We expect this facility to be operational next month.

The rationales and objectives of our various facilities differ, according to the nature of the problem being addressed. In some cases, as in our programs to backstop money market mutual funds, the purpose of the facility is to serve, once again in classic central bank fashion, as liquidity provider of last resort. Following a prominent fund's "breaking of the buck"--that is, a decline in its net asset value below par--in September, investors began to withdraw funds in large amounts from money market mutual funds that invest in private instruments such as commercial paper and certificates of deposit. Fund managers responded by liquidating assets and investing at only the shortest of maturities. As the pace of withdrawals increased, both the stability of the money market mutual fund industry and the functioning of the commercial paper market were threatened. The Federal Reserve responded with several programs, including a facility to finance bank purchases of high-quality asset-backed commercial paper from money market mutual funds. This facility effectively channeled liquidity to the funds, helping them to meet redemption demands without having to sell assets indiscriminately. Together with a Treasury program that provided partial insurance to investors in money market mutual funds, these efforts helped stanch the cash outflows from those funds and stabilize the industry.

The Federal Reserve's facility to buy high-quality (A1-P1) commercial paper at a term of three months was likewise designed to provide a liquidity backstop, in this case for investors and borrowers in the commercial paper market. As I mentioned, the functioning of that market deteriorated significantly in September, with borrowers finding financing difficult to obtain, and then only at high rates and very short (usually overnight) maturities. By serving as a backup source of liquidity for borrowers, the Fed's commercial paper facility was aimed at reducing investor and borrower concerns about "rollover risk," the risk that a borrower could not raise new funds to repay maturing commercial paper. The reduction of rollover risk, in turn, should increase the willingness of private investors to lend, particularly for terms longer than overnight. These various actions appear to have improved the functioning of the commercial paper market, as rates and risk spreads have come down and the average maturities of issuance have increased.

In contrast, our forthcoming asset-backed securities program, a joint effort with the Treasury, is not purely for liquidity provision. This facility will provide three-year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans. Unlike our other lending programs, this facility combines Federal Reserve liquidity with capital provided by the Treasury, which allows it to accept some credit risk. By providing a combination of capital and liquidity, this facility will effectively substitute public for private balance sheet capacity, in a period of sharp deleveraging and risk aversion in which such capacity appears very short. If the program works as planned, it should lead to lower rates and greater availability of consumer and small business credit. Over time, by increasing market liquidity and stimulating market activity, this facility should also help to revive private lending. Importantly, if the facility for asset-backed securities proves successful, its basic framework can be expanded to accommodate higher volumes or additional classes of securities as circumstances warrant.

The Federal Reserve's third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio. For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. Notably, mortgage rates dropped significantly on the announcement of this program and have fallen further since it went into operation. Lower mortgage rates should support the housing sector. The Committee is also evaluating the possibility of purchasing longer-term Treasury securities. In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.

These three sets of policy tools--lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities--have the common feature that each represents a use of the asset side of the Fed's balance sheet, that is, they all involve lending or the purchase of securities. The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound.

Credit Easing versus Quantitative Easing

The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.

The stimulative effect of the Federal Reserve's credit easing policies depends sensitively on the particular mix of lending programs and securities purchases that it undertakes. When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market. Because various types of lending have heterogeneous effects, the stance of Fed policy in the current regime--in contrast to a QE regime--is not easily summarized by a single number, such as the quantity of excess reserves or the size of the monetary base. In addition, the usage of Federal Reserve credit is determined in large part by borrower needs and thus will tend to increase when market conditions worsen and decline when market conditions improve. Setting a target for the size of the Federal Reserve's balance sheet, as in a QE regime, could thus have the perverse effect of forcing the Fed to tighten the terms and availability of its lending at times when market conditions were worsening, and vice versa.

The lack of a simple summary measure or policy target poses an important communications challenge. To minimize market uncertainty and achieve the maximum effect of its policies, the Federal Reserve is committed to providing the public as much information as possible about the uses of its balance sheet, plans regarding future uses of its balance sheet, and the criteria on which the relevant decisions are based.4

Exit Strategy

Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize. In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy.

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters. Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term, which will slow the rate at which our balance sheet can shrink. We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

Importantly, the management of the Federal Reserve's balance sheet and the conduct of monetary policy in the future will be made easier by the recent congressional action to give the Fed the authority to pay interest on bank reserves. In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors. However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate.

Moreover, other tools are available or can be developed to improve control of the federal funds rate during the exit stage. For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system. In considering whether to create or expand its programs, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster full employment and price stability.

Stabilizing the Financial System

The Federal Reserve will do its part to promote economic recovery, but other policy measures will be needed as well. The incoming Administration and the Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity. In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.

In the United States, a number of important steps have already been taken to promote financial stability, including the Treasury's injection of about $250 billion of capital into banking organizations, a substantial expansion of guarantees for bank liabilities by the Federal Deposit Insurance Corporation, and the Fed's various liquidity programs. Those measures, together with analogous actions in many other countries, likely prevented a global financial meltdown in the fall that, had it occurred, would have left the global economy in far worse condition than it is in today.

However, with the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions' balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered. Public purchases of troubled assets are one possibility. Another is to provide asset guarantees, under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks. Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank. These methods are similar from an economic perspective, though they would have somewhat different operational and accounting implications. In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.

The public in many countries is understandably concerned by the commitment of substantial government resources to aid the financial industry when other industries receive little or no assistance. This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt. Indeed, the destructive effects of financial instability on jobs and growth are already evident worldwide. Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest.

Even as we strive to stabilize financial markets and institutions worldwide, however, we also owe the public near-term, concrete actions to limit the probability and severity of future crises. We need stronger supervisory and regulatory systems under which gaps and unnecessary duplication in coverage are eliminated, lines of supervisory authority and responsibility are clarified, and oversight powers are adequate to curb excessive leverage and risk-taking. In light of the multinational character of the largest financial firms and the globalization of financial markets more generally, regulatory oversight should be coordinated internationally to the greatest extent possible. We must continue our ongoing work to strengthen the financial infrastructure--for example, by encouraging the migration of trading in credit default swaps and other derivatives to central counterparties and exchanges. The supervisory authorities should develop the capacity for increased surveillance of the financial system as a whole, rather than focusing excessively on the condition of individual firms in isolation; and we should revisit capital regulations, accounting rules, and other aspects of the regulatory regime to ensure that they do not induce excessive procyclicality in the financial system and the economy. As we proceed with regulatory reform, however, we must take care not to take actions that forfeit the economic benefits of financial innovation and market discipline.

Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail." It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period. The existence of too-big-to-fail firms also violates the presumption of a level playing field among financial institutions. In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking. Also urgently needed in the United States is a new set of procedures for resolving failing nonbank institutions deemed systemically critical, analogous to the rules and powers that currently exist for resolving banks under the so-called systemic risk exception.

Conclusion

The world today faces both short-term and long-term challenges. In the near term, the highest priority is to promote a global economic recovery. The Federal Reserve retains powerful policy tools and will use them aggressively to help achieve this objective. Fiscal policy can stimulate economic activity, but a sustained recovery will also require a comprehensive plan to stabilize the financial system and restore normal flows of credit.

Despite the understandable focus on the near term, we do not have the luxury of postponing work on longer-term issues. High on the list, in light of recent events, are strengthening regulatory oversight and improving the capacity of both the private sector and regulators to detect and manage risk.

Finally, a clear lesson of the recent period is that the world is too interconnected for nations to go it alone in their economic, financial, and regulatory policies. International cooperation is thus essential if we are to address the crisis successfully and provide the basis for a healthy, sustained recovery.

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Footnotes

1. A basis point is one-hundredth of a percentage point. Return to text

2. Board of Governors of the Federal Reserve (2008), "FOMC Statement and Board Approval of Discount Rate Requests of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco," press release, December 16. Return to text

3. Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. The New York Fed's Open Market Desk engages in trades on behalf of the Federal Reserve System to implement monetary policy. Return to text

4. Detailed information about the Federal Reserve's balance sheet is published weekly as part of the H.4.1 release. For a summary of Fed lending programs, see Forms of Federal Reserve Lending to Financial Institutions (229 KB PDF). Return to text

Delivered at the London School of Economics on January 13, 2009.

The proximate cause of the financial market turbulence, of course, is the home mortgages made from late 2005 through early 2007, near the end of long U.S. housing boom that began in 1995. Since the peak in activity in 2005, housing investment has fallen by more than 40 percent. Average housing prices, as measured by the FHFA repeat sales index, have fallen nearly 9 percent since their peak in April 2007. The resulting erosion in home equity for many borrowers has meant that mortgages made near the peak of the boom, especially the subprime and non-traditional categories, are experiencing much larger losses than expected.

It will take years of research to untangle the quantitative contribution of various causal factors to the decade-long housing boom, the accompanying rise in subprime mortgage lending, and the subsequent increase in mortgage losses. A definitive assessment is too much to ask at this point, but a list of the most plausible suspects can easily be discerned. One candidate that is often overlooked is the significant increase in productivity growth, and thus growth in real household income, which began around 1995 and lasted until some time earlier in this decade. To the extent that households came to see the increase in trend real income growth as likely to continue, one would expect to see a sustained rise in the demand for housing. Moreover, current data suggest a decline in trend productivity growth in the middle of this decade, around the time housing demand peaked and began falling.

Another plausible contributing factor was the wave of technological innovation in retail credit delivery, which allowed lenders to make finer distinctions between potential borrowers. This facilitated lower interest rates for some borrowers and an expansion of lending to borrowers formerly viewed as unqualified for credit. As in any industry undergoing an innovation-driven structural shift (the telecommunications industry in the late 1990s, for example), the natural evolution of the industry can involve overshooting and retrenchment. Subprime lending with high loan-to-value ratios was profitable while home prices were rapidly rising, but profitability fell sharply when price trends reversed. Home price trends are hard to predict with any confidence, and lenders who found past subprime mortgage lending profitable in 2004, 2005 and 2006 may have underestimated the probability of a broad and sustained decline in home prices.

The regulatory and supervisory regime surrounding U.S. housing finance also seems likely to have contributed to the boom in housing and housing finance. Here, several factors deserve mention. Supervisory agencies, like borrowers, lenders and investors, assigned a low probability to the possibility of an adverse housing demand shift of the magnitude and geographic extent that we have seen. In addition, private sector incentives to foresee and protect against such shocks were to some extent dampened by the presence of the federal financial safety net — that is, deposit insurance and the access of commercial banking organizations to Federal Reserve lending. Market participants may have inferred that a housing market shock that was large enough to afflict a broad swath of the financial system would elicit significant official support, particularly for institutions perceived as "too big to fail."2 Past instances of government intervention to prevent large financial institutions from failing — from Continental Illinois to Long Term Capital Management — have encouraged such inferences. The federal safety net probably also played a role in banks' involvement in the securitization process at the heart of housing finance, particularly among institutions perceived as too big to fail. The use of off-balance sheet arrangements and the provision of back-up lines of credit created contingent exposures for the banking system that by design were most likely to be realized in generally bad states of the world, when the safety-net protection of the formal banking sector would be most valuable. In addition to these incentive problems, the inferred prospect of support for the government-sponsored housing finance enterprises, Fannie Mae and Freddie Mac, lowered their borrowing costs and contributed to their demand for mortgage-backed securities. Legislative incentives for such enterprises to extend credit to low-income borrowers also would have stimulated their demand for securities backed by subprime and nontraditional mortgages.

Another key causal suspect is the relatively low path of interest rates after the recession earlier this decade, especially in 2003 and 2004. Some economists have argued, with the benefit of hindsight, that tighter monetary policy during that period would have led to better outcomes by preventing core inflation from rising, thus limiting the housing boom and mitigating the subsequent bust.3 This view strikes me as quite plausible, but again, further research will be required to substantiate this hypothesis.

That's all prologue, however, to the turmoil that has plagued financial markets since the middle of last year, when the potential scale of the home mortgage problem became more widely appreciated. The turmoil intensified in mid-September of this year, and volatility has been elevated since. Financial market participants have faced three major categories of uncertainty. The first concerns the aggregate amount of losses on mortgage lending. For mortgages made in 2006 and early 2007 — the vintages in which losses are concentrated — significant uncertainty still remains regarding total losses.

Second, financial market participants have faced uncertainty about where the losses will turn up. Mortgage risks were split up and spread widely, both within the United States and abroad, through securitization and use of the insurance capabilities provided by credit derivative contracts. As a result, financial market participants are understandably apprehensive about whether a particular counterparty's mortgage-related losses will erode their capital buffer enough to threaten their viability.

Third, market participants have at times faced uncertainty about prospective public sector intervention.4 The disparate responses to potential failures at several high-profile organizations this year may have made it difficult for market participants to forecast whether official support would be forthcoming for a given counterparty. Shifts in expectations regarding official intervention may have added volatility to financial asset markets that already were roiled by an increasingly uncertain growth outlook. And uncertainty about the form of government support — asset purchases versus dilutive capital purchases, for example — may have hindered the provision of fresh equity capital.

Most of what has been observed in financial market since the summer of 2007 is fairly intelligible in light of these sources of uncertainty facing market participants. Apprehension about potential losses caused lenders to demand higher risk premia in interbank credit markets for institutions with at least some presumed mortgage-related exposure. Market participants became especially concerned about the heightened risk associated with lending at longer maturities, and so risk premia became especially elevated for term lending. Some borrowers were unwilling to pay higher premia for term loans, and shortened the tenor of their funding. Others were willing to pay the unusually high premia in order to "lock in" funding and protect themselves against an erosion in counterparties' perception of their creditworthiness. More broadly, the proliferation of intermediation channels in recent years has meant that for many borrowers, the next best financing option may not be much more costly. For example, many commercial paper issuers have back-up lines of credit with banks that they can draw on in the event they are unsatisfied with market pricing. Thus observing that a given intermediation channel is "frozen," "clogged," or "dried up" may not indicate dysfunction, per se, but may indicate instead just a portfolio reallocation in response to a shift in risk assessments.

The striking feature of central bank lending and other government financial support during the recent turmoil is the extent to which it has extended well beyond the boundaries that previously were understood to constrain such lending, both in the range of institutions and the contractual terms on which credit has been provided. Intervention has been driven by a desire to prevent damaging disruptions to financial markets, and thus reduce the overall costs of the turmoil. While this objective is clearly understandable, central bank lending can create the expectation that similar support will be forthcoming when market disruptions occur in the future. Such expectations can themselves be very costly, because they can distort the incentives faced by, and as a result, the choices made by private-sector participants. For example, in the past year, expectation of official support may have induced some firms to take the risk of turning down capital infusions or merger offers in hopes of finding better terms in the future. Prospective equity investors may have demanded stiffer terms to compensate for the possibility of dilutive government intervention. Clearly, these recent examples of the moral hazard effects of official intervention are detrimental to broader public policy objectives, and place a significant burden on the supervisors of financial institutions to constrain such risk-taking.

The critical policy question of our time is where to establish the boundaries around the public-sector safety net provided to financial market participants, now that the old boundaries are gone. In doing so, the prime directive should be that the extent of regulatory and supervisory oversight should match the extent of access to central bank credit in order to contain moral hazard effectively. The dramatic recent expansion in Federal Reserve lending, and government support more broadly, has extended public sector support beyond existing supervisory reach, and thus could destabilize the financial system, if no corrective action is taken. Restoring consistency between the scope of government support and the scope of government supervision is essential to a healthy and sustainable financial system. One option is simply to adapt our regulatory and supervisory regime to the new wider implied reach of government lending support. This strikes me as an unattractive option, if for no other reason than the current uncertainty about the outer bounds of that support. Constraining moral hazard in such a regime would be an immense and daunting task. I take it as given, therefore, that the scope of financial safety net ultimately must be rolled back.

Note that it will not be sufficient simply to roll back the current lending programs when the economy begins recovering. The precedents that have been set during this episode will influence how market participants expect policymakers to react during the next episode of financial market turmoil. Establishing a coherent and stable financial regulatory regime will require rolling back expectations about how the policymakers will respond to the next financial market disturbance or the next recession. Doing so will be difficult. But rolling back those expectations will be impossible if moral hazard concerns are always set aside in the exigencies of a crisis.5

Assessing the effects of the financial market turmoil on real economic growth is not as straightforward as it might seem. One popular notion is that the credit market disruptions we've seen over the last year or so impede the financial sector's ability and willingness to extend credit to households and business firms, thereby creating an additional drag on spending. The widely observed correlations between economic activity and measures of bank credit extension lend support to this theory. But causation can flow in the opposite direction as well. When overall economic activity seems poised to contract, the outlook for household income and business revenues deteriorates as well, and borrowers become less creditworthy, all else constant. My reading of current conditions is that bank lending is constrained more now by the supply of creditworthy borrowers than by the supply of bank capital. This may explain why recent programs aimed at reducing credit spreads in particular financial sectors seem to have had such limited effects; if credit market stress is a symptom rather than a cause of the economic slowdown, then intervention in particular credit markets may not be an effective demand management tool.

The decline in residential construction activity since early 2006 has affected not only credit markets — it has had a significant impact on broader economic activity as well. For a time, the weakness was isolated in the housing market and the rest of the economy continued to expand at a relatively healthy rate. But in late 2007, consumer spending began to slow. Household net worth has declined as home prices have fallen virtually nationwide over the last year-and-a-half, and, more recently, equity prices have slumped. Increases in energy prices up through the middle of last year took a substantial bite out of real incomes. Moreover, payroll employment peaked at the end of 2007, and has since declined by about 2 million jobs. As the labor market has weakened, wage growth has tapered off. Except for the temporary bulge due to the stimulus payments last year (which did not, in the end, leave much trace on household spending), real personal income has steadily decelerated, and is now below where it was a year ago. Given this catalog of adverse developments for U.S. households, it should be no surprise that consumer spending was sluggish in the first half of last year and has fallen significantly since then.

When household spending slows substantially, investment is usually not far behind. Business spending on equipment and software fell in each of the first three quarters of 2008, and the near-term outlook is not favorable. Many firms are facing dimmer sales prospects, higher funding costs, and more restrictive borrowing terms. Thus, further softening in this segment of business investment appears quite likely. Indeed, new orders for capital goods are off sharply since the summer. The other segment of business fixed investment, spending on new structures, has been flourishing for some time now. Over the three years leading up to the third quarter of 2008, real nonresidential fixed investment — a segment that includes office buildings, hotels, malls and the like — grew at a 12 ¼ percent annual rate. That category seems to have slowed significantly in the second half of last year, although not as much as I had expected. Anecdotal reports indicate that the flow of new projects has diminished considerably, and it seems clear that nonresidential investment will decline over the course of this year, with only the magnitude of slowing remaining uncertain.

Foreign trade was adding significantly to GDP growth until recently; net exports added over 1 ½ percentage points to real GDP growth for the first three quarters of 2008. Since then, the trade contribution to U.S. growth has been declining in response to diminishing world growth prospects and the recent strength in the dollar. As a result, we can't count on the foreign sector to offset weak domestic demand for goods and services going forward.

Last month, the National Bureau of Economic Research officially confirmed what virtually all economists already knew — namely, that a recession began in December of 2007 when payroll employment peaked. For a time, the decline was fairly mild — in fact, milder than the last two recessions, both of which were themselves mild by historic standards. But conditions began deteriorating much more rapidly after the extraordinary deliberations in Congress in the second half of September. Since then, according to reports, many households and firms are taking a "wait and see" attitude, reducing or postponing nonessential outlays in response to a general sense of uncertainty about the potential meaning of these dramatic events for their own economic circumstances. Economic indicators have weakened markedly across a wide array of sectors since then, and the current contraction in economic activity now appears to be on par with the recessions of 1974-75 and 1981-82.

Looking ahead, housing market conditions will be critical to the outlook for overall economic growth. The housing market is by no means healthy right now; inventories of unsold, vacant homes are still large in many areas of the country, and, as a result, average home prices still are declining at a rapid pace. Having said that, I find it hard to believe new home construction has too much farther to fall, and that would imply that residential investment will soon exert much less of a drag on GDP.

Consumer spending will be another key determinant of the growth outlook. Because households tend to base their consumption plans on their income prospects, any improvement in consumer spending growth likely will depend on a shift to a more optimistic assessment of those prospects. Once households become convinced they can see an end to the deterioration in labor market conditions and the fall in equity and home prices, consumer spending growth will be based on improving longer-run income prospects and is likely to pickup substantially. It's too soon to tell just when and how rapidly that shift will occur, however.

But all told, it strikes me as reasonable to expect the U.S. economy to regain positive momentum sometime in 2009, for several reasons. First, monetary policy is now quite stimulative and real interest rates are quite low. Second, the energy and commodity price shocks that dampened economic activity last year have subsided already or are in the process of doing so. And third, as I said, the drag from declining residential investment seems likely to diminish significantly in the next year. In fact, I would be surprised if we don't see a bottom in housing construction sometime in 2009.

While the downturn in real economic activity is going to pose challenges for monetary policy in the period ahead, it's essential that we not let inflation drift from view. Since 2004, overall inflation has trended upward, and has been higher than I would like over the last few years. Much of the acceleration we saw last year reflected energy prices, however, and with oil prices down, we have seen overall inflation subside in recent months. Moreover, many economists are forecasting relatively low inflation in the months ahead, on the grounds that widening economic slack is generally associated with declining price pressures. I would be cautious about relying on this correlation as a causal relationship, however, even though it is detectable in many datasets.6 There have been times in the past when inflation declined only temporarily when activity slowed, and re-accelerated when the recovery began. And while it may seem premature to be worrying about how inflation behaves after the recession is over, we need to be sure our policy remains consistent with a strategy that does not allow inflation to ratchet up over the business cycle.

As I noted earlier, monetary policy is now quite accommodative. As growth prospects deteriorated after August 2007, the Federal Open Market Committee has brought the federal funds rate down from 5 ¼ percent to near zero. The fact that banks can always hold idle balances earning no interest will prevent further reductions in the funds rate from here. But even though it is common to think of policy in terms of the central bank's interest rate target, monetary policy fundamentally is always about the amount of monetary liabilities issued by the central bank — also known as the "monetary base." After all, hitting an interest rate target requires varying the quantity of central bank money, reducing the supply to raise rates and increasing the supply to reduce rates. Even when the policy rate has been driven down to zero, central banks can still dictate the supply of central bank money.

When interest rates approach zero, one often hears concerns about deflation, that is, a falling price level. I do not believe that deflation is major risk right now. But deflation can be dangerous because for any given interest rate, it increases the corresponding real (or inflation-adjusted) interest rate, and thus stifles growth. For a sustained deflation to emerge, people have to believe that the money supply will fall along with the price level. That's what happened during the first three years of the 1930s, at the beginning of the Great Depression, when the U.S. consumer price index fell by 27 percent, and the monetary base shrank by 28 percent.7 Central banks can prevent deflation by credibly committing to keep the money supply from contracting. Such a commitment is a natural byproduct of a credible commitment to price stability, but for a central bank that has not yet formally adopted an inflation objective, preventing deflation can present additional challenges. This is why some central banks increase the quantity of their monetary liabilities dramatically when interest rates are at zero — to convince the public they will not let the money supply contract in the future.

The monetary liabilities of the Federal Reserve Banks have more than doubled over the last several months, from around $840 billion the week ending September 11, to around $1.7 trillion the week ending December 31. Virtually all of this increase was in the form of bank reserves — the deposit balances that banks hold at their Federal Reserve Banks — which went from $8 billion to $848 billion over that period. (The rest of the monetary base consists of paper currency.) This increase in the Fed's money supply was a consequence of the collection of credit programs initiated last fall. Prior to October, the Fed was able to "sterilize" new lending through offsetting asset sales that soaked up the additional bank reserves, which otherwise would have increased the monetary base. After October, the cumulative amount lent became too large to sterilize, and further lending added to the monetary base. Luckily, the implementation of these large credit programs coincided with a time in which additional monetary stimulus was warranted.

But monetary policy and credit programs do two different things. Monetary policy stabilizes the purchasing power of money over time by keeping the price level stable and relatively predictable, and by doing so, contributes to maximum sustainable economic growth. Credit policy is also aimed at promoting growth, but it is more a form of fiscal policy in that it uses the public sector's balance sheet to alter the allocation of resources. In this instance, credit market interventions have been financed to some degree by the issue of new monetary liabilities, but they could just as well be financed with non-monetary liabilities, such as U.S. Treasury securities.

Mixing monetary and fiscal policy is fraught with risks. Many historical instances of monetary instability have been the result of central banks being prevailed upon to use their balance sheets for fiscal ends in ways that impeded their ability to keep inflation under control. That is why in recent decades, countries around the world have provided a measure of independence to their central banks, within frameworks that ensure accountability, in order to explicitly insulate them from short-run political exigencies that might diminish the credibility of their commitment to control inflation. The cornerstone of that framework in the United States dates back to 1951, when the Treasury-Fed Accord formally gave the Federal Reserve independent control of its balance sheet.8

Both the short-term benefits and the long-term costs of central bank credit have been and will no doubt continue to be debated for some time to come.9 But no matter how one assesses the overall merits of such programs, it is important to recognize that these are fiscal measures that are distinct from monetary policy. While at the present time, credit programs do not conflict with our monetary policy strategy, there could well come a time at which monetary stimulus needs to be withdrawn to prevent a resurgence of inflation, even though credit markets are not deemed fully healed. At that time, containing inflation may require closing down credit programs, or finding an alternative, non-monetary financing arrangement for them. Price stability, after all, is the vital first ingredient in financial market stability.

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1 A version of this speech was delivered at the Maryland Bankers Association Annual Economic Outlook Forum in Linthicum, Maryland on January 9, 2009. I am grateful to Roy Webb and John Weinberg for assistance in preparing this address.

2 Gary H. Stern and Ron J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts. The Brookings Institution Press, 2004.

3 John B. Taylor, "Housing and Monetary Policy," Federal Reserve Bank of Kansas City Symposium, 2007.

4 Jeffrey M. Lacker, "Financial Stability and Central Banks," Speech to European Economics and Financial Centre, London, June 5, 2008.

5 Marvin Goodfriend and Jeffrey M. Lacker, "Limited Commitment and Central Bank Lending," Federal Reserve Bank of Richmond Economic Quarterly, Fall 1999, vol. 85, no. 4, pp. 1-27.

6 Jeffrey M. Lacker and John A. Weinberg, "Inflation and Unemployment: A Layperson's Guide to the Phillips Curve," Federal Reserve Bank of Richmond 2006 Annual Report.

7 Robert L. Hetzel, The Monetary Policy of the Federal Reserve: A History. Cambridge: Cambridge University Press, 2008.

8 The Accord was necessitated by the conflict between the Treasury's desire for low borrowing costs conflicted and the FOMC's need to keep inflation from rising with the onset of the Korean War. See Robert L. Hetzel and Ralph F. Leach, "The Treasury-Fed Accord: A New Narrative Account," Federal Reserve Bank of Richmond Economic Quarterly, Winter 2001, vol. 87, no. 1, pp. 33-55.

9 Jeffrey M. Lacker, "Financial Stability and Central Banks," Speech to European Economics and Financial Centre, London, June 5, 2008; and Jeffrey M. Lacker, "What Lessons Can We Learn From the Boom and Turmoil?" Speech to the Cato Institute 26th Annual Monetary Conference, November 19, 2008.

Delivered to the South Carolina Business & Industry Political Education Committee in Columbia, South Carolina.

The Economic Outlook

By way of introduction, I would like to make a few observations on the economic situation. With the holidays concluded, it is clear that sales fell short of expectations for many retailers. Despite significant discounting it seems that consumers, worried about the economy and their own economic situation, curtailed their spending. Indeed, it appears that the economy contracted quite significantly in the final quarter of 2008, and may continue contracting over the first half of 2009. We are seeing businesses retrenching and unemployment rising, and many of our international trading partners expect equally grim results.

As a result, this recession looks to be longer and more severe than was originally forecast. Still, there are indications that the second half of the year will show improvement.

Consider several developments. Energy prices have fallen dramatically, making it much less expensive to drive cars or heat homes, freeing up much-needed cash flow for many consumers. Fiscal-stimulus packages being discussed in Washington could provide an economic boost. And monetary policy is also contributing. With the federal funds rate at historic lows, in a range only slightly above zero, and various lending facilities helping to lower the elevated spreads on many interest rates, the result is that many short-term interest rates are now significantly below the levels seen at the end of the third quarter. Also, recent actions by the Federal Reserve to reduce mortgage rates are having an impact, with mortgage rates already falling about 100 basis points from the end of the third quarter. While all of these developments will take a little time to fully impact the economy, they should be sowing the seeds for a recovery later in 2009.

Observations on the Housing Market

Now I would like to turn to the focus of my remarks, the housing market. By way of context, residential investment[Footnote 2] has been declining since the first quarter of 2006 (see Figure 1, which plots the quarterly percent change), and this decline in residential investment is already of notable length and depth relative to previous housing downturns.[Footnote 3]

It goes without saying that it is important to the broader economy that the housing market stabilizes. Normally, housing markets decline because mortgage interest rates have risen and the higher cost of obtaining a mortgage weighs down residential investment. During more normal times, the Federal Reserve can address this by reducing the federal funds rate, a step that usually helps to lower mortgage rates – and the housing market improves.

But this housing downturn is different. Increasingly, the housing market is impacted more by the availability of credit than the cost of credit.

Borrowers who have poor credit histories or little equity in their homes are having difficulty finding mortgages – even higher-rate mortgages. Borrowers looking for home equity loans or seeking to refinance are finding that falling housing prices have reduced their ability to borrow against the value of their home. Borrowers that stretched to purchase or refinance their home are finding it difficult to stay current on mortgage payments if a family member is laid off or assigned reduced hours, or if other problems strike the household.

Given all these factors, it is important to recognize that no one solution is likely to fix our housing market challenges. And let me be clear, I am not for a moment suggesting the return of lax underwriting standards. Rather, I am suggesting that with a variety of well-designed approaches, tailored to current problems, the housing market can and should stabilize – by which I mean easing the difficulties with the cost and availability of mortgage credit that we are seeing, which in turn would support housing markets more generally.

I plan tonight to first discuss some recent trends in the housing market. I will then touch on actions that could influence the cost of financing for housing. I will then discuss some actions that could influence the availability of financing for housing – especially for troubled borrowers – before offering a few concluding remarks.

I. Recent Trends in Housing

As Figure 2 illustrates, single-family housing starts have declined precipitously from their peak in January 2006. The extent of the decline is so striking, in part, because of the large increases in housing starts that occurred over this decade. But housing starts are at their lowest level in the past 50 years – and many private forecasters suggest they have not yet bottomed out.

Of course, the decline in housing starts is playing a necessary role in reducing the excess inventory of new homes for sale. As shown in Figure 3, there has been a substantial decline in that inventory – although at 374,000 units for sale as of November, new homes for sale still remain above the historical average.

Sales have declined for new homes of all price ranges. For the most expensive homes, “jumbo” mortgage rates remain very elevated relative to conventional mortgages. At the other end of the spectrum, purchasers of the least expensive homes are having great difficulty securing financing if they have little down payment equity, or low credit scores.

A critical aspect of the current situation has been the disruption of the securitization[Footnote 4] process, where mortgages are sold to be part of a security backed by many (pooled) mortgages, and re-sold onto the secondary market to investors. For expensive homes that are financed with jumbo mortgages, the disruptions in securitization have caused rates on jumbo mortgages to rise even while the federal funds rate has dropped sharply. Prior to the financial-market disruptions that began in August 2007, jumbo mortgage rates had moved closely with conventional mortgage rates, with an approximately 25 basis-point premium over conventional mortgages (see Figure 4). However, the spread became quite large as securitizing jumbo mortgages became increasingly difficult. Many jumbo mortgages were provided by portfolio lenders who began to demand a premium over what they had required when the loans could be more easily securitized.

The current government-sponsored enterprise (GSE) cut-off for jumbo mortgages is $417,000 nationally, although the limit is $625,500 in some areas with particularly high costs of housing[Footnote 5] and is somewhere between $417,000 and $625,000 in certain cities and counties. In places with a relatively high cost of housing, the large premium for jumbo mortgages is a deterrent to home purchases. Raising the maximum amount on conforming mortgages would likely go some way towards reducing this spread, by making it easier for the industry to securitize home loans and thus for borrowers to purchase homes in regions where housing costs are high.

Of course, securitization is also disrupted for subprime[Footnote 6] and Alt-A loans. The result has been that borrowers with limited down-payments, low credit scores, or other issues are finding it increasingly difficult to obtain mortgage financing – even at rates well above conventional prime mortgages.

With the securitization market not seeming ready to recover in the near term, one thinks of the traditional way that low- and moderate-income borrowers qualified for mortgages prior to the expansion of the subprime market – through Federal Housing Administration (FHA) lending programs. They alleviate some of the risk of lending to borrowers who can only afford a small down payment and therefore might have difficulty obtaining a conventional mortgage product.

However, many would say that FHA lending has a reputation for bureaucracy and unwieldiness. By many accounts, FHA has been working to address this, and there have been significant modifications made to traditional FHA lending programs. At the Boston Fed we have developed a brief guide with questions and answers that may be helpful to institutions considering becoming an FHA lender – either a correspondent or a full mortgagee.[Footnote 7] The resource is available on our website.[Footnote 8]

FHA mortgage lending expanded quite significantly in the latter half of 2008. Still, many banks remain unwilling to participate. Making these programs more accessible to borrowers and banks would help ensure that low- and moderate-income borrowers can obtain financing, which should help stabilize the market for lower-priced homes.

II. Policies that Influence the Cost of Financing for Housing

As we consider steps that could assist the recovery of housing markets, I would now like to share some perspectives on the potential for policies to influence the cost of financing for housing. Over the past 18 months, the Federal Reserve aggressively lowered the federal funds rate, as financial problems worsened and the economic outlook deteriorated. But despite aggressive easing, many interest rates in the marketplace remained high, or rose – thus, the “spreads” between overnight fed funds and many rates in the marketplace widened considerably.

These elevated spreads reflected investors’ pessimism about the economic outlook and lack of liquidity in many financial markets. The lack of liquidity raised investors’ concerns about their ability to resell financial assets other than Treasury securities without very steep discounts. This has been particularly evident for assets with longer maturities, lower credit quality, or structured financing. The sharply discounted sale prices on some mortgage-backed securities implied a very bleak outlook for default experience.

While the federal funds rate declined substantially over the past 18 months, the rates that many borrowers paid to finance assets rose, or declined by much less than would have been expected given the decline in the federal funds rate. This unusually large widening of interest-rate spreads implies that the transmission mechanism for monetary policy has been impacted. If the goal of monetary policy is to avoid severe economic problems and maintain liquid markets, the evident disruption to the transmission mechanism implies that more than just a lower base rate is needed.

So, over the past year the Federal Reserve System designed a variety of liquidity facilities, aimed in large part at reducing the interest rate spreads on short-term, high-quality assets. In particular, the interbank loan market (as reflected in the London Interbank Offered Rate or LIBOR) and the market for short-term commercial paper saw extremely high spreads, as Figure 5 and Figure 6 show. Because the central bank established a variety of liquidity facilities designed to address these markets, the spreads have declined substantially. Further evidence of reduced stress in short-term markets comes from the Federal Reserve’s Term Auction Facility (TAF), where the auctions have recently been under-subscribed and stop-out rates have been equal to the Overnight Index Swap (OIS) rate.

As investors become more confident that they can sell assets if needed, the premium on liquidity falls, and interest spreads decline. By supporting short-term credit markets, the Federal Reserve is signaling its determination to take appropriate actions to prevent “seize-ups” in financial markets, reducing the risk premium. In short, we have seen improvements of late in the functioning of many short-term credit markets, and I expect this improvement will continue.

Improvements in short-term credit markets do have indirect effects on the housing market. Some mortgages, particularly sub-prime loans, were tied to the six-month LIBOR rate. As short-term rates have fallen, those who either refinance or whose adjustable rate mortgages adjust are suffering smaller payment shocks.

However, many interest rates remained relatively unresponsive to the decline in the federal funds rate. Figure 7 shows that during 2007 and the first half of 2008, mortgage rates remained around 6 percent and the rates on “Baa” rated corporate bonds actually rose. As conditions in the short-term credit markets have started to improve, and as the base federal funds rate is trading between 0 and 25 basis points, it seems that improving housing finance is likely to take concerted fiscal and monetary policy actions.

On the fiscal side, it is possible that Fannie Mae and Freddie Mac could play a more significant role in restoring liquidity and providing a secondary market for mortgages that reflect the lower cost of funds in many credit markets. Further exploration of the GSEs’ options for pricing and programs may result in additional support to the mortgage market.

On the monetary policy side, the Federal Reserve announced on November 25 that it would be buying up to $100 billion in GSE direct obligations, and up to $500 billion in mortgage-backed securities.[Footnote 9] A subsequent announcement on December 30 provided more details.[Footnote 10] Since the announcement of the program, designed to reduce the recently widening rate spreads on GSE debt and on GSE-guaranteed mortgages, mortgage rates have declined (see Figure 8). Some mortgages in Boston are now available for under 5 percent.

Lower mortgage rates help alleviate the current problems in several ways. First, potential home buyers have the possibility of buying their homes with the lowest rates in the past 30 years. Because interest rates may only be lower temporarily, they provide an incentive for buyers to purchase now rather than wait in the hope that home prices fall more. In terms of cash flow, locking in a lower rate now may be more important than potentially buying the home at a somewhat lower price, later. Obviously, getting buyers “off the sidelines” and back into the market is critical for a housing market recovery. Second, the lower rates provide the opportunity to refinance. This can improve cash flow, freeing up household resources to fix up the home or consume other items. Third, lower rates have the advantage of benefiting credit-worthy borrowers as well as more troubled homebuyers.

Low mortgage rates primarily benefit home buyers with significant equity for a down payment and good credit scores, and borrowers that seek to refinance and still have significant equity in their house as well as good credit scores. However, if prices stabilize, home owners and holders of mortgage instruments will benefit. Since stabilizing the housing market is critical, expanded use of policies that address the cost of housing finance may give further impetus for new home buyers and existing mortgage holders to take advantage of what are very low rates by historical standards.

III. Troubled Homebuyers and the Availability of Financing for Housing

Now a few comments on the availability of home finance. Clearly, there are many borrowers that are unlikely to fully benefit from the aforementioned lower mortgage rates, because they have negative home equity or poor credit scores. It can be helpful to think of these troubled borrowers in segments. There are those who are stressed but still making their payments, despite impaired credit scores or home equity; those who are temporarily unable to make payments (for example because of reduced hours, a spell of unemployment, or health issues); and those whose inability to make the payments is not temporary, but permanent. Different approaches are probably necessary for borrowers in these different circumstances.

For borrowers who continue to make payments but are under stress and unable to ease their payment burden through refinance (perhaps because they cannot provide a significant down payment), one possibility is to improve access to FHA loans. During the subprime boom, many lenders stopped providing FHA loans.[Footnote 11] Improving access to FHA programs, and providing greater incentive for bankers to provide FHA loans, could help many borrowers gain access to the market at relatively favorable rates. Since many banks have been raising their minimum credit score to qualify for mortgages, the FHA may be able to provide loans for borrowers whose credit history is not up to current thresholds, yet have the capacity to make payments.

During a recession like the current one it becomes increasingly common for borrowers to experience temporary setbacks. A family member might lose a job, have hours reduced, or no longer get overtime. These can all present significant difficulties, and these problems can be compounded if a family member encounters significant health issues. For such individuals, steps such as deferring payments or reducing interest rates can prevent foreclosure. By providing a temporary or permanent reduction in payments, the lender can avoid foreclosure and bridge the borrower through a difficult period. Of course, with a job loss and loss of income the required payment reduction, while temporary, can be quite significant, on the order of 50 percent. For this type of borrower, small modifications are unlikely to prevent foreclosures.

The United Kingdom has announced a program that focuses on borrowers facing temporary challenges – allowing lenders to reduce interest payments, with the deferred payments added to the principal and paid when the borrower’s circumstances improve.[Footnote 12] The British government guarantees the lender against a percentage of the deferred interest payments. In a similar vein, a proposal developed by several Federal Reserve economists, and available on our website,[Footnote 13] suggests that the U.S. government could pay a significant portion of monthly payments for borrowers who are facing severe but temporary financial setbacks. There are two variants to the proposal. One way in which such a plan might work is for the government to offer these borrowers temporary loans that must be paid back once the borrower returns to financial health. Another version of this plan calls for the government to offer grants, not loans, to borrowers who have adverse life events, such as job loss.

Importantly, both versions include aspects that will minimize the number of people who would sign up for government help when they do not really need it.[Footnote 14] While any extension of direct government assistance to borrowers has potential “moral hazard” problems, the mere potential for such problems should not automatically derail proposals that are likely to keep temporarily troubled borrowers in their homes.

Of course, variants of these proposals are currently being used by mortgage servicers. At an event at Gillette Stadium last August, the Federal Reserve Bank of Boston in conjunction with the Kraft family, the New England Patriots Charitable Foundation, the HOPE NOW Alliance, and NeighborWorks America brought troubled borrowers together with mortgage servicers to help address preventable foreclosures. The results, based on follow-up contacts with a subset of the 2,200-plus borrowers that attended the event, are shown in Figure 9. A little more than one-third of borrowers, about 35 percent, received some type of modification or workout offer from servicers. The most prevalent type was a loan modification that reduced monthly payments, which was received by 27 percent of borrowers. These were achieved by reductions in interest rates or by plans that lowered payments on a temporary basis. Only in very rare cases was the outstanding balance of the mortgage reduced.

Allow me to make an important parenthetical note. As mortgage rates decline, the ability of servicers to provide these interest rate concessions to borrowers should increase.

Large foreclosure-prevention events like this are one way to bring troubled borrowers together with servicers, since borrowers often complain they have difficulty reaching servicers and servicers complain that many borrowers do not open mail or return calls. Indeed, we at the Boston Fed will soon be announcing another such foreclosure-prevention workshop, to be held in Connecticut. While such events can play an important role, I think we would all agree that more systematic approaches or programs are desirable to reach a larger number of troubled borrowers.

The third pool of troubled borrowers involves those that realistically are not going to be able to make their mortgage payments. In such cases, it may well be impossible for lenders and borrowers to work out a plan. But that does not mean that nothing can be done to make the best of a difficult situation, for the borrower as well as their neighbors and the housing market in their area. One possibility is to provide borrowers who have little or no housing equity and are unable to make mortgage payments with assistance to move to a rental property. Some may eventually have the capacity to purchase a home that is affordable to them, while for others, renting may be the appropriate long-term solution. But there is an important role for stabilization in high-foreclosure communities and a need to put foreclosed properties back to productive use, whether for rental or homeownership. An alternative would involve the government making a significant financial commitment that makes the mortgage affordable on terms acceptable to the lender – but the cost of such a program would likely be very high.[Footnote 15]

Conclusion

The housing market has played a significant role in current economic problems. But with appropriate steps, the housing market could stabilize this year. The recent reductions in mortgage rates, in part due to monetary policy actions, have enabled more borrowers than would otherwise have done so to purchase or refinance homes. Expansion of this effort, and encouraging greater GSE participation, should encourage borrowers that have equity and reasonable credit scores to purchase or refinance homes.

For more troubled borrowers, programs will need to be designed to address the specific nature of their problem. For some borrowers, greater use of FHA programs may be appropriate; while for others, interest rate concessions that are now more affordable for lenders may serve as a bridge for the temporarily impaired.

Let me conclude by making a point that should not be overlooked. Although it is a discussion for another day, we need to remember that once the market has stabilized, much work needs to be done to structure mortgage securitization in a way that that reduces the likelihood of future episodes of significant upheaval in mortgage finance. And more generally, financial regulatory reform will also be a key policy topic this year.

Thank you and I wish you the very best in the year ahead.

Delivered at the Massachusetts Mortgage Bankers Association 2009 Annual Dinner on January 8, 2009.

Complete speech here, with figures.

At first blush it should be said that economies grow when the ideas of entrepreneurs are matched with capital. Joseph Schumpeter wrote that entrepreneurs “disrupt”, but in order for them to do so they must first have access to existing economic assets in order to render them more productive.

When we consider the above, it’s fair to say that the federal government’s present proclivity to bail out anything and everything is anti-entrepreneur. Indeed, it is when companies are allowed to fail that the intrepid among us are able to snap up human and physical assets on the cheap in order to deploy them more profitably. So the first positive step from our federal minders would be for them to let markets reward the winners, all the while allowing the failed commercial combinations to go out of business.

Outgoing Treasury Secretary Henry Paulson seems to reinvent the Troubled Assets Relief Program (TARP) on a daily basis, but one of his foremost desires remains a reflation of sagging banks. In this instance he would like them to issue more credit cards so that individuals start consuming again. This sounds intriguing at first glance, but then economies never lack consumption so long as there is production. Bringing the entrepreneur into the equation once again, if TARP is tied to aiding the flagging consumer, eager new business entrants will suffer on the margin for capital being consumed rather than loaned to them with future growth in mind.

On the housing front, there’s seemingly a bipartisan consensus among economists that a healthy housing market is the path to our economic resurgence. The thinking here is backwards. A vibrant housing market doesn’t so much grow the economy as it’s the consumptive result of an otherwise productive commercial setting. Simply put, strong property markets in New York City and San Francisco aren’t the driver of either economy; instead the housing markets in both are the fortunate result of robust economic activity in both cities.

So when the federal government seeks to use monies taxed or raised from the private sector in order to reduce mortgage rates and mortgage payments, it is in fact authoring our economy’s continued decline. This is surely the case if we yet again put the entrepreneur at the center of any presumed economic reawakening. To the extent that the government is reorienting capital away from the innovative sector, there is surely a smaller pool of capital available for innovators to bid for.

But perhaps the most paralyzing governmental activities when it comes to future growth are the efforts being made by the Treasury and the Federal Reserve to ease what many deem a “credit crunch.” When markets tighten with regard to credit, this is an essential market signal telling sidelined investors that returns will be high for the investor willing to take big risks.

In the above sense, start-ups in Newark (NJ) and East St. Louis regularly face tight credit conditions, but at the same time courageous investors are frequently rewarded for taking those risks. To the extent that rates of interest are presently high even for what many would consider safe investments, it’s essential that the rate signals be true as a way of attracting the very capital and growth that will eventually bring borrowing rates down once again.

While difficult credit conditions right now might paint a bleak picture for entrepreneurs, even worse for the latter is the process whereby the federal government blurs the price of credit, and in doing, drives investors away altogether. Capitalism is in the end reliant on the efficient deployment of capital, and when the blunt hand of government distorts this process, the certain result is less capital for all manner of new business entrants.

Schumpeter ultimately made plain that without access to capital, the entrepreneur “cannot become an entrepreneur.” And so as long as the federal government expropriates capital while distorting the market for same, the agents of growth eager to divert down-and-out assets to higher uses will lie in wait. In short, the answer to these difficult times isn’t more government, but instead a humble government that simply allows producers to produce.

The definition of “insanity” is, “doing the same thing over and over again, expecting a different result”. Given the failure of “stimulus” everywhere and every time it has been tried (the U.S. in the 1930s, 2001, and 2008, Japan in the 1990s, etc.), Keynesianism is actually a form of insanity. Accordingly, let’s call the belief in stimulus “stimulunacy” and the people who believe in stimulus “stimulunatics”.

As they battle to the death over the specific allocation of the spending (infrastructure, aid to the States, food stamps, tax rebates, etc.) the stimulunatics ignore the one thing that all such plans have in common. The very first step in every “stimulus” program is for the government to go out into the market and sell bonds.

When the government sells bonds, it takes money—and therefore demand—out of the economy. Then, some time later, the government puts the money back into the economy in the form of spending or tax rebates or whatever. Later, when the data becomes available, economists are shocked, shocked to find that “consumers saved their rebates” or “business investment fell by an unexpected amount”, or “imports increased”, thus completely negating the “stimulus”. Their hopes dashed, but their belief in “stimulus” unshaken, the stimulunatics then call for more “stimulus”.

The fact is that for the government to be able to sell the bonds in the first place, consumers have to save, or businesses have reduce their investments, or foreigners have to sell more in the U.S. Otherwise, where would the dollars to buy the bonds come from?

“Wait!” the stimulunatics cry. “What if the Federal Reserve buys the bonds with newly-created money? Won’t that increase demand?”

The answer is, “Sure—but then you don’t need the ‘stimulus’ program.”

Demand is created by money, and as soon as the Fed creates more money, it creates more demand. Government “stimulus” spending is irrelevant to this process.

“But wait!” the stimulunatics protest. “What if the banks won’t lend out the newly-created money? What if we are in the dreaded ‘liquidity trap’? What if the Fed is ‘pushing on a string’?”

The answer to this one is, “There is no such thing as a ‘liquidity trap’.”

The “liquidity trap” fantasy had its genesis in the peculiar practice of conducting monetary policy against an interest rate target. If a central bank is targeting an interest rate and it gets “behind the curve”, it can lower its target to zero and still not be creating enough money to prevent deflation.

This is what happened to Japan during the 1990s. Japan’s economy sank into a deflationary recession that went on for more than ten years. During this period, Japan, which must have lots of stimulunatics in positions of power, borrowed and spent trillions of yen on “stimulus” programs. The only effect of these programs had was to drive Japan’s national debt up to more than 120% of GDP, about three times higher than that of the U.S.

Eventually, the Bank of Japan abandoned its interest rate target and simply started creating more yen (so-called “quantitative easing”). It was quantitative easing, not Japan’s enormous “stimulus” programs, that eventually eased Japan’s deflation and recession. The lesson is that if you need more demand, you need more money, not government “stimulus” programs to move the existing money around in circles.

There is no limit to the Fed’s ability to create money, so there is no limit to its ability to create demand. The Fed creates money by buying assets. It is true that the newly created money appears in the form of bank reserves. However, it is also true that the Fed buys each asset from someone. That someone formerly owned the asset, and now they have money. Having just been the seller in the transaction involving the asset, that person is in a position to be the buyer in another transaction. If this person decides to stuff the newly-created cash in a mattress, the Fed can just keep buying assets until it gets the level of demand that it wants.

“But wait!” the stimulunatics cry. “If the Fed creates a lot of new money, won’t that produce inflation?”

The answer to this is, “Very possibly. This is one of the problems with an undefined dollar. But ‘stimulus’ spending does nothing to solve this problem.”

Because the dollar is an undefined “floating” currency, there is no way to know how the demand the Fed creates will express itself. The Fed can force nominal GDP to rise, but it currently has no control over how much of the increase comes in the form of inflation and how much as real economic growth.

The undefined, unstable dollar is actually the most fundamental economic problem we face, and was the underlying cause of the current economic/financial crisis. A stable dollar is a prerequisite for a stable, growing, prosperous economy.

So, we must stabilize the dollar. But what if we do that and the economy still isn’t growing fast enough?

While it is not possible for the Federal government to stimulate “demand”, it is possible to stimulate private business investment. It is private business investment that directly creates both employment and GDP growth.

The most potent way to stimulate private business investment in the U.S. would be to abolish the corporate income tax. Based upon recent CBO numbers, eliminating the entire corporate income tax would cost only about $326 billion the first year. This is less than half of the money that the stimulunatics are planning to pour down their various rat holes this year.

Stabilizing the dollar and eliminating the corporate income tax would ignite an economic boom of staggering proportions. This would be real economic stimulus, not Keynesian stimulunacy.

A few months after his inauguration, Lincoln described his understanding of the founding fathers’ approach to government in his July 4, 1861 message to congress: “the leading object of government is … to lift artificial weights from all shoulders; to clear the paths of laudable pursuit for all; to afford all an unfettered start and a fair chance in the race of life. Yielding to partial and temporary departures, from necessity, this is the leading object of the government for whose existence we contend.”

The current discussion about proper regulation of the financial markets involves the age-old debate of whether free markets work more effectively or whether more government regulation helps the economy.

In answering this question, one should consider Lincoln’s interpretation of the founding fathers’ “leading object of government.” When a government imposes legislation and regulations on the markets that discourage certain enterprises and encourages those with artificial weight from the government, there is both a financial and a social cost.

In seeking to remove artificial weights, Lincoln looked to the Declaration of Independence. Lincoln believed that the statements in the Declaration of Independence were not object truths in existence, but were aspirational goals to be sought by our government. He recognized that while “all men are created equal” and “endowed by their creator with certain unalienable rights”, the government of the United States had not, and could not, reach the perfect place so described. Nevertheless, Lincoln pushed the country toward that goal and led the country closer to those ideals.

Now we are faced with a much different question regarding how best to apply government power. The answer, though, stems from the original role set forth for the government. We should not abandon the ideals established by our founding fathers, but rather use them to lead us through difficult times – as Lincoln did.

Government should not choose which businesses to encourage and which ones to discourage. It is the marketplace that decides those that are most productive and essential and those that should flounder. It is the markets that drive innovation and creation of new and vital ventures.

Yet, for now, we have accepted and embraced certain government intervention. We have, as Lincoln stated, “yield[ed] to partial and temporary departures, from necessity.” Such acceptable temporary departures include the temporary propping up of frozen credit markets and the economic stimulus given to government industries, such as defense and infrastructure. But these temporary departures, yielded to upon necessity, should not make us think that it is necessary to enact permanent legislation.

We have not reached – and probably will never reach – the perfect free marketplace in which all participants have complete transparency and freedom, but that does not mean that we should abandon the pursuit of the best marketplace we can achieve. Nor does it mean that we should allow the government to control and choose the activities to be pursued by those it governs.

Part of what makes up a free society is a free marketplace in which individuals succeed and fail on their own, not because the government has chosen their success or failure. Lincoln did not abandon the concept of “all men are created equal” simply because he did not believe that it could exist in reality. Instead, he pursued the “unalienable rights” of all men, regardless of the imperfect ability of the government to deliver those rights.

If Obama is to bring “change” to Washington D.C., he must live by the high ideals adhered to by Lincoln. In particular, he must avoid regulation and interference in the markets that lay artificial weights upon the shoulders of men and women.

Precisely this specter explains why the word "depression" is so routinely deployed, even though we're a long way from the bread lines of the 1930s. But the Great Depression also signifies a period when we lost control. For all the New Deal programs, the Depression lasted a decade and ended only with World War II. Even in 1940, unemployment averaged almost 15 percent. It's the worry that government won't triumph over today's economy that justifies, for many people, the bleak analogies.

The pessimism stretches across class and political lines. A December survey by the Pew Research Center asked whether economic conditions would be worse in a year. Among those with incomes under $30,000, 51 percent thought so; for those with incomes exceeding $100,000, the response was almost identical, 53 percent. Another question was whether unemployment would rise in the next year; 57 percent of Democrats, 64 percent of independents and 66 percent of Republicans said yes.

This democratic (with a small "d") despondency has many causes. As more Americans invested in stocks, more became exposed to the market's wild psychological and financial swings. The plunge in home values has made many workers with secure jobs poorer. And, of course, layoffs themselves have become more democratic. Once, the young and blue-collar workers bore the brunt of firings. Now, managers, investment bankers, journalists, scientists -- almost anyone -- can be canned. Age confers little security. In December, almost a third of the jobless were 45 and over.

What offends middle-class Americans, most of us, is economic capriciousness. People crave order, predictability and security. They want to believe that personal virtues of studying, working hard and planning will be rewarded in the marketplace. Even in good times, these ambitions are often frustrated. But in today's economy, the disconnect has widened. Setbacks and losses seem increasingly divorced from personal effort. Our whole values system seems besieged.

Since World War II, Americans have only once before experienced a similar economic trauma: the double-digit inflation of the 1970s (13 percent in 1979). Work and thrift were undermined because inflation threatened the worth of wages, salaries and savings accounts. Then as now, people were terrified; inflation seemed uncontrollable. Starting with Lyndon Johnson, four presidents had failed. No one knew how high it might go. Then as now, we seemed unable to chart our destiny.

What suppressed inflation was the brutal 1981-82 recession undertaken by Federal Reserve Chairman Paul Volcker and supported by the newly elected Ronald Reagan. Unemployment reached a peak of 10.8 percent, but gluts of jobless workers and idle factories broke the wage-price spiral and ushered in two decades of strong economic growth. Reagan won a landslide reelection in 1984; his campaign featured a signature TV spot that boasted, "It's morning again in America."

Up to a point, there are parallels for Obama. Today's misery is a political opportunity. Reagan's popularity soared on the belief that he had reestablished economic order. The country had reasserted control of its future. These gains offset the recession's severity and its hangover. In 1984, unemployment still averaged 7.5 percent.

If Obama can overcome the sense of helplessness, he will surely reap much political credit. There need not be a boom -- the economy must achieve just enough sustained growth to convince most people that it's manageable and that we have not descended into a new dark age.

Here, the parallels break down. Volcker and Reagan embarked on a deliberate effort to quell inflationary psychology; the question was whether the recession could be maintained long enough to do the job. Obama faces a global recession brought on by murky forces barely understood. The effort to counteract them and to prevent further economic damage is a grand and confused experiment. If it fails, Obama's burden will be back-breaking.

I walked right up to the counter! At Mike’s Pastry, second in fame only to the Old North Church where Paul Revere espied his lanterns! I didn’t have to do that neat trick of slinking along the left past the clueless mob until I could catch the eye of a harried server always ready to conspire with a patron who actually knows what he wants. Mike’s Pastry, from which a steady flow of little white bakery boxes emanates like a mighty river one can follow back upstream anytime from anywhere in the city.

I was so dumfounded when not one but two servers asked me what I wanted I could barely blurt out “two sfogliatelle with powdered sugar” before forking over all the singles in my wallet and beating a panicked retreat.

Don’t worry about the Producer Price Index, the National Purchasing Managers Index, the Consumer Confidence Index, or the Durable Goods Order Report.

The Sfogliatelle Index has hit the skids!

After a sleepless night I was encouraged by early morning reports on NPR that Congress was already swinging into action. “We will not let this critical economic engine of our fair city succumb to a decline in demand,” intoned Representative Blarney Flank. “I have on my desk an amendment to the TARP program that will finance the distribution of two-and-a-half billion sfogliatelle coupons to all those made hungry by greedy mortgage bankers and overpaid Wall Street CEOs.”

Before I could jump for joy and ask where I could apply for my coupon, my hopes were dashed. Congressional hearings had apparently been scheduled by Pennsylvania Senator R. Len Spectacle for that afternoon to investigate the impact of the proposed Sfogliatelle Amendment on the Philadelphia-based Tastykake Corporation. “It is important – no imperative – that in these troubled times we consider the needs of all of our essential confectioners.”

I sensed gridlock coming. Surely, the sfogliatelle advocates could muster 60 votes to break any filibuster threats mounted by mere Tastykake eaters trying to muscle in on my coupons?

Before I could search for Representative Flank’s number to phone in my support and get invited to a fund raiser, an ominous voice from the TV told me how serious this crisis had become.

“Two-and-a-half billion confection coupons is not nearly enough,” Nobel Prize winning guru Paul Klugman bellowed as he whipped a crowd of finance groupies into a frenzy. “We must consider the multiplicative effects of a decline in confection consumption on the entire agribusiness supply chain both in the US and abroad. Have we not learned from our experiences in the Great Depression that failure to spend our way out of poverty can only impoverish our spenders!”

This appeal to my patriotism made me want to sneak out for another sfogliatelle. But why pay Mike’s outrageous prices when a coupon was only a few votes away? Let those dumb Philadelphians have their nasty Tastykake coupons too, it’s not like they’re spending my money.

As the day wore on and the Financial News Network reported blow-by-blow details of the emerging consensus surrounding the National Confectioners Consumption Preservation Bill, I pined for the simpler days when a sfogliatelle was just a sfogliatelle and not a national priority. But I suppose that as long as this new era of comity and bipartisanship prevails, I can rest easy knowing that the planners of every detail of our economic future know exactly what they are doing.

Early in his speech Reagan set it all out: “These United States are confronted with an economic affliction of great proportions.” He then defined the central problem: “We suffer from the longest and one of the worst sustained inflations in our national history. It distorts our economic decisions, penalizes thrift, and crushes the struggling young and the fixed-income elderly alike. It threatens to shatter the lives of millions of our people.”

Media commentators regularly compare the current downturn with the Great Depression, which seems like a big stretch. And there’s a good chance Reagan was dealt a much tougher hand than the one Obama is holding today.

For one thing inflation today is zero. Back in Reagan’s time it was double-digits. Interest rates today are historically low. In Reagan’s day they were 15 to 20 percent. We have suffered a tremendous oil shock, as did Reagan. But today’s shock has completely reversed. And while today’s recession is over a year old, Reagan inherited a recession that began in 1979 and didn’t end until late 1982.

Obviously, we now have the housing problem and the bank credit crunch. But some of that was present in Reagan’s challenge, too. And a recent study from the Minneapolis Fed shows that several measures of output and employment haven’t come close to the severe levels reached during many post-WWII recessions, much less the Great Depression.

Rising to these challenges, Reagan gave his Fed chairman, Paul Volcker, the political ground to stand on to slay inflation with tough monetary restraint and a strong dollar. It was a signature achievement, and it opened the door to more than 25 years of unbelievable prosperity and wealth creation. Reagan also fingered excessive taxes as a chief recessionary factor. His second great achievement was dropping the top marginal tax rate on individuals from 70 percent to 28 percent.

It’s interesting how Obama has also cast himself as a tax cutter, even though he’s not slashing marginal tax rates. He instead opts for tax credits. But there’s a similarity here to Reagan. So far we don’t know if Obama will repeal the Bush reductions in marginal tax rates on investment, but he seems to be leaning against it (even as House Speaker Nancy Pelosi wants immediate repeal).

One inaugural line of Reagan’s in some sense encapsulates his philosophy: “In this present crisis, government is not the solution to our problems; government is the problem.” It arguably is the most famous line of the speech. Fifteen years later, in a State of the Union message, President Bill Clinton said “the era of big government is over.” Yet Barack Obama has said that only government can solve our current economic problems. Will he say as much in his inaugural address, and will it represent a complete reversal of the past three decades?

Reagan, of course, was the quintessential optimist, and his inaugural speech is chock full of optimism: “It is time to reawaken this industrial giant. . . . And as we renew ourselves here in our own land, we will be seen as having greater strength throughout the world. We will again be the exemplar of freedom and a beacon of hope for those who do not now have freedom.”

He also said, “We are not, as some would have us believe, doomed to an inevitable decline. So, with all the creative energy at our command, let us begin an era of national renewal. Let us renew our determination, our courage, and our strength. And let us renew our faith and our hope.” One can only hope that Obama, who has been sounding very bearish lately, can strike such a bullish and optimistic tone about America’s economic future.

Finally, regarding our enemies, Reagan spoke of “the will and moral courage of free men and women.” He said, “Let that be understood by those who practice terrorism and prey upon their neighbors.” Reagan mentioned George Washington, Thomas Jefferson, and Abraham Lincoln. He praised all those who gave their lives in defense of America’s freedom and national security. He said, “We are a nation under God, and I believe God intended for us to be free.”

It is reported that Barack Obama is reading past inaugural speeches in preparation for his own. Let’s hope he has read the great words of Ronald Reagan’s inaugural address in 1981.

What started as the Subprime Crisis in 2007 and morphed in the Global Credit Crisis in 2008 has become the Euro Crisis in 2009. Sober people are now contemplating whether a euro area member such as Greece might default on its debt. In addition to directly damaging bank balance sheets, this would destroy confidence in its banking and financial system. Unable to borrow and facing horrific bank recapitalisation costs, the country would have to print money. To do so it would have to abandon the euro and reinstate its old national currency.

As not a few critics – from Willem Buiter to Wolfgang Munchau to yours truly – have observed, the previous paragraph is rife with dubious premises and logical non-sequiturs. To start with, that Greece will be allowed to default is questionable. There is an alternative, namely fiscal retrenchment, wage reductions, and assistance from the EU and the IMF for the cash-strapped government.

To be sure, this alternative will be excruciatingly painful. No one will like it except possibly the IMF, which will relish the opportunity of reasserting its role as lender to developed countries. There will be demonstrations against the fiscal cuts and wage reductions. Politicians will lose support and governments will fall. The EU will resist providing financial assistance for its more troublesome members.

But, ultimately, everyone will swallow hard and proceed, much as the US Congress, having played rejectionist once, swallowed hard and passed the $700 billion bank bailout bill when disaster loomed.

Admittedly, if the current crisis has taught us one thing, it is that we should not underestimate the ability of politicians to get it wrong. But even the most blinkered politicians will see what is at stake here. Investors would flee en masse from the banks and markets of a country that contemplated abandoning the euro (Eichengreen 2007). No matter how serious the crisis, politicians will realise that attempting to jettison the euro will only make it worse.

Another lesson of the crisis is that financial shocks can spread unpredictably. No one knows whether or not a Greek default would cause Irish and Italian bond prices to collapse, precipitating full-fledged debt and banking crises there. But no one wants to find out. In the end, the EU will overcome its bailout aversion.

Euro Adoption Is Irreversible: Was it a Mistake?

The euro area will hang together, in other words, because the decision to enter is essentially irreversible. Getting out is impossible without precipitating the most serious imaginable financial crisis – something that no government is prepared to risk.

But then was the mistake getting in the first place? Opponents of monetary union founded their arguments on asymmetric shocks. They argued that adverse shocks affecting some members but not others were so prevalent that locking them into a single monetary policy was reckless. If those asymmetric shocks hit heavily-indebted countries, then the latter would also have no capacity to deploy fiscal policy in stabilising ways. Absent coping mechanisms like a system of inter-state transfers, the only option would be a grinding deflation and years of double-digit unemployment. More prudent would have been to allow such countries to retain the option of pushing down the exchange rate instead of pushing down wages. Desperately needed improvements in competitiveness would then be more easily engineered. This is the “daylight-savings-time argument” for exchange rate flexibility.

Part of what we have seen is clearly an asymmetric financial shock. Countries like Greece with debt and deficit problems have been singled out by investors who are now fleeing everything that emits the slightest whiff of risk. Similarly, the countries with the biggest housing bubbles, such as Ireland and Spain, are now suffering the most serious slumps as their bubbles deflate and problems ramify through their financial systems. It is their bond spreads that have shot up. It is there where output has slumped most sharply and where the need for wage reductions is most dramatic. The only mystery is why it took investors so long to focus on their problems – why were they not singled out six months or a year ago?

Asymmetric Financial Shock, Symmetric Economic Shock

But the more days pass, the more it becomes evident that the truly big event is the negative economic shock affecting the entire euro area. Different euro area members may have felt financial disturbances to a different extent, but they are all now experiencing the economic disturbance in the same way – they are all seeing growth collapse. Germany, which thought itself immune from the economic crisis, is now seeing its exports slump and unemployment rise. The rise in unemployment may be small so far, but it is the tip of the iceberg. And there is no longer any doubt about how much ice lies just below the surface.

This shock is symmetric – it is affecting all euro area members. In turn this means that a common monetary policy response is appropriate. There will now be mounting pressure for the ECB to cut interest rates to zero, move to quantitative easing, and allow the euro exchange rate to weaken. (This last part of the adjustment is already beginning to happen without the ECB having to do anything about it.) Now that recession and deflation loom across the euro area, this is a response on which all members should be able to agree. It can be complemented by fiscal stimulus. If countries in a relatively strong budgetary position, like Germany, are in the best position to apply it, all the better; the result will be help from outside for their more heavily indebted, cash-strapped neighbours who need it most.

What The ECB Should Do

Of course, this assumes – to return to an earlier theme – that policy makers do the right thing. The ECB will have to abandon its fixation with inflation, cut rates to zero, and proceed with quantitative easing. Germany will have to abandon its deficit phobia and apply the fiscal stimulus that it and the larger euro area so desperately need. After wallowing in denial, both are now moving in the requisite direction. But there is no time to waste.

If 2008 was the year of the asymmetric financial shock, then 2009 is the year of the symmetric economic shock. In the same way that the former should have been the year of the euro’s greatest jeopardy, the latter can be the year of its salvation. But for this to be true, policy makers must act.

References

Eichengreen (2007). “Eurozone break-up would trigger the mother of all financial crises”, VoxEU.org, 19 November 2007.

Barry Eichengreen is professor of economics and political science at the University of California, Berkeley.

And with President George W. Bush set to depart the White House today, it’s perhaps useful to look at his policies through a supply-side prism. Sadly, for a president who ran as an economic conservative, the economic policies forwarded by the Bush administration had very little to do with supply-side economics. Indeed, if his policies are to be viewed objectively, it should be said that adherents of the classical model should be eager to see Bush go.

With regard to regulations, they first and foremost inhibit natural economic activity that might otherwise be different absent rules set by the government. In one sense, Bush didn’t do too badly. When it came to the growth of the federal registry, pages under Bush rose 11 percent versus 21 percent during the presidency of Bill Clinton. On the other hand, the pages in the registry actually declined 12 percent under Ronald Reagan, and as Bush ran as Reagan’s heir, it’s fair to say he failed in this area.

Worse, not all regulations are the same in terms of how they deaden economic spirits. In that sense, Bush failed for eagerly signing Sarbanes-Oxley, a law that was successful only insofar as it expanded the need for legal and accounting services. Far from an economy enhancer, SarBox to a high degree turned otherwise entrepreneurial CEOs into slaves of accountants and lawyers. Failure was criminalized, and as such, the very risks that need to be taken by companies in order to grow were subsumed by draconian new rules that elevated economic facilitators over producers.

The Bush administration also foisted on the economy the Troubled Asset Relief Program (TARP), a program billed as capitalism’s savior. Given the collapsed shares of its alleged beneficiaries, it would be more true to say that government investment is always and everywhere an economic retardant given the basic truth that government money never comes without strings attached. In short, with the government now an owner of our banking system due to irrational fears suggesting the system was on the verge of collapse, our financial system will be weakened for the foreseeable future based on past and future certainty that its investment won’t be passive. In time, TARP will make the Community Reinvestment Act and other unfortunate regulations seem miniscule by comparison.

On the trade front, the departing head of one of Washington’s most prominent think tanks recently said despite Bush's many mistakes, he was strong when it came to free trade. Apparently this person missed the imposition of steel and soft-wood lumber tariffs early in Bush’s tenure, shrimp tariffs later on, and the administration's frequent jawboning of China for its allegedly weak yuan. Some might point to Bush’s aggressive efforts to pass a trade agreement with Columbia, along with positive rhetoric with regard to the latest (and failed) GATT round, but through the imposition of earlier tariffs the U.S. lost a lot of credibility that made future trade agreements less doable.

Perhaps worst of all, Bush caved when GM and Chrysler threatened bankruptcy absent a federal bailout. Suffice it to say, taxpayer subsidization of our ailing carmakers is but a tariff by a different name, and it might foretell a negative response from foreign governments. In the end, tariffs are a tax like any other, and as we work in order to consume freely, tariffs are a tax on work that Bush did too little to reduce.

When GOP partisans draw an economic line in the sand to defend Bush, they usually do so by noting the 2003 reductions in taxes on income and capital gains. There they have a point in that ’03 cuts were a certain positive for reducing the penalties on work and investment success.

But it should also be said that many of those same defenders miss the point. While almost to a man they would decry the explosion in spending under Bush not seen since the days of LBJ, they frequently fail to see the main reason why government spending is such a huge weight on the economy.

Spending is problematic because at its core, it too is taxation. When governments tax or borrow in order to spend, they are by definition reducing the amount of capital available in the private sector. Government spending is a tax, because spending by the government is money taken directly from our wages.

Worse with regard to Bush, his administration foisted no less than two “stimulus” packages on the economy; spending that once again withdrew capital from the private sector. And if that wasn’t bad enough, stimulus can only be an economic retardant for the wealth redistribution that it entails causing its alleged beneficiaries to work even less.

Lastly, when the government is not taxing or spending, it can tax us another way, and that is with inflation. Regardless of relatively low government measures of inflation wrought by productivity overseas, Americans were handsomely fleeced during the Bush years.

While the dollar bought 1/250th of an ounce of gold in 2001, as of this writing it buys 1/819th of an ounce. The aforementioned tariffs were a strong signal from the Bush administration that it desired a weaker dollar, and the aforementioned jawboning of China with regard to the value of the yuan was yet more confirmation.

Bush’s Treasury Secretaries of course paid lip service to a strong dollar being in our interest, but their frequent admonition that “markets” should set the price of the dollar concept revealed that a collapsing unit of account would be countenanced. And when we consider the strong correlation between weak dollars and failed presidents, the greenbacks’s decline on Bush’s watch is the largely untold explanation for his unpopularity. Put simply, voters will put up with a lot, but if the money they earn is being devalued, they become angry. Bush and the Republican majority ignored this truth all the way to minority status.

So while Bush got taxes right in 2003, his other economic policies largely taxed real work, and the direction of the S&P 500 during his tenure confirms as much. Indeed, while many would tie the lowering of tax rates to rising markets, the policies pursued under Bush undermined the good and the S&P fell 34 percent during his time in office. Even if we measure the S&P post 9/11, we find that it still fell 8 percent. To show readers how poor this performance was, the S&P even gained under Jimmy Carter - in his case 24 percent.

What’s comforting in all this is that the basic rules with regard to economic growth still hold. If we reduce the regulatory, tariff, tax and currency barriers to growth, the economy performs well. Unfortunately, none of this was done under Bush. At best we can say that his policies were anti-supply side.

So while his being the only 21st century president means George W. Bush can presently claim to be both the best and worst of the century so far, it seems not much of a reach to assume that the man who said his administration had to intervene in markets in order to save them will go down as the worst economic president of the 21st century. Whatever history's judgement, supply-side thinkers should eagerly bid Bush goodbye for bringing discredit to economic theories that he sadly never implemented.

Now, faced with the greatest economic crisis in generations, Obama will need to make a choice between his intellectual formation, which points to interventionist government, and his temperament, which pulls him toward restraint.

There is a short-term and a long-term challenge. The first has to do with the recession, the second with government commitments that cannot be met and that will sap the capacity of Americans to remain prosperous.

The response to the first problem, which is under way, has been extremely risky. In the last three months alone, the money supply has increased by an annual rate of 40 percent, if we don't count savings deposits. (It was 17 percent with savings deposits included.) That is half the rate of growth between 2001 and 2005, the period of easy money that created the conditions that led to the financial crunch in the first place.

Since the Great Depression is the precedent most cited these days, we should remind ourselves that one of the most important causes of the crash of 1929 was the 61.8 percent increase in the money supply that took place between 1921 and 1929.

The longer-term problem that Obama inherits is in the government's net operating cost. Considered a more accurate measure of the budget deficit, the net operating cost for the last fiscal year was $1 trillion. You can imagine what these numbers will look like at the end of the current fiscal year once the economic stimulus package, probably worth close to $1 trillion, is added.

The government's overall debt amounts to $10 trillion -- a bit less than half related to Social Security and Medicare. In 2008, the cost of Medicare was already far in excess of the money generated by the tax that funds it; in 2017, when a second Obama administration would end, Social Security will be in the same situation. According to the Financial Report of the U.S. Government, which reads like a Stephen King novel, 15 years from now the debt will be higher, as a percentage of the nation's GDP, than at its worst period in American history.

Obama's wise temperament faces this challenge from his socialistic intellectual formation: how to resist the pressure to continue to throw money at the recession, and how to reverse the entitlement growth that is turning the government into an albatross around the people's neck.

He has two advisers who could help hold his formation in check: Paul Volcker, whose tight-money policy at the Federal Reserve in the 1970s facilitated the prosperity of the Reagan years, and Christina Romer, whose 1994 paper "What Ends Recessions?" sought to prove that fiscal spending was not the cause of recovery after the eight recessions that took place between World War II and the early 1990s.

Obama's temperament should find reassurance in the Democrats and Republicans who, in the 19th century, resisted pressures to expand the money supply and increase the size of government in times of recession, ushering in long periods of economic growth. As Ivan Eland shows in his book "Recarving Rushmore," that was the case of Martin Van Buren in the Panic of 1837, Ulysses Grant in the Panic of 1873, Rutherford Hayes in a lesser meltdown the following decade, and Grover Cleveland in the Panic of 1893.

The president's intellectual compass will be inclined to follow Franklin Roosevelt's example. But his temperament should remind his formation that the New Deal, an orgy of public spending, actually postponed the recovery. According to economists Harold L. Cole and Lee E. Ohanian, by 1939 unemployment was still high and real output was 25 percent below trend. Long-term investment did not pick up until 1941. A decade had been lost.

If Obama's temperament prevails, he could be one of this country's great leaders. If it does not, his remarkable journey will signify only a stirring symbol.

The Times notes that the source of the problem is that "Private investors are scarce. For all but a small group of healthy banks, bankers and analysts say, the government may be the only investor left."

But the obvious question is: why are private investors scarce? Maybe it has something to do with the terms of the "stimulus" aimed at them. The Times story contains only one hint at this:

Mr. Obama's economic team is planning a broad overhaul of the program to impose more accountability and more restrictions on executives at companies that receive government money.

"More accountability" means more government management of the banks; more restrictions means more measures designed to reduce the profitability of the banking industry and drive out the best talent.

For an example of what all of this "accountability" means, consider the Wall Street Journal's overview of the government's treatment of the healthiest of the big nationwide banks, Bank of America.

"Bank of America CEO Ken Lewis earned kudos last year for stepping into the breach when the mortgage market and Wall Street cratered. BofA's purchase of Countrywide Financial and its September agreement to buy Merrill Lynch offered a welcome dose of optimism and private capital amid the panic.

In December, Mr. Lewis realized that he had been too optimistic…. After BofA shareholders approved the Merrill purchase on December 5, Mr. Lewis saw Merrill's assets plunge in value and began to explore a way out. At least he wanted a better price….

Mr. Lewis's effort to protect his common shareholders was vetoed by his most important shareholder, the feds. In October the US Treasury had insisted on investing $15 billion in his bank. Come December, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke told him that Merrill had to be saved, and that BofA had to be the savior….

In other words, the feds believe that the way to calm financial markets is to force the nation's largest, and a heretofore healthy, bank to swallow toxic assets it didn't want."

But here's the really awful part: the Treasury's forced investments in Bank of America are held in the form of preferred shares paying an 8% dividend. Yet the bailout agreement forced on the bank "limits quarterly common stock dividends to a penny a share." Oh yes, and Bank of America "will also have to accept new executive compensation limits. And the bank will need to submit for government approval a plan to modify troubled mortgages." The Journal's commentary concludes: "Mr. Lewis doesn't seem thrilled that the government has a larger piece of his business. When asked yesterday when the bank might escape federal ownership, he replied, 'I wish I knew,' and then added, 'clearly as soon as possible.'"

Similarly, Bloomberg's David Pauly describes the incoming administration's attempt to suppress the stock dividends paid by banks, a measure which effectively eliminates the "last reason to own bank shares."

"Banks have traditionally paid hefty dividends. In the years before the onset of the subprime mortgage crisis, payouts by Bank of America Corp., for instance, yielded about 3 percent to 4 percent of the company's stock price and grew steadily.

Now President-elect Barack Obama plans to take away even that attraction, Lawrence Summers, who will head the new administration's National Economic Council, informed Congress this week.

Obama…will order the Treasury Department to limit dividends paid by commercial banks and investment banks that receive "exceptional assistance" from the government to "de minimis amounts."

While investors have known that current yields were ballooned by falling share prices and that massive bank losses made some payouts unsustainable, many may have bet that relatively stronger banks would still maintain nice returns….

Now, what dividends, if any, banks can pay may depend on how extraordinary "exceptional" may be interpreted and how trifling "de minimis" may turn out to be….

It seems likely that dividends of all the major bank recipients of Washington rescue money will be restricted."

Again, while private investors may be out of luck, the government will still get its dividend: "Obama's Treasury may want to assure the banks have enough money to pay the dividends they owe US taxpayers. The preferred shares in financial institutions that the government bought in the rescue effort pay 5 percent dividends for the first five years, 9 percent after that."

All of this reminds me of a minor subplot from the 1990 film Goodfellas. The movie is interesting as a relatively un-glamorized portrait of the life of mobsters—though that won't necessarily make for a fun evening's viewing. The subplot involves the hapless owner of an Italian restaurant that becomes a favorite hangout for the mobsters. When they become a bit too rowdy, the owner goes to the godfather and asks him, in the politest possible way, if he can tell his men to keep it down and stop scaring off the regular customers. The godfather immediately demands a part-ownership in the restaurant—and it is clear that this is an offer the owner can't refuse.

What follows is a series of scenes in which the mobsters feel free to show up at the restaurant and steal cases of beer from its coolers, for example, or walk out after a large meal without paying the bill. After all, they're business partners, aren't they? Eventually, having bled the restaurant dry through this kind of petty theft, they set fire to the place in order to collect the insurance money.

That's how the banks must be feeling right now about their own unwanted "business partner," the federal government. Having been coerced into accepting bailout money from the Treasury, they now find that their new partner is draining away every last bit of wealth that used to belong to the bank's real owners, its private shareholders.

No wonder that the LA Times reports that "An index of 24 major bank stocks has fallen every month since September and dived 29% just since year-end, to a 13-year low Friday."

Much more of this mob-style "stimulus," and private shareholders will have been driven completely out of the financial industry—which will then be taken over by the goodfellas at the Treasury and the Federal Reserve.

The Treasury Department, which Geithner will head, reports that it now takes Americans 7 billion hours a year to comply with the tax code, including an estimated 3.55 billion hours of work by individual taxpayers, who also spend about $27 billion on tax software or outside tax preparation services. The proportion of households using professional tax preparation services has risen from 38 percent in 1980 to 90 percent today. It’s not hard to see why. The instruction booklet for form 1040, the most common form that individual taxpayers use, has increased in that time from about 40 pages to 155.

This is exactly the opposite of what is going on in most developed and developing countries. A two-year-old survey of tax reform among the 30 members of the Organisation for Economic Co-Operation and Development found that most countries have, since 2000 alone, implemented changes meant to simplify their tax systems and broaden their tax base. At the head of this reform movement were countries that had instituted some form of a flat tax, that is, a single tax rate that kicks in above a basic income level.

However, even countries that are not employing a flat tax are simplifying their systems by eliminating deductions and tax credits—which make it easier to determine your actual taxable income—and then lowering their tax rates to offset the disappearing deductions. With those kinds of changes going on elsewhere, no wonder that a study by PricewaterhouseCoopers for the World Bank ranked the United States 122nd out of 175 nations in terms of tax complexity.

Given the monster that our tax system has become, tax reform of this sort would seem to be a non-partisan no-brainer, a move that could save ordinary Americans hundreds of dollars without even cutting taxes. Since nine in 10 households spend money on tax preparation services, the savings would range along the income spectrum. Indeed, low-income filers are now just as likely to employ professional help, given the complexity of applying for tax credits like the Earned Income Tax Credit.

And then there is simply the benefit of reducing the stress and anxiety levels that more and more people feel trying to deal with a tax code which becomes increasingly likely to trap you into making the kind of mistake that generates an unexpected big bill for back taxes, interest and penalties. If Geithner is guilty of nothing more than screwing up his tax returns, what does that say about a system that has become so dense and obscure that even a trained economist and president of the New York Federal Reserve Bank, and the accountant who advised him, got his tax situation wrong?

That we find so little support for tax simplification is a testament to how much politicians of both parties, and perhaps ordinary citizens, have come to see the IRS code not merely as a means for raising government revenues, but as a tool of social policy. Pick a cause on the Left, Right or in the Center—from encouraging home ownership to supporting working families to subsidizing higher education to incentivizing investment in environmentally-friendly energy—and we use the tax code to support it through deductions and credits. Many of those causes are no doubt worthy—who can argue about helping spur home ownership?—but once you make the tax code your agent of change you are on a slippery slope. The more deductions, credits, rates and alternate taxes we fold into our system in search of perfect equity and the promoting of worthy causes, the more likely we make it that ordinary Americans who get audited will get hit with big bills for back taxes.

A number of Geithner’s supporters have argued that it would be a shame to kill the nomination of someone so well qualified to run Treasury because of simple tax oversights. But as long as we keep passing off the tax blunders of sophisticated, well qualified individuals, we condemn the rest of Americans to an increasingly frustrating and counterproductive wrestling match with our unwieldy tax code.

Maybe, if Geithner is confirmed, this experience will make him the advocate for tax simplification that we need.

So far, we have killed many terrorists in the current Iraq war, but they still have support and financing from places like Syria and Iran. The most infamous terrorist group and terrorist leader, the Taliban and Osama bin Laden, are still alive and running, safely ensconced in Pakistan where they are out of reach. Yet, the U.S. will not launch a massive air assault on Pakistan.

Although there hasn’t been another terrorist event on our home soil, the world has failed to respond to the threat in a meaningful way. The recent attack in Mumbai should serve as a wake-up call. One reason nations have been ineffective in responding to these attacks is that they are divided on how to deal with them. But that is exactly what allows terrorists to accomplish their goals.

Let’s take a look at the main players to see why countries are so divided over countering terrorism. The main players can be divided into three classes: active abettors, terrorists and passive abettors. First and foremost we have the Russians supporting Iran and Syria. Those three countries are the active abettors. The Russians need the price of oil to be 100 dollars a barrel, not 40. The best way to get the price up is to knock out the competition, and a war fought between Iran, Syria, Israel and the U.S. would likely damage oil production in the Middle East, Russia’s main competition.

Russians may not want too many Americans dead, but Syria and Iran want Americans and Israelis dead. For years, Syria and Iran have been arming Hezbollah, Hamas and the Iraqi terrorists. They use the Palestinians as their stooges. Iran even instigated the 2006 Lebanon-Israeli war.

Then we have the real terrorists. They use everybody to accomplish their goals. They’ve been very effective this decade and there is no reason to believe that they haven’t been emboldened by their “successes.” Who can forget the train attacks on Spain which toppled a government and caused an immediate Iraq pullout? Worse, they will launch even more horrific attacks in the future.

The group that lets this all occur is the passive abettors. This group includes Europe, China and those in America who believe that Bush let this all happen or that America deserves it. The passive abettors believe terrorism isn’t a serious problem and that it will go away once the U.S. changes its ways. This group doesn’t support sanctions against rogue nations.

So what’s to come? I believe the Mumbai attack was the beginning of the next series of terrorist attacks. Strategically, it makes sense for bin Laden to cause fights between India and Pakistan. Tension over their border will mean the Pakistanis won’t be focused on going after him. On top of this, the Israeli-Arab war has been restarted. This seems to be a well-planned provocation to escalate the war in Iraq.

If another attack happens in America, the major damage will, once again, be to our national unity, our Achilles heel. In turn, this will begin anew the political blame game. Those who voted for Obama will say that Bush was ineffective against the terrorists and those who voted for McCain will say that it would not have happened if their man got elected.

Either way, it is clear that the last seven years has proven that terrorism cannot be successfully fought by a divided world. Perhaps the Chinese and the Europeans will wake-up and realize that they should not only start protecting themselves, but also join the fight against global terrorism. Allowing their biggest customer to fall into harm’s way isn’t good for terrorism or the world’s economies. No country can afford to let that happen again.

Testifying recently before a United States congressional committee, former Federal Reserve chairman Alan Greenspan said that the recent financial meltdown had shattered his "intellectual structure". I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book was published in 2007 – before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of "creative destruction". In Greenspan's summary of Schumpeter's thinking, a "market economy will incessantly revitalise itself from within by scrapping old and failing businesses and then reallocating resources to newer, more productive ones". Greenspan had seen "this pattern of progress and obsolescence repeat over and over again".

Capitalism advanced the human condition, said Schumpeter, through a "perennial gale of creative destruction", which he likened to a Darwinian process of natural selection to secure the "survival of the fittest". As Greenspan tells it, the "rougher edges" of creative destruction were legislated away by Franklin Roosevelt's New Deal, but after the wave of de-regulation of the 1970s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom of the 1990s that "finally gave broad currency to Schumpeter's idea of creative destruction".

This was the same Greenspan who in 1996 warned of "irrational exuberance" and, then, as Fed chairman, did nothing to check it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable, book with that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimise the "destructiveness" of the "creation". It manages to combine technology-driven cycles of booms and recessions with markets that always clear (ie there is no unemployment).

How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies such as General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government's key responsibilities is to smooth the cycle, "real" business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological "shock" that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention. It was called securitised mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such "shocks". Indeed, "real" business-cycle economists typically argue that, but for Roosevelt's misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidising inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests of the New Business Cycle school, at a time of high American unemployment in the 1980s.
"My driver is an unemployed PhD graduate," he said to Lucas. "Well, I'd say that if he is driving a taxi, he's a taxi-driver," replied the 1995 Nobel laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny.

Robert Skidelsky is professor of political economy at Warwick University.

Eager to attract support from the Republican side of the aisle, Obama has expressed a high degree of willingness to include tax cuts in his post-inauguration legislation. At first blush, tax cuts sound appealing and speak positively about a politician who’s been up front with his belief that a “monopoly on good ideas does not belong to a single party.”

Good political theater for sure, but we might add that neither party has a monopoly on bad ideas either. Reading the fine print, we see that the definition of a tax cut in Washington is far more nuanced than what we might be used to. The tax cuts Obama has in mind might attract votes, but they have very little to do with economic growth.

First up are income credits described as tax cuts. The latter are meant for low-income families, and as the Wall Street Journal described them, they will allow “more families that earn too little to pay income taxes to claim at least some of the $1,000-per-child tax credit.” At present, a household must have income of $12,500 per year to be eligible for tax credits, but under the Obama plan, the cutoff will be reduced to $3,000.

So what Obama and his advisors call a tax cut is really only a transfer payment from one set of hands to another. Such redistribution fosters no new production, and with that, no subsequent demand.

For at least two reasons, the credit will be an economic retardant. Productive workers will see more of their earnings taxed or borrowed in order to stimulate immediate consumption. When we consider that all profits in society result from past parsimony, we can see that the productive economy will be weakened if this form of alleged stimulus is put in place.

Most important, Obama should not run from the basic truth that economic growth is always and everywhere the result of productive work effort. To the extent that low-income families are plied with yet another form of welfare, this will reduce the individual incentives within impoverished households to engage in more work.

Put simply, the tax credits masked as cuts will reduce the work incentives for those redistributed from, all the while making real work less necessary for the alleged beneficiaries of the credit.

On the taxation front for top earners, the story gets worse. The late Warren Brookes once wrote that “We are all blessed by the genius of the relatively few.” What Brookes meant was that thanks to the frequently innovative and entrepreneurial efforts of a vital few in this country, all Americans are able to enjoy better jobs and better products.

That is far from Obama’s mind. He has made plain that he intends to return the tax rate on top earners to the Clinton-era level of 39.6 percent, and the capital gains rate on investment success will move from 15 to 20 percent. Higher tax rates in the Obama model are meant to pay for the aforementioned credits, along with yet another stimulus package.

Assuming Obama’s plan to soak the rich works, it has to be said that increased revenues for the federal government will reduce the amount of capital available for the business sector to fund the wages of the poor. Whether the government is borrowing or taxing in order to redistribute, capital is being removed from the private pool of available funds meant to create new industries, new companies, and new jobs.

And when it comes to Brookes’s vital few, the poor and the middle class alike will be made worse off if the successful among us choose to remove their skills from the productive economy due to higher penalties on work.

Jean-Baptiste Say once noted that the heavily taxed “are seldom regular in their payments,” but it seems he actually downplayed the negatives that come with penalizing the successful. If they were merely irregular in their payments to the tax man the economy would be fine, but the real threat is perhaps the unseen. Indeed, it’s tax distortions which cause the rich to be irregular in their work and investment habits that lead to economic degradation.

With regard to corporate taxation, according to another Wall Street Journal account, a key provision of Obama’s plan is to “allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years.” Translated, failing companies will write their losses off on the backs of successful individuals and companies alike.

When we consider what actually causes economies to grow, the corporate tax provision is creating incentives for something quite the opposite. In his Theory of Economic Development, Joseph Schumpeter wrote that “development consists primarily in employing existing resources in a different way.” But if failing companies are kept alive not by a simple reduction in the tax rate on their profits, but rather thanks to a bailout of the non-financial variety, entrepreneurs waiting in the wings to redeploy mismanaged physical and human capital will be hampered in their efforts to bring the economy out of its slump.

In the end, entrepreneurs can only innovate to the extent that they’re able to purchase the assets of failed business combinations with visions of more profitable future combinations. So when governments prop up failed or dying businesses, far from saving the economy, they only hurt it by delaying the process whereby people and capital are managed productively.

All of which brings us to the jobs portion of the Obama corporate tax plan. For the companies that make new hires or forgo layoffs, the Obama administration is set to offer a one-year tax credit in return. Once again, the incentives here are backwards, and if heeded, will surely stimulate the opposite of growth. Indeed, if there’s one certain rule when it comes to business success, it has to do with producing as much as possible with as little labor as possible. Far from a job killer, when companies do more with less they free up the very capital that allows them to expand into other potentially profitable areas previously out of reach due to a lack of funds.

To the extent that businesses keep workers employed for non-productive reasons, the economy will surely be rendered poorer in time. Workers are like capital. When either labor or capital is wasted, the end result is less growth.

The tax portion of the Obama package includes write-offs for business expenditures, and it’s safe to assume here that companies producing business equipment will be the beneficiaries of this new rule. Equipment write-offs recall a frequent Wainwright theme over the years that when the Federal Reserve moves around its target interest rate, it merely reschedules economic growth, as opposed to fostering new economic activity. Write-offs should be viewed in much the same way. Businesses will simply move up equipment purchases in the near-term; those purchases will detract from capital spending over the long-term.

It’s also important to remember that as a mature economy, U.S. economic growth has very little to do with spending on capital equipment, but quite a lot to do with spending on human capital. Using Google as an example, its growth over the years has been the result of heavy investment in the best minds, as opposed to the best equipment. Equipment write-offs at best address a past version of the U.S. economy that most Americans would no longer recognize.

Sadly, the tax portion of Obama’s recovery plan was only put in place to give Republicans the political cover necessary to vote for the various spending initiatives that the new administration envisions. This is the alleged “stimulus” part of Obama’s economic package, and as Wainwright publications have emphasized over the years, government spending can in no way stimulate economic growth.

Beyond the negative work incentives created by wealth redistribution, the basic reality is that no one—least of all government—can profit from the same transaction twice. That’s the assumption the government is making when it claims it can grow the economy through the transfer of wealth already created. In a sense, the very notion of stimulus turns routine economics on its head.

But to address arguably the worst aspect of Obama’s proposed $775 billion spending package, we must once again bring in the notion of the entrepreneur waiting in the wings. It’s tautological to say that entrepreneurs cannot innovate without capital. When the federal government is borrowing at relatively low rates from the private sector, there’s necessarily less capital at higher rates for entrepreneurs to access in order to utilize human and physical capital more effectively.

At its core, Barack Obama’s economic recovery plan is anti-entrepreneur, and as such, anti-growth. So while we should expect to read quite a lot about how “change” in Washington will enhance our economic wellbeing, we shouldn’t be fooled. The new administration plans to engage in feverish activity. It may be meant to make us better off, but it would be charitably naïve to mistake it for any real prescription for economic recovery.

The Obama Treasury could put a floor under bank losses, through government guarantees on their bonds, or by creating an aggregator bank that purchases those securities from banks altogether.

Guarantees would give the banks profits on bonds whose underlying loans are mostly repaid, and shift to taxpayers losses from those bonds whose loans are mostly not repaid. That would require additional large subsidies from taxpayer to the banks.

An aggregator bank, however, could turn a profit. It could purchase all the commercial banks’ potentially questionable securities, at their current mark to market values, with its own common stock and funds provided by the TARP. Then the aggregator bank could balance profits on those securities whose loans pan out against losses on securities whose loans fail.

An aggregator bank could perform triage on mortgages. It could work out those whose homeowners can be saved with some adjustments in their loan balances, interest rates and repayment periods; foreclose on mortgages whose homeowners could not meet payments with reasonably concessions; and leave other loans alone.

Commercial banks acting alone cannot accomplish triage as effectively, because individually they can have little effect on how much housing values will fall. In contrast an aggregator bank, holding so many mortgages and working in cooperation with Fannie Mae and Freddie Mac, could have a salutary impact on housing values. It could put some breaks on falling home prices.

Beyond toxic securities, policymakers need to fix what got banks into this mess. The 1999 repeal of Glass-Steagall permitted the creation of financial supermarkets, like Citigroup, that combined commercial banks with investment banks, brokerages, and the bizarre universe of hedge and private equity funds.

Those nonbank financial firms are run by salesmen and financial engineers that don’t understand long-term commitments as bankers to borrowers with solid incomes and sound business plans. Investment bankers, securities dealers and fund managers, essentially, get paid commissions on sales and for betting other peoples’ money on arbitrage opportunities. They put together people that have money with those that need money, and those people that can't bear risk with those that can.

In contrast, commercial bankers, historically, had skin in the game—bank capital and a fiduciary responsibility to depositors. They were paid salaries, not commissions on the volume of loans they wrote or bought from mortgage brokers to package into bonds. They expected to be fired if their loans prove imprudent.

To investment bankers and securities dealers, it does not matter how risky a loan is, because they can always bundle it into a bond to sell it off or insure it with a swap. That's nonsense, as we have learned. Adopting that thinking commercial banks got stuck with too many loan-backed bonds and buying swaps that were not backed by adequate assets.

Commercial banks need to be separate and more highly regulated. The ongoing process of breaking up Citigroup and placing its banking activities into a separate entity should be replicated at other Wall Street and large regional banks.

Freed from toxic assets and the complications of affiliations with financial institutions having other agendas, commercial banks could raise new private capital and make new prudent loans as President Obama’s stimulus package lifts consumer spending and business prospects.

Such approaches would disappoint those who champion unbridled free markets but Wall Street’s financiers have abused the opportunities offered them by deregulation to the peril of the nation.

President Obama needs to craft solutions that address the world as he finds it, not as intellectuals tell him it should be.

Unfortunately, shortly after the TARP funds were voted, the Treasury Department decided that the money could not be used for its intended purpose because there was no way to determine appropriate prices to pay for the toxic assets.

By definition, toxic assets are those whose value is so uncertain that there is no functioning market for them. If TARP paid too little for the toxic assets it bought, the banks would not be restored to financial health. If it paid too much, the banks would get a windfall at taxpayer expense. The Treasury Department also realized that in any price negotiation, the banks would know more about the nature and value of the assets than would the people representing TARP.

Since abandoning the original concept of buying up toxic assets, TARP funds have been deployed to fight financial fires. Some of the money has even been used to bail out the U.S. auto industry. Meanwhile, the problem of toxic assets clogging up the nation’s financial arteries has remained.

Fortunately, there is a way to buy up toxic assets that does not require assessing their value today. It is based upon the indisputable fact that at some point between now and thirty years from now, the value of all of today’s toxic assets will be known with certainty.

The Treasury should create a “bad bank” to buy up toxic assets. Let’s call it The Bad Bank of the United States (BBUS).

BBUS would buy whatever assets a financial institution wanted to sell to it, paying whatever price the institution asked, up to (say) 80% of par value. The institution would get cash. BBUS would get the toxic assets plus a special contingent variable warrant (CVW), good for common stock in the institution.

BBUS would place all of the toxic assets obtained from each institution in a separate account. The cash generated by the assets would be retained in the account and invested in Treasury securities. Each account would be charged interest on the original purchase price of the assets at the Treasury’s cost of funds plus (say) 1% to cover the operating expenses of BBUS. The detailed status of each account would be posted on the Internet.

BBUS would wait until all of the toxic assets in a given account had resolved themselves, either by being paid off according to terms or via some default process. At that point, there would be some amount of cash in the account. If this amount was greater than what BBUS had paid for the assets, half of the excess would be returned to the financial institution and half retained by BBUS. If the amount in the account was less than what BBUS paid for the assets, BBUS would exercise the CVW.

Each CVW would give BBUS the right to demand that the financial institution that sold it the toxic assets hand over common shares equal in value to any deficit in its account at BBUS. For example, if on the date that the assets in an account were fully resolved the fund had a deficit of $1 billion, the institution would have the option of either paying BBUS $1 billion in cash or handing over common shares with a market value of $1 billion. BBUS would dispose of any shares received as soon as practical.

It is possible that there would be financial institutions whose entire market capitalization would be less than the deficit in their toxic asset account at BBUS. In these cases, BBUS and the taxpayers would take a loss. These losses would (potentially) be offset by BBUS’s 50% share of the gains on the accounts that returned more than BBUS paid for the assets.

It might seem strange to allow financial institutions to select the toxic assets they sell to the BBUS and to set the prices of those assets up to some maximum. However, financial institutions will have incentives to price these as accurately as they can. If they set prices too high, they forgo current tax deductions and set themselves up for involuntary equity dilution down the road. If they set them too low, they will lose money unnecessarily.

Given that the government played a major role in creating the toxic asset crisis in the first place (via an unstable dollar and various laws promoting mortgage lending to sub-prime borrowers), it is not unreasonable that the government assume some financial risk. Under the BBUS plan, participating financial institutions will bear as much of the risk they can bear without impairing their ability to perform their economic function.

Because the detailed status of each account at BBUS will be published on the internet, the markets will take into account the projected gains or losses in these accounts in valuing each financial institution. This will feed back into the market price of the institution’s common shares. However, because BBUS will not have recourse against the institution for anything but common stock, this should not impair the credit worthiness of the institution or its ability to raise capital via debt or preferred stock.

The BBUS approach would solve the problem of toxic assets once and for all, while minimizing the costs and risks to both taxpayers and financial institutions. It would do this by side-stepping the problem of assigning prices to assets that are deemed toxic specifically because their value is currently so uncertain.

As investment retreated, manufacturing and construction orders went down, employees were laid off, consumer demand dropped and what started as a trickle of bad economic news turned into an avalanche with no visible end in sight.

The problems in the banking system are complex and not susceptible to quick and easy fixes.

In the run-up to the current crisis, banks and other financial institutions invested heavily and foolishly in mortgage and other asset-backed securities. When property owners are no longer able to make payments on their mortgages, these mortgage-backed securities become "troubled," "distressed" or "toxic" assets on the balance sheet of the financial institution. That, in turn, makes the banks unwilling to lend to consumers and businesses.

Last fall, Congress created a $700 billion Troubled Asset Relief Program (TARP) to prevent a full-scale collapse of the financial system. Initially, the Treasury Department intended to use TARP to buy these troubled assets from financial institutions, hoping that would free the banks to resume lending to businesses and consumers.

The pressure to act immediately and the difficulty of getting the program up and running quickly led Treasury instead to buy stock in the banks. While certainly well-intentioned, TARP hasn't done what we hoped it would do. Simply giving banks money, as the Treasury Department has done until now, has not removed the toxic assets or opened up the flow of credit.

As we enter a new stage in the effort to revive the economy, we must be open to new ideas. In that spirit, I want to suggest one change to the tax law that I believe will help breathe life into our credit markets by revitalizing the private market for mortgages and mortgage-backed securities:

The recovery of principal on deeply discounted, mortgage-backed securities should be taxed at the reduced long-term capital-gains tax rate rather than the higher ordinary income-tax rate.

Through this simple and straightforward change in the tax law, we could enhance the value and liquidity of mortgage-backed securities and breathe life into the secondary trading of these troubled assets.

My proposal would help banks unload their risky assets, improve their balance sheets and start lending again. It would help lift real estate values by freeing bank capital for new mortgage loans. It would unleash capital for consumer lending and help stimulate the real economy and save jobs.

Investors willing and able to take on significant investment risks would have an incentive to step in with the understanding that their return would be more substantial when the economy turns around because they would be paying lower capital gains taxes, not higher ordinary income taxes.

In the unlikely event this proposal does not succeed in stimulating demand for mortgage-backed securities, there will be no cost to the government.

I have written the economic leaders of the Obama administration and key congressional tax-writers encouraging them to include this tax proposal in the final economic stimulus bill. In order to create an extra incentive for investors to buy now, eligibility for the capital gains treatment could be limited to mortgage-backed securities purchased over the next 12 months.

Now more than ever, creative action is needed to address the problems plaguing our financial system. We owe it to future generations to look for innovative opportunities to lift the economy that do not add to the federal debt.

That is why I hope the new administration and my colleagues will embrace this carefully targeted tax incentive to encourage private investment in distressed assets, and help free the capital and credit that our economy desperately needs to grow again.

Second: the financial crisis. Lower lending deprives the economy of the credit to finance businesses, homes and costly consumer purchases (cars, appliances). The deepest cuts involve "securitization" -- the sale of bonds. Investors have gone on strike. In 2008, the issuance of bonds backing credit card loans fell 41 percent and those backing car loans 51 percent.

Third: a trade crisis. Global spending and saving patterns are badly askew. High-saving Asian countries have relied on export-led growth that, in turn, has required American consumers to spend ever-larger shares of their income. Huge trade imbalances have resulted: U.S. deficits, Asian surpluses. As Americans cut spending, this pattern is no longer sustainable. Asia is tumbling into recession.

Overcoming any of these crises alone would be daunting. Together, they're the economic equivalent of a combined Ironman triathlon and Tour de France.

Consider consumer spending. The proposed remedy is the "economic stimulus" plan. This seems sensible. If government doesn't offset declines in consumer and other private spending, the economy might spiral down for several years. Last week, House committees considered an $825 billion package, split between $550 billion in additional spending and $275 billion in tax cuts.

But in practice, the stimulus could disappoint. Parts of the House package look like a giant political slush fund, with money sprinkled to dozens of programs. There's $50 million for the National Endowment for the Arts, $200 million for the Teacher Incentive Fund and $15.6 billion for increased Pell Grants to college students. Some of these proposals, whatever their other merits, won't produce many new jobs.

Another problem: construction spending -- for schools, clinics, roads -- may start so slowly that there's little immediate economic boost. The Congressional Budget Office examined $356 billion in spending proposals and concluded that only 7 percent would be spent in 2009 and 31 percent in 2010.

Assume, however, that the stimulus is a smashing success. It cushions the recession. Unemployment (now: 7.2 percent) stops rising at, say, 8 percent instead of 10 percent. Still, a temporary stimulus can't fuel a permanent recovery. That requires a strong financial system to supply an expanding economy's credit needs. How we get that isn't clear.

The pillars of a successful financial system have crumbled: the ability to assess risk; adequate capital to absorb losses; and trust among banks, investors and traders. Underlying these ills has been the consistent underestimation of losses. Economists at Goldman Sachs now believe that worldwide losses on mortgages, bonds, loans to consumers and businesses total $2.1 trillion. In March, the Goldman estimate was about half that.

All the new credit programs -- the Treasury's Troubled Asset Relief Program (TARP) and various Federal Reserve lending facilities -- aim to counteract these problems by providing government money and government guarantees. Probably Obama will expand these efforts, despite some obvious problems: If government oversight becomes too intrusive or punitive, it might deter much-needed infusions of private capital into banks. Again, let's assume Obama's policies succeed. Credit flows rise.

Even then, we have no assurance of a vigorous recovery, because the economic crisis is ultimately global in scope. The old trading patterns simply won't work anymore. If China and other Asian nations try to export their way out of trouble, they're likely to be disappointed. Any import surge into the United States would weaken an incipient American recovery and probably trigger a protectionist reaction. Down that path lies tit-for-tat economic nationalism that might harm everyone.

Indeed, if the rest of the world doesn't buy more from America, any U.S. recovery may be feeble. What's needed are policies that correct the imbalances in spending and saving. As Americans save more of their incomes, Asians should save less and spend more, so that they rely more on producing for themselves rather than exporting to us. The great trade discrepancies would shrink.

But this sort of transformation requires basic political changes in Asia. Whether China and other Asian societies can make those changes is unclear. The implications are sobering. The success of Obama's policies lies, to a large extent, outside his hands.

My first column argued that the global financial crisis is really a run on all explicit and implicit forms of insurance, which is showing up as a freezing of credit markets at all but the shortest maturity.

In this column I discuss the consequences of this and what to do about it. Specifically, I argue that an efficient solution involves the government taking over the role of the insurance markets ravaged by Knightian uncertainty.

A modern economy without financial insurance

An economy with no financial insurance operates very differently from the standard modern economies we are accustomed to in the developed world.

there is limited uncollateralised or long-term credit (since such loans always have an insurance built in through the possibility of default),

the risk premium sky-rockets,

economic agents hoard massive amount of resources for self-insurance and real investment purposes.

In this environment, financially constrained agents obviously cannot go about their businesses with the flexibility they once enjoyed. However, the real hope for a recovery, as well as the concern for a meltdown, lies on the other side of the spectrum, on the unconstrained agents.

Mountains of investment-ready cash frozen by fear of the unknown

At this juncture of the crisis, there are mountains of investment-ready cash waiting for some indication that the time to enter the market has arrived. But investors are frozen staring at each other, and by so doing, they are further dragging the economy downward. The normal speculative forces that trigger a recovery are for everybody to want to arrive first, to “make a killing.” But with so much fear around us, investors have changed the paradigm and they are now content with letting somebody else try his or her luck first, so we are stuck.

Other cash-rich investors see great investment opportunities in the not-so-distant future, but, in the meantime, they do not unlock their resources for fear that the temporary investments may turn illiquid, a process which in itself contributes to widespread illiquidity, or because the lack of competition brought about by crisis almost ensures a better deal in the future. And yet others go one step further in profiting from illiquidity and panic itself – by shorting run-prone financial institutions, they close the circle of fear that fuels the runs.

We need to reverse this mechanism by restoring the appetite for arriving first.

Bringing the recession back to familiar turf

I do not mean to say that this recession is an imaginary one. On the contrary, I believe it is a very serious recession. My point is simply that good policy has an opportunity to bring the recession back to familiar turf, and when this happens, the recession will become a manageable one from which current asset prices, on average, will look like once-in-a-lifetime deals.

The silver lining to this diagnostic is that the core policy prescription becomes evident.

Facts framing the correct policy response

My sense is that, to a first order of approximation, the correct policy response should build on the following three observations:

Many of the ex ante “imbalances” are more structural in nature than is implied in the consensus view, and hence will remain with us long after the crisis is over. They stem from a global excess demand for financial assets and, especially, for AAA financial assets.

The main policy mistakes took place during rather than prior to the crisis. The core aspect of the crisis is a collapse in all forms of (explicit and implicit) financial insurance due to a sharp rise in (Knightian) uncertainty. The policy response has been too slow in addressing this core issue. Until very recently, the Treasury’s response often exacerbated rather than reduced perceived uncertainty. The failure to prevent Lehman’s demise represents the worst of this dubious and ad hoc policy approach, but the “exemplary punishment” (of shareholders) policy during the Bear Stearns collapse also failed to recognise its uncertainty impact.

Contrary to what investors thought at the peak of the boom, the (private) financial sector in the US is not able to satisfy the global demand for AAA assets when large negative aggregate events take place. The US government does, however, have the capacity to fill this gap, especially because it is the recipient of flight-to-quality capital.

These observations hint at a policy framework for the current crisis and for the medium run.

Medium-run and firefighting policy responses

As long as the government becomes the explicit insurer for generalised panic-risk, we can in the medium run go back to a world not too different from the one we had before the crisis (aside from real estate prices and the construction sector). That is, monolines and other financial institutions can leverage their capital for the purpose of insuring microeconomic risk and moderate aggregate shocks. They cannot, however, be the ones absorbing extreme, panic-driven, aggregate shocks.

This must be acknowledged in advance, and paid for by the insured institutions. Reasonable concerns about transparency, complexity, and incentives can be built into the insurance premia. Collective deleveraging, as currently being done, should not constitute the core response; macroeconomic insurance should.

Government generalised-panic risk instead of deleveraging

The structural policy framework for the medium run also carries over to the crisis-policy itself, i.e. the “firefighting policy”. The essence of a solid recovery should build not from deleveraging and a forced and brutal contraction of the financial sector. Rather it should be built on the explicit and systemic provision of insurance against further negative aggregate shocks to the financial sector’s balance sheet that might be caused by panic or predatory actions.

The recent government intervention with respect to Citi – with its mixture of (paid) insurance and capital – is a promising precedent. So too was the second government package for AIG.

These interventions need to be scaled up to the whole financial system (banks and beyond), and it is better to do it all at once, for in this case the likelihood of the government ever having to disburse funds for its insurance provision becomes remote.

Optimal policy for the US

The government must immediately replace the main insurance markets ravaged by uncertainty. The good news is that, unlike the situation in most other economies in the world, the US, as a whole, is perceived as a safe haven and hence rather than triggering capital outflows, its financial crisis has done the opposite. The main implication of this safe-haven status is that the cost of funding massive policy interventions is very low.

In formulating the list of insurance markets to be supported, it is important to look beyond the obvious. Surely one of the first worrisome symptoms during the crisis was a contraction in all forms of non-overnight uncollateralised lending among highly reputable financial institutions. Later on we saw the corporate sector losing trust in these financial institutions and hence drawing on their credit lines, by which they shifted from insurance arrangements to a much more inefficient (from a systemic point of view) form of self-insurance.

The housing stock’s insurance function

Yet another, perhaps more subtle, insurance collapse came from the housing market crash itself, as households lost the buffer offered by Home Equity Lines of Credit (HELCs) against any shock they may face. This loss of insurance became all the more significant after Lehman’s demise, when the collapse in equity markets erased another buffer and overall economic uncertainty spiked. The sharp rise in margin requirements has played a similar role for leveraged investors.

Trimming tail-risk is more efficient than bank capital injections

In all these contexts, trimming the (lower) tail-risk offers the biggest bang-for-the-buck. In this sense, capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, certainly much more than the current TARP. The reason is that Knightian uncertainty generates a sort of double-(or more)-counting problem, where scarce capital is wasted insuring against impossible events (Caballero and Krishnamurthy 2008b).

A simple example can reinforce this point. Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays one dollar to agent A, and the opposite happens in state Y. Thus, only one dollar is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only one dollar is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than one dollar. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.

Of course real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.

But there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.

The Knightian uncertainty perspective and asset-purchase programmes

The Knightian uncertainty perspective also sheds light on some of the virtues of the asset-purchase program of the original TARP. In practice, financial institutions face a constraint such that value-at-risk must be less than some multiple of equity. In normal times, this structure speaks to the power of equity injections, since these are “multiplied” many times when relaxing the value-at-risk constraint. In contrast, buying assets reduces value-at-risk by reducing risk directly, which typically does not involve a multiplier. However, when uncertainty is rampant, some illiquid and complex assets, such as CDOs and CDO-squared, can reverse this calculation. In such cases, removing the uncertainty-creating assets from the balance sheet of the financial institution reduces risk by multiples, and frees capital more effectively than directly injecting equity capital.

Does this mean that there is no role for capital injections? Certainly not. Knightian uncertainty is not the only problem in financial markets, and capital injections are needed for conventional reasons as well. The point is simply that these injections need to be supplemented by insurance contracts, unless the government is willing to increase the TARP by an order of magnitude (i.e. measure it in trillions).

Final remarks

Before concluding, I wish to clarify that I am not arguing that the world was perfect before the crisis and that the aspects mentioned in the consensus view should be ignored.

Of course, we should continue to work to produce the right regulatory environment where the silver lining of crises is that problems become more apparent. But we should also acknowledge that this is a dynamic process which is likely to lead to new and different problems in the future, and therefore it is never ending. Instead, the questions that have concerned me here are twofold. Given this constant flow of microeconomic incentive problems, what is the role played by the global macroeconomic environment in causing fragility? And, how can we deal with it without “throwing out the baby with the bath water”?

Summary

In a nutshell, I have argued that, by now, fear has distorted the price of risk and its insurance to an extreme. In this context, it makes little sense to apply the ordinary recipe of restructuring and liquidation that works during normal times. The main role of the government should be to provide insurance against systemic events at non-Knightian prices. This recipe applies as much during as after the crisis.

US crisis as an emerging-market-like crisis

Paradoxically, the weakness that has plagued emerging market economies for decades has now stricken the financial systems of developed economies and that of the US in particular. The weakness is the sudden loss of investors’ confidence which has ravaged credit markets and the stability of previously sound financial institutions. The conventional advice to emerging markets has been to accumulate international reserves and reduce short term liabilities. Consistently, the message now for financial institutions in developed economies is to accumulate capital and deleverage. I have, over the years, repeatedly argued that this policy prescription for emerging markets is a highly inefficient mechanism to solve their external vulnerability problem. For similar reasons, I view the capital accumulation and deleveraging mechanism as a highly inefficient solution to the financial vulnerability problem behind the current crisis.

Essentially, the US (and other) financial markets are experiencing the modern version of a systemic run as we had not seen since the Great Depression. It used to be that depositors ran from banks. Some of this still happens, but runs in modern financial markets, to be systemic, have to involve a larger class of assets. A run against explicit and implicit financial insurance is essentially a run against virtually all private sector financial transactions but for those with the shortest maturities. Thus, the modern lender-of-last resort facility has to be a provider of broad insurance, not just deposit insurance. This is what it will take to get us back into a reasonable equilibrium where we can initiate a recovery from a (more) “normal” recession.

The recent UK intervention

On the day before I gave these remarks in New York City, the UK began the day well by announcing a mega-insurance policy for its financial markets. The good news was turned into yet another run on banks’ equity once it became apparent that the spectre of shareholders dilution is still present.

While it is reasonable for the government to protect taxpayers, it is unreasonable for it to inject equity into banks at fire-sale prices, as this is the equivalent of (or the other side of) selling insurance at Knightian prices. The logic of my argument above suggests that if public injections of equity are to happen, these should not take place at fire-sale/Knightian prices but at some reasonable long-run price. Convertible debt aid that is converted at fire-sale prices has a payoff structure which is just the opposite of the put option payoff that is needed from this aid, and hence it is likely to exacerbate rather than dampen the problem.

References

Normalcy is Just a Few Bold Policy Steps Away
Ricardo J. Caballero
December 17, 2008

Moral Hazard Misconception
Ricardo Caballero
Financial Times, 16 July 2008

The Future of the IMF
Ricardo J. Caballero
May 2003, American Economic Review, Papers and Proceedings, 93(2), 31-38.

Hedging Sudden Stops and Precautionary Contractions
Ricardo J. Caballero and Stavros Panageas
Journal of Development Economics, 85 (2008) pp 28-57

Bubbles and Capital Flow Volatility: Causes and Risk Management
Ricardo J. Caballero and Arvind Krishnamurthy
January 2006, Journal Monetary of Economics, 53(1), pp. 35-53.

Government’s role as credit insurer of last resort and how it can be fulfilled, by Perry Mehrling and Alistair Milne, October 2008
http://www.econ.barnard.columbia.edu/faculty/mehrling/creditinsureroflastresortfinal09Oct2008.pdf

Ricardo Caballero is professor of economics at MIT.

Originally posted at VoxEU.org

Or does family derive from the word of God? If so, which god? There are certainly a lot of holy books and interpreters to choose from, none of which can be exclusively embraced or categorically rejected by a body politic that separates church and state.

Is the family dead? One might think so when observing the plight of the inner city poor replete with unwed mothers, absent fathers, abandoned children, over-burdened grandmothers, and harried social workers.

Is the family a series of easily entered but bitterly broken contracts? It is in any suburban neighborhood with its frequent divorces, serial marriages, adjudicated custody agreements, packed day care centers, and institutionalized grandparents.

Does gay marriage and adoption promise, or threaten, to separate the social functions of sex, family, and procreation? Birth control, abortion, maternal surrogacy, sperm banks, and in vitro fertilization certainly separated them biologically.

Can an extended spiritual community be a family? Suppose it’s based on patriarchal polygamy, coerced concubinage, and reclusive communal living punctuated by periodic police raids triggered by befuddled social service agencies?

Maybe the family has no materiality at all and is just a malleable social convention. For one example, consider science fiction writer Robert Heinlein’s multi-generation group marriages brilliantly explored in "The Moon is a Harsh Mistress." These resemble nothing so much as customized special purpose Limited Liability Corporations (LLCs).

As we enter the post-racial era of the civil rights movement, few contests will be as interesting to watch as democracy's effort to redefine the family, attempting to legally sanction social innovations untested by ancient usage whose broader impacts we but dimly see.

When Obama's honeymoon period ends will it be a red or a blue tribal chieftain who restarts the Culture Wars, staging the first scene in the next act of paid political theater, firing up the base and demonizing the opposition?

Watch in amazement as the judge, the legislator, the tort lawyer, the tax accountant, the minister, and the talk show host dive into this mélange seeking divergent ends. Beyond the entertainment value, the resolution of this donnybrook will profoundly transform the way we live, work, are born, and die.

Have you heard about the elder care contracts being written between aging parents and their adult children? These asset transfer agreements are designed to get around regulatory barriers erected to stop children from artificially impoverishing grandma in order to gain free access to taxpayer-supported nursing home care. Is this elder-care income taxable and do children serving as independent contractors caring for parents in their own homes have to pay both the employee and employer side of social security taxes? Will this trip up some future Treasury Department appointee?

How long will it be before the government starts paying a majority of the nation’s mothers to care for their own children? Some say it’s just a matter of time as the income tax code ramps up cash distributions even for citizens that don’t pay income taxes.

In Italy a forty-something sued his own father, successfully forcing dad to financially support junior’s chosen lifestyle as an unemployed student. Will European legal norms eagerly embraced by some of our fellow citizens include this one, and will America end up undergoing voluntary depopulation as parents begin to view children as liabilities instead of assets?

Civil unions were first accepted by a few employers, then recognized by a few courts, and next endorsed by the electorate of some states while forbidden by others. Can a company incorporated in a state with one set of laws that operates in a state with another be sued for failing to offer comparable healthcare packages to employees that live in a third state who obtained a same sex marriage in a fourth?

Can you find a single word in the U. S. Constitution that explicitly gives the federal government the power to sort this all out? Or do federal powers no longer emanate from the constitution as much as from the Voice of the People or the unfettered penumbras cast by a few men in robes?

Perhaps the Compromiser-in-Chief will forge a cafeteria-style plan that offers flexible family options structured like some corporate benefits packages. Let’s see, I'll take the ten year renewable, same sex marriage contract with the joint custody adoption option, no-fault pre-nuptial agreement, hold the revocable-trust estate plan.

However this works out, the one-size-fits-all nuclear family where each is left to figure out who takes care of whom is passing into history.

The economic impact of socializing family entitlements and responsibilities will reverberate for generations. What can you do but sigh and pile the unpaid bills on top of the largest intergenerational debt programs every created, namely Social Security and Medicare.

If the nation goes this route and we all live like one big family, will the title Mr. President be changed to Big Daddy?

Arlen Specter told reporters early on Monday that he would vote yes, but he changed his mind and voted no. Robert Byrd, by the way, captured the sentiments of John Kyl, Jim Bunning, and many others when he said: "Had [Geithner] not been nominated for Treasury secretary, it’s doubtful that he would have ever paid these taxes."

The surprising number of no votes suggests that both parties will keep Geithner on a short leash. And it was President Obama who ran over to the Treasury Department to swear Geithner in right after the Senate vote. This was unusual, but it’s clear the new president is trying to stop the bleeding of his new Treasury man. Instead of a hoped-for early confirmation to get the next stage of the financial-bailout package moving, Geithner wound up being one of the last cabinet officers confirmed.

But Geithner’s gaffes are not all tax related. He tripped up again last Friday when it was discovered that he attacked China in written responses to Senate Finance Committee questions. This caused quite a stir on Wall Street, as gold soared and the dollar fell. Mr. Geithner will be the biggest bond salesman in American history as he attempts to successfully finance what will be trillions of dollars in new debt obligations. That’s why it’s hard to understand how he would poke a stick in the eyes of his biggest banker, namely China, by labeling them a "currency manipulator."

Currency manipulator is an actionable phrase that could trigger a 27 percent tariff on Chinese imports, according to the highly protectionist resolution sponsored by Republican Lindsey Graham and Democrat Charles Schumer. Henry Paulson took great care to avoid that phrase during his tenure.

The yuan appreciated close to 20 percent in recent years, before falling as China moved to help its sagging economy by stopping its deflationary currency policy. And during Obama’s presidential campaign there were numerous protectionist overtones aimed at halting trade deals with Colombia, Panama, and South Korea, and at rewriting NAFTA. But the China card is a new one.

During the Clinton years, Treasury man Robert Rubin and economic advisor Larry Summers, under whom Geithner served, maintained a strong and stable dollar policy. So with all these government bonds to sell, you would think Mr. Geithner would also want a stable currency to help his funding efforts. But his attack against China undermines the stable-dollar idea, and could force Treasury rates much higher during his term.

Since Geithner is something of a wounded warrior from the tax non-payment controversy, Team Obama’s economic policy is shifting toward a Larry Summers power-center right now. So it is equally important to note Summers’s clear statements on Meet the Press on Sunday, when he called for repeal of the Bush tax cuts on investors and successful high-end economic activists.

However, investor capital is on strike against stocks, real estate, and distressed toxic assets. So it’s puzzling that Summers told NBC’s David Gregory that the Bush tax cuts must be repealed. He left open the date. But he left no uncertainty about the intent.

Of course, this could have a significant deterrent effect on investor decisions. It certainly connects the dots between Obama policy and the rantings of House Speaker Nancy Pelosi, who has similarly called for repeal of the Bush tax cuts. One would think, in today’s deflationary investor environment, that pro-growth economic policies would seek to reward investors, not punish them.

If Summers and Geithner propose a new government "bad bank" to purchase toxic assets, then somebody in the private sector is going to have to buy them at resale. This is why some economists have proposed a multi-year capital-gains tax holiday, including a significant increase in capital-loss write-offs against future tax liabilities. Or at a minimum, the new administration could spur interest in distressed assets by extending the Bush tax cuts, not repealing them.

But even before Mr. Geithner settles into his new job, prosperity-killing threats from investor tax hikes, protectionism, and a weak dollar could throw a wet blanket over economic recovery.

What's terrible is some of these job losses shouldn't have happened. No company, of course, can evade all the ill effects of a global recession, and Caterpillar is just one of many being hit.

But a protectionist climate in Congress is poison to company earnings. Without that protectionism, the impact of the downturn would be far less.

One of the things Congress could do is pass free trade with Colombia. Contrary to populist doggerel, it's a net job creator, not a job-killer. Free trade kills foreign government tariffs on American goods sold abroad and enables companies like Caterpillar, which are hard-hit by them, to sell more.

Caterpillar's results show this. It reported a downturn in sales in emerging markets for its decline in profits.

This is especially bad because some of Cat's biggest growth comes from such countries, in particular those that either have or want free trade with the U.S.

The effect can be quantified. Economist Dan Griswold, director of the Center for Trade Policy Studies at the Cato Institute, found exports were responsible for 6,667 new U.S. jobs at Caterpillar alone.

"Caterpillar is in many ways a typical American company," Griswold told IBD. "It sells more abroad (63% of sales) than here, and it's increasingly a global company. The success of its U.S. workers and shareholders is determined by its success abroad. That depends on free trade, freedom of investment, and strong relations with its commercial partners."

Without free trade, Caterpillar is stuck paying around $100,000 in tariffs for each earthmover it sells to Colombia, a big mining country that's one of Caterpillar's best markets.

There's no doubt Colombians want to buy Caterpillar machines without tariffs, too.

Last year, Colombia's pro-free-trade union leaders told IBD they favored free trade because they want their companies to invest in the higher quality Caterpillar earthmovers.

That would spur more output and hiring of union workers. It also would make mining safer. Caterpillar's own earnings report Monday noted that "capacity in the world's infrastructure, mining and energy industries is still inadequate or outdated," and for that reason it expects continued demand growth.

But Colombian companies won't buy as many Caterpillars if they keep getting hit with huge tariffs on sales of its earthmovers, diggers and giant dump trucks. And the same is true of other countries that don't have free-trade deals with the U.S.

They'll buy from cheaper foreign competitors instead. For Caterpillar, this means lost sales, lost profits and lost American jobs.

Griswold thinks the political climate here is a big part of the problem.

"Unfortunately, the Obama Administration and Congress . . . seem to want to make it more difficult to invest abroad, and Congress refuses to pass free trade," he said. "It's not only the downturn, but a president and a Congress that threaten to raise investment costs and not lower trade barriers."

Griswold and other free-trade advocates concede that Caterpillar and others like it would feel the downturn no matter what. But the impact on all firms is made much worse by the new anti-free-trade sentiment taking root in Washington. "What made the recession of 1929 into a Depression was when the U.S. embraced protectionism," said Bill Lane, director of government affairs at Caterpillar.

At a time when every job counts, it's getting pretty outrageous that Congress refuses to take every step possible to conserve American jobs. Some 56,000 jobs were lost on Monday alone. Free trade is one of the few things Congress can do to stanch this bleeding.

All of the above takes on greater prominence in light of Treasury Secretary Tim Geithner’s statements about China last week. After mouthing the increasingly meaningless line bludgeoned to death by George W. Bush’s Treasury’s secretaries that a “strong dollar is in the national interest”, Geithner added that “President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency.” Geithner’s statement bodes ill for the dollar, and as a result, for future stock performance.

To begin, Geithner’s desire that China’s central bank revalue the yuan is an explicit admission on his part that he would like China to continue to manipulate the yuan’s value; albeit to a higher level against the greenback. Sadly for dollar holders, investors regularly key on the comments of Treasury secretaries, and the dollar price of gold has skyrocketed over $60/ounce since Geithner spoke. Sure enough, one way to increase the yuan’s value versus the dollar is for the dollar to fall, and investors are so far accommodating our new secretary’s wishes.

Worse, in jawboning the Chinese about the value of the yuan, Geithner is showing an impressive misunderstanding about why we produce in the first place. Put simply, we produce so that we can consume. In that sense, the only number that matters when it comes to trade between the U.S. and China has to do with how much we’re trading.

In that sense, the mostly tight link between the yuan and the dollar since the ‘90s has been a boon for wealth-enhancing trade between producers in each country. From 1998 to 2007, exports from China to the U.S. increased 351 percent, and from the U.S. to China they’ve risen 355 percent. And while the protectionists in our midst might eagerly note that China has exported a great deal more of goods in total dollars to the United States during the time in question, this merely speaks to the truth that a lot of the dollars we send to China come back as investment; investment not counting in trade figures.

What’s important is that currency stability between the two countries has been wealth enhancing for producers in each country engaging in their economy specialty. Just as comparative advantage within these fifty states has fostered all manner of U.S.-based economic specialization and wealth creation, the expansion of the division of labor to China’s millions of able-bodied workers has similarly enriched us. For those who doubt this, try to imagine how much smaller our economy would be if every state in the Union had a different floating currency. Much as trade would decrease in an impoverishing way if a New Jersey currency were to float versus a New York currency, so will we weaken ourselves if the value of the yuan starts to gyrate relative to the dollar.

And when we consider market returns, it’s then that we see that Geithner is truly playing with fire when he jawbones China. Indeed, contrary to the broad assumption that Federal Reserve activity is the main driver of the dollar’s value due to its control over “money supply”, the real truth is that Treasury secretaries hold more sway.

When Carter Treasury Secretary Michael Blumenthal expressed unhappiness with the allegedly weak Japanese yen (history always repeats itself) in June of 1977, the dollar proceeded to collapse. The Reagan Treasury talked up the dollar in the early ‘80s, but Secretary James A. Baker used the 1985 Plaza Accord to bring the dollar down, and markets complied. Baker’s indifference to the falling dollar in October of 1987 is thought by many to have sparked the ’87 crash.

Moving to the Clinton years, tariff threats on Japanese luxury autos combined with Secretary Lloyd Bentsen’s acceptance of a weak dollar brought it down during Clinton’s first term, but the dollar’s value jumped during his second term owing to the basic truth that during Robert Rubin’s tenure at Treasury, not once did a responsible official there ever express unhappiness with the yen’s value versus the greenback.

It’s well-known now, but all three of Bush’s Treasury secretaries revealed their weak-dollar stance in suggesting that "markets" should set the value of the dollar concept, and investors once again complied with a collapsing unit of account. This is important when we consider equity performance. Carter and Bush were weak dollar presidents, and equity performance was dismal under both. Reagan and Clinton were mostly strong dollar presidents, and stocks soared under both.

So in assessing Geithner, his intimate involvement in the disaster that has been TARP should have disqualified him for Treasury out of the gate. That he’s now shown his true colors with regard to a weak dollar makes his confirmation even more of a mistake given the impressive correlation between falling currency values and poor economic performance. What’s unknown at this point is whether Barack Obama will countenance the very currency policy that sank George W. Bush’s presidency. Indeed, if history is any kind of indicator, Obama’s embrace of Geithner foretells a future in which the numerous agents of “change” in this country will have very long faces.

Today, we seem to be living out Wesley’s most feared version of the pursuit of affluence unencumbered by virtue. Scam artists perpetrate giant Ponzi schemes against their friends and associates. Executives arrange compensation packages that pay themselves handily for failure. Ordinary people by the hundreds of thousands seek a shortcut to riches by lying on mortgage applications. Heartless phony bailout schemes take the last dollar of people already in distress.

To survive all of this it seems capitalism needs a new dose of restraint. But absent a vast religious revival in the West, which seems unlikely, where will a renewal of the virtues of the work ethic come from? That question becomes ever more difficult to consider because as religious practice fades and our institutions reject traditional values, so too does the memory of the role that these elements played in the rise of capitalism.

In the Church of the Middle Ages, work was something the faithful performed to survive, not something that had a value of its own. The most important occupations were not determined by the market but by church leaders: the monastic life first, followed by farming and then crafts. Although the Church saved what was left of Europe’s culture and economy after the fall of Rome, the continent’s standard of living barely changed for 1,000 years under a worldview that was suspicious of all but commerce on the smallest scale.

Calvin undermined that view by placing work in a new religious context. Work was something that God willed us to do—even the rich. The worldly success that one achieved through hard work was a sign that one was perhaps a member of the elect. But the fruits of hard labor weren’t meant to be spent lavishly on oneself. The Protestant reformers preached that the faithful should reinvest the profits of hard work in new ventures rather than squander them because it seemed unlikely that people who were profligate were saved.

Over time this view of work became so widespread that many of the West’s institutions accepted it, especially in America, a land settled by dissident religious sects that embraced the Protestant ethic. By the middle of the 18th Century Ben Franklin could publish a bestseller with the title “The Way to Wealth,” a secularized guide to work values filled with observations like “A penny saved is a penny earned,” and "Early to bed, and early to rise, makes a man healthy, wealthy and wise.” By the early 19th century de Tocqueville could marvel that America’s preachers seemed as interested in promoting prosperity in this world through industriousness as “eternal felicity” in the next. Our public schools reinforced this message, not because it was religious but because it became the American way.

It was also here in America that the Catholic Church, initially suspicious of capitalism because it was thriving in Protestant countries, embraced the work ethic. As vast waves of poor immigrants from Catholic countries, most especially Ireland, streamed into America in the 19th century, church leaders, worried about a backlash, set up schools that taught the children of these foreigners the same virtues of hard work, thrift and the pursuit of advancement that Wesley had transmitted to the English working class. Within a generation, the Irish of America were thriving the way their countryman across the Atlantic wouldn’t prosper for nearly another 100 years.

But Wesley’s paradox has been a part of this landscape of work and prosperity, too. Secularism rose in the U.S. in the late 19th century and peaked in the Roaring Twenties, another age of materialism. Then the Great Depression and the Second World War brought a revival of religious observance, which continued during the boom years of the 1950s, before another decline began in the 1960s and continues through today.

Perhaps most pointedly, the values of the Protestant ethic also began to disappear from our larger society, especially from our schools, whose principals and instructors, largely schooled in American university education departments that have abandoned the idea that there is a common set of American cultural values, found such Franklinesque admonitions as "There are no gains without pains" too old-fashioned (although one can occasionally find a football coach or phys ed. teacher who echoes this wisdom).

The gradual disappearance of the Protestant ethic has shifted the emphasis in our economy from work and production to work and consumption—but most of all to consumption. A culture of thrift has become a culture of debt, and in the process many people have blurred the line between the legitimate competitive activity that is so essential to capitalism and criminality. When Franklin wrote that the bailiff does not visit the working man’s house because “industry pays debts,” he probably wasn’t thinking of the no-doc, no down-payment, interest-only adjustable rate mortgage with a balloon payment given to someone who conspired with his mortgage broker to obtain a loan for which he isn’t qualified.

The meltdown of the financial markets in the last few months has left us grappling with how we can keep markets free and principled at the same time. The only debate so far is between those who want more government regulation—who want to impose from the outside via the regulator’s eye the restraint that our institutions once tried to instill in us--and those who think that more government will only undermine our prosperity. Neither side seems to be winning the public debate because most Americans are probably equally as appalled by the shortcomings of the markets as they are by the prospect of more government control of them.

People instinctively know something is missing, just not what. A religious revival in America seems unlikely. Is it equally as unlikely that our institutions, most especially our schools, would once again promote the virtues that made capitalism thrive and Western societies prosper--not just hard work, but thrift and integrity, or what we once called the Protestant ethic?

These are just a few of the comments we culled about the fiscal disaster from our nation's newspapers. Except these quotes didn't come from 2008 or 2009. They came from 1992.

For some, it may be hard to remember. But we had a banking crisis back in the late '80s and early '90s that was in most respects far worse than the one today. It led to the collapse, dissolution or bankruptcy of hundreds of banks and savings and loans.

The concern was the same as now — that ailing S&Ls and commercial banks would go under in such numbers that they would drag the whole economy with them.

But we didn't nationalize the banks. Nor did we just dump money into them. Instead, in 1989, the government created something called the Resolution Trust Corp. Over six years, it bought up bad bank assets, held onto them, repackaged them for sale and finally got rid of them. Weak and tottering S&Ls were closed.

All told, from 1989 to 1995, the RTC folded up 747 S&Ls and sold off a portfolio of assets having a current value of $660 billion.

And doggone if it didn't work. Bad banks closed, and those that survived were healthier for it. Bad assets came off their books, and they went back to doing what they were supposed to do: lending.

Total cost to the public: $231 billion in today's dollars.

Now we're pondering how to spend the second tranche of the $700 billion Troubled Asset Relief Program, or TARP, that was passed last fall. We've spent hundreds of billions to bolster the balance sheets of some 250 U.S. banks.

How that money has been spent is not clear, however, and the banks seem as feeble today as they were in September.

In our opinion, the experience with the RTC is instructive. Sure, we'd rather the government stay out of the private sector. But if it's to be involved, as current politics seem to dictate, it's best to make sure that what it does won't destroy our economy. And it might even help.

President Obama is said to be mulling a plan to create one big "aggregator bank," dubbed the Bad Bank. It would essentially do the same thing as the RTC — buy bad bank assets to get them off the banks' books and, let's hope, get them to lend again.

During this crisis, banks have already posted losses of $500 billion, and the nonpartisan head of the Congressional Budget Office said Tuesday he expects at least $450 billion more in red ink.

To "inject capital" into the banks, as some suggest, won't be enough.

It hasn't seemed to work too well so far. This may be a case where a Bad Bank is good.

Sadly, news accounts since October have yet again shown that when the rich are hurting, the poor hurt even more. The logic underpinning trickle-down economics is difficult to refute, and if the news since the fall is any kind of indicator, the concept’s reversal amid our economic decline continues to harm the poor and middle class.

To begin, we can reference a December article by Miriam Jordan in the Wall Street Journal. Titled “When the Going Gets Tough, Some People Lay Off the Nanny”, Jordan among others profiled Dolores Jacobo, nanny for three-month old twins in an “affluent Malibu, Calif., household.” According to Jordan, Jacobo had “earned her place as an integral member” of the family, but with the family hit hard by this nation’s economic decline, Jacobo was recently informed that her $1,000-a-week position was being eliminated.

Jacobo is not alone in this regard. Jordan observed that “on a recent morning, it was standing room only in the waiting room at DDL Domestic Agency in Los Angeles.” Applicants for new caregiver positions included Alba Monterrosa, a 31-year old single mother of two who had previously earned $600/week caring for the 3 and 5-year old children of Suzanne Sirof. But thanks to the economic downturn, Sirof can no longer afford Monterrosa.

Moving to houses of worship, another Wall Street Journal article from last month titled “In Hard Times, Houses of God Turn To Chapter 11 in Book of Bankruptcy”, showed how churches are similarly taking the enervated economy on the chin. As the article noted, during “this holiday season of tough times, not even houses of God have been spared.” According to various accounts, church giving is down as much as 15 percent, and as a result, some have been forced to file for bankruptcy.

When it comes to charities, a November article from the Journal chronicled “Big Players” that have scaled back on charitable donations. Due to losses in the stock market combined with a recessionary outlook, the “pipeline from corporate America to the nation’s charities is starting to dry up.” Formerly big givers such as Bear Stearns, Lehman Brothers and Merrill Lynch have either collapsed or been bought, not to mention the fact that billionaires – including Bill Gates – have said they’ll be scaling back the dollar amount of their grants.

Other billionaires joining Gates when it comes to less giving include renowned philanthropist David Koch, who says he’s “not making new commitments.” Former AIG chief Hank Greenberg’s foundation is heavily weighted in AIG stock, but with the insurer’s shares well down, Greenberg says “You can’t give what you haven’t got.” Las Vegas casino mogul Sheldon Adelson has watched his Sands’ holdings decline by $30 billion, which means the traditional recipients of his largesse will see a decline in the funds they receive, assuming they receive anything at all.

Residents of Palm Beach, the legendary playground of the rich, were in particular hit hard given how many had exposure to the allegedly fraudulent dealings of Bernard Madoff. According to the Wall Street Journal’s Paulo Prada, if the worst materializes, “Gardeners and dog walkers are likely to lose jobs, along with accountants and lawyers.”

For the business owners whose shops and restaurants line Palm Beach’s Worth Avenue, they worry that the “alleged fraud will exacerbate what already has been an unusually quite season.” That being the case, it’s fair to assume that the waiters and waitresses heavily reliant on tips will experience for the first time in a while what it’s like to serve relatively impoverished customers.

As for Jewish charities, some have already folded altogether, and some face disastrous shortfalls. According to the Wall Street Journal’s Eleanor Laise and Dennis Berman, programs “for bone-marrow transplants, death-row inmates and human rights campaigns” have already been threatened “as dozens of philanthropies took stock of their exposure” to Madoff.

Moving to our institutions of higher learning, a Los Angeles Times article from Christmas day pointed to donation shortfalls at Syracuse University that if not corrected, would force 400 students to drop out. Thanks to California’s budget crisis, student fees at schools in the UC system will rise 10 percent next year, while the Cal State system will reduce its enrollment by 10,000 students.

Citing losses in its $17.2 billion endowment, Stanford plans to reduce financial aid. President-elect Barack Obama’s former college, Occidental, plans to freeze non-faculty hiring, and the University of Southern California plans the same.

And with retail sales down, Liz Claiborne CEO William McComb now catches various subways and trains to New York City airports in order to shield his shareholders from costs related to cabs and livery drivers. Last month, this writer made a speech in Pittsburgh, and was taken in a cab from downtown to the Pittsburgh airport by cabdriver Jim Marosz. Marosz said the downturn has taken his fares down 30 percent. In the words of Marosz, “our fares go up and down with the economy.”

So while elite economic thinkers turn their noses up to the notion of trickle-down economics, all it takes to confirm the latter’s truth is to pick up any major newspaper on any given day. With the U.S. economy struggling, the rich are very much hurting. Sadly, it remains the case that those not rich will feel their pain most acutely.

All of the above will hopefully be remembered the next time a politician posits that economic bliss will result from hurting the rich. Indeed, while the rich surely pay the most in taxes and experience the greatest losses of wealth during tough economic times, it’s invariably the poor who truly feel their pain.

SCHIP is the first congressional skirmish in what will no doubt be a multiyear ideological war over the government’s role in health care. President Obama ran on a platform of setting up a new public health- care plan, while insisting that Americans would continue to have the choice of signing up for private plans. That is a legislative battle yet to come.

Republicans and Democrats both want to reauthorize SCHIP, but with a difference. Republicans want to expand it by $5 billion over five years, an annual increase of 20%. They want to treat this federal-state program as the government treats food stamps and housing vouchers—available to low-income Americans, who need them, but not to middle-income households.

In contrast, congressional Democrats propose to increase SCHIP by $32 to $39 billion over five years, according to estimates by the Congressional Budget Office, almost tripling the program by 2013. They seek to move the government, it seems, toward national health insurance that would be like national defense—available to everyone, and paid for by the taxpayers, as in Europe and Canada.

On January 14 the House of Representatives passed a bill to increase SCHIP spending, paid for by increasing tobacco taxes (assuming the smokers don’t quit in response to the higher tax). House Speaker Nancy Pelosi declared, “My colleagues, this is a day of triumph for American children.”

If the Senate follows suit, the legislation will go to President Obama, who indicated during the campaign that he would sign it, unlike President Bush, who vetoed a similar SCHIP increase as excessive.

The Democratic bills are more costly because they would insure more children by raising income eligibility well into the middle class. Last year, SCHIP covered about 7 million low-income children and Medicaid covered an additional 23 million. CBO estimates that the proposed bills would add another 6.5 million children to the SCHIP and Medicaid—and, according to Census Bureau data, 42 million children would be eligible.

The bills would raise family income ceilings for states to qualify for Federal reimbursement. The present limit is 200% of the poverty line, or $44,000 for a family of 4 (although individual states can and do fund higher levels without the Federal share). The new bills would potentially raise the limit to 300%, or $66,000. An exception for New York would include families at 400%, or $88,000.

According to the Senate Minority Leader, Kentucky’s Mitch McConnell, “This is more than double the median household income in many states, including Kentucky. It’s grossly unfair that a family in Kentucky making $40,000 must pay for the health insurance of a family making double that — especially if the Kentuckian can’t afford it for his own family.”

The median U.S. household income is $50,000. Sixty percent of American households earn less than $62,000. By raising government insurance eligibility to embrace three fifths of households, Congress would change SCHIP from a low-income to a middle-income program—even as middle-income households d pay lower taxes under the pending economic stimulus plan. That’s not fiscally responsible.

In addition to the higher eligibility limits, the bill adds more immigrant children, and drops the five-year waiting-period now required for legal immigrants to be eligible for the programs. Nor would the Democrats require states to show how they would reduce the “crowding out” of private insurance by expanded government coverage.

Senator McConnell’s alternative bill, Kids First, would increase SCHIP spending by $5 billion over 5 years, covering an additional 3 million children. Only in Congress is $5 billion regarded as an insignificant sum.

The SCHIP debate prefigures crucial health-care questions for Americans of all ages in the next few years: Who should be insured under federal plans, and who under private plans? Do the American people want creeping nationalization of health-care financing, as they have seen creeping nationalization of the banks?

In 1965 Congress created Medicare, to cover health care for the elderly regardless of income. Today, it is an enormous program, gradually eating up the Federal budget, with trillions of dollars in unfunded liabilities. Medicare reform is a top priority on President Obama’s to-do list. But it will do little good to solve Medicare's finances if Congress expands spending for children’s health care, increasingly heedless of income.

Truer words were never spoken. When it comes to weather, the current Democratic majorities in the nation's capital don't have a clue. But neither that nor the weather deterred Gore from testifying Wednesday before the Senate Foreign Relations Committee on the need to pursue a treaty to lower carbon emissions at a United Nations conference in Copenhagen next December.

The storm has been blamed for at least 23 deaths and a glaze of ice and snow that caused widespread power failures from the Southern Plains to the East Coast. As the roads in D.C. iced and the snow fell, Gore might as well have quoted Groucho's line: "Who are you going to believe, me or your own lying eyes?"

Gore would probably blame the storm on global warming too. In his eyes and those of fellow warm-mongers, global warming causes everything — including the global cooling that has been both obvious and documented since 1998. These cyclical trends used to be called weather. Now they're ominously called "climate change."

To underscore his point, Gore flipped through more than four dozen new slides showing melting ice caps, Western wildfires, deforestation and oxygen-depleted seas in a hearing room where the lights were dimmed. Dim bulbs or not, some facts were left out of his presentation.

Each year, millions of square miles of sea ice melt and refreeze. The amounts vary from season to season. Despite photos of floating polar bears taken in summer, data reported by the University of Illinois Arctic Climate Research Center show global sea ice levels the same as they were in 1979, when satellite observations began.

The island nation of Tuvalu, poster child for rising sea levels, is still well above water at last report.

Pictures of a collapsing Antarctic ice shelf that's been warming for decades are common. But the shelf in question constitutes just 2% of the continent, and temperatures show that the entire continent has been cooling for decades, with thickening ice.

Western wildfires are due in large part to the failure to clear dead trees and underbrush that fuel these fires because lumber companies might profit or the habitat of endangered critters might be harmed.

Deforestation has been fueled by the Gore-induced quest for biofuels and the planting of cleared areas with crops like corn to be put in our gas tanks. The Paris-based OECD says the use of fuels such as ethanol made from corn, palm oil and other sources using crops as raw material amounts to "a cure that is worse than the disease they seek to heal."

Oxygen-depleted seas are caused in part by this increased planting of crops for biofuels such as ethanol to replace petroleum, something Gore supports. This has created dead zones for marine life in places like the Chesapeake Bay and the Gulf of Mexico, while driving up food prices around the globe.

Gore insists that climate change brings drought, famine and increasing numbers of ferocious storms. However, total hurricane energy activity, as measured by the National Oceanic and Atmospheric Administration, has dropped by two-thirds since the record was set in 2005. Hurricane activity, like all weather, is cyclical.

As environmental guru Bjorn Lomborg, author of "The Skeptical Environmentalist," points out, famine has declined rapidly over the past half-century even as greenhouse gases have risen.

That is, until we started using food to fuel our cars. The World Bank estimates that this policy has driven at least 30 million people worldwide into hunger.

If it keeps snowing, Al, there's a shovel-ready job waiting for you in D.C.

Thomas Jefferson suggested that “democracy will cease to exist when you take away from those who are willing to work and give to those who would not.” Redistribution, when it is from those with good ideas and strong work ethic to those without, is a special form of “beggar thy neighbor.” As we visit restaurants with empty tables and stores with idle clerks, are we seeing the result of policies that “beggar thy client”? When we see resources siphoned from the public economy into financial institutions that misjudged risk, automakers that misjudged demand, airlines that misjudged costs, a health-care system drowning in paperwork, and so forth, are we “beggaring” the very engines of innovation and economic advancement, including any and all who do not feed at the public trough?

But, of course, the plan is not to pay for this government largesse with current taxes. The plan is to borrow the incremental cost. So, the argument goes, we are not beggaring our bosses, our clients, our innovators and the hardest working among us. But, if current taxpayers are not bearing the cost, then future taxpayers must. Is it possible that the capital markets are reacting to an ambitious agenda which tacitly seeks to “beggar our children”?

After the Napoleonic Wars and again after World Wars I and II, England owed more than 250% of its national income. It took England most of the 19th century to bring the Napoleonic debt burden back below 50% of GDP, and a third of a century to do so after World War II. Some have suggested that this debt burden ultimately cost Great Britain its supremacy in world commerce. In the 30 years after World War II, after flirting with socialism which sought equality through a 98% top tax rate, the UK finally elected Mrs. Thatcher, who recognized that growth requires entrepreneurs and innovators, not a centralized command economy. Eastern Europe has also, selectively and with many false starts, recognized the same in recent years.

So what? In mid-2008, the United States government debt – aggregating across national, state, county and city – owed a far more modest 120% of GDP. Or did it? If we add in the unfunded portion of our Social Security and Medicare entitlement programs, the debt is already past 400% of GDP. And if we add in our corporate and household debt, our total indebtedness is a truly remarkable 800% of GDP, up from 500% of GDP a scant decade ago. Surprisingly, the TARP program has made little initial difference on our national indebtedness, mostly shifting debt from the corporate sector to the government. But, the proposed spending surge, and the tacit nationalization of broad swaths of the private sector, will add mightily to our debt burden.

History is ambiguous in assessing the impact of large national debt. Those who decry any and all deficit spending overlook the fact that a deficit smaller than the average growth in GDP can lead to a shrinking debt burden relative to GDP. Those who take the opposite view, suggesting that deficits do not matter, overlook the fact that no nation has ever experienced a deficit larger than 100% of GDP without daunting consequences, ranging from depression to bankruptcy to war. Indeed, many have argued that the seeds of Nazism were sowed by Germany’s crushing debt burden from World War I, and the resulting depression and hyperinflation of the 1920s.

So, what are we to make of our fast-rising indebtedness?

• Do we intend to eliminate large swaths of the indebtedness by abrogating our Social Security and Medicare obligations? It’s hard to imagine that the largest-growing roster of voters, those over 55, will allow that to happen.

• Do we intend to reduce the real value of our indebtedness by debasing our currency? This reduces the cost of our debt, but often at a cost of stagflation or depression.

• Do we abrogate our foreign indebtedness? With most of our foreign indebtedness owed to Russia, China and the Middle East, this is not likely to lead to a benign outcome.
Alternatively, do we intend to grow our way out of this mess? That’s the obvious intent.

• Do we rely on the multiplier effects of Keynes to stimulate spending and growth? People spend when they (1) have money and (2) have confidence that they’ll have more in the not-too-distant future. There’s no serious lack of the former, but spending has plunged because of a lack of clarity on the latter.

• Viewed from the supply side of Adam Smith, growth becomes difficult when innovators and entrepreneurs have no confidence that they’ll enjoy the fruits of their ideas and their successes. A government that views success with suspicion, stifles innovation with regulation, and criminalizes failure (SarbOx) is no friend to entrepreneurs.

Individuals and businesses invest more wisely than governments. If Obama wants to lead from the center, he needs to reassure us that entrepreneurialism will not be discouraged and risk bearing will not be punished. The capital markets will react well if the Obama administration unleashes the power of human innovation; they have reacted badly after the election, and again with the inauguration, because the markets fears that this is not in the cards. To borrow another quote from Jefferson, “I predict future happiness for Americans, if they can prevent the government from wasting the labors of the people under the pretense of taking care of them.”

The most authoritative macroeconomic theories are those advanced by Nobel Prize Winners in Economic Science, to use the official title of the prize. The Economics Nobel Prize is awarded at the same time as the Nobel Prize in Physics, Chemistry, and Medicine, the three hard sciences. The implication is that macroeconomics has the same predictive power as the theories of physics, chemistry, and molecular biology. Indeed, we should judge the validity of macroeconomic theories in the same way we judge the theories of the hard sciences. If anything, we should demand even more rigor and reliability from macroeconomics, because it is far more important than any hard science. The failure of macroeconomic actions in the Great Depression led to World War II, in which many millions were killed, to say nothing of the vast misery caused by the Depression itself.

Years ago, I had a dispute on the comparative rigor of astronomy and macroeconomics with Harvard economist H. Gregory Mankiw, who from 2003 to 2005 was Chair of President Bush’s Council of Economic Advisors. Mankiw admitted that the predictive power of modern macroeconomic theory was abysmal. But he argued that astronomy was no better in the late sixteenth century, when astronomers were debating whether it was Ptolemy or Copernicus who was correct.

Mankiw claimed that the decision for Copernicus over Ptolemy, for heliocentric astronomy over geocentric astronomy, was based on the personal biases of the astronomers rather than on the superior predictive power of the Copernican model of the Solar System. According to Mankiw, in the beginning, the bias of Ptolemy’s conservative supporters was naturally dominant, but later, the younger, progressive Copernicans were able to take over the astronomy departments. Mankiw concluded that we should therefore not be too hard on macroeconomists, who are at least no worse than Renaissance astronomers when they base their predictions on personal (political) biases rather than objective observation obtained from experimentally verified theory.

I have studied the actual comparative predictive power of Ptolemaic and Copernican planetary theory between 1543, when Copernicus published his great book, and 1609, when Kepler published his first two laws of planetary motion. In actual fact, Copernicus was on the average twice as accurate in predicting the positions of the planets as Ptolemy. But Copernicus was not always superior to Ptolemy: the older theory gave more accurate predictions of the positions of the inner planets Mercury and Venus.

I have gone over the writings of the sixteenth century astronomers, and they were completely aware of this relative predictive power. These astronomers were not yielding to their biases either for or against Copernicus. They were paying careful attention to the observations, which did not give a clear victory to either theory. They concluded that more and better observations were needed. The Danish astronomer Tycho carried out these observations, and his German assistant Kepler used Tycho’s better data to create a theory whose predictive power was a factor of a hundred better than either Ptolemy or Copernicus. This settled the debate, and Kepler’s work led to Newton’s mechanics upon which all modern physics and chemisty, indeed modern technological civilization, are based.

The moral of the story is simple. Macroeconomists should realize that the inability of their theories to make accurate predictions means that they do not know what they are talking about. We non-economists should realize this also, and realize that our leaders, who are being advised by macroeconomists, haven’t got a clue where they are leading us. Their actions may lead us out of the current recession, or they may lead us into a depression as bad as the Great Depression.

Franklin Roosevelt is often given credit for experimenting with the economy in a scientific manner. He did nothing of the sort. Any experiment involving human beings has to be a controlled experiment, as in medicine. Half the patients are given the new medicines and the other half, the controls, either the old medicine, or a placebo. Then, and only then, can one tell if the medicine actually improves the condition over doing nothing (the placebo), or is making matters worse. In contrast, Roosevelt — and today’s economic advisors to the President, unfortunately — propose to apply their economic medicine to the entire economy. This is astrology, not science. The professors of economics have no true, experimentally confirmed knowledge of macroeconomics.

The widely touted macroeconomic “experts” are no experts at all.