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Two bad recent signs concerning the movement to reform financial regulation: The first is the first public meeting of the Financial Crisis Inquiry Commission, created by Congress four months ago to investigate the causes of the financial crisis and report back at the end of next year. The commission has gotten off to a slow start, and even though only one member of the commission could (I believe, though I am not certain, and welcome correction) be described as a professional economist (Keith Hennessey), and even he is more a political operative, the commission has appointed as its executive director not an economist but a lawyer--a prosecutor in the California attorney general's office. And at its first public meeting members of the commission made statements which suggest that they will divide along the predictable political lines (six of the members are Democrats, four Republicans).

One can hope; but it seems unlikely that the commission will do a good job. It will look for crooks and frauds rather than for underlying causes, unless an underlying cause can be pinned to the tail of the politically party to which the pinner does not belong.

Meanwhile the Administration and the Fed plow ahead with their own programs of regulatory reform, without waiting for the commission's report--which may indicate how the commission is regarded by the government's economic leaders. The latest proposal, this one from inside the Fed, is that the Fed should issue regulations empowering it to regulate the compensation practices of all banks that belong to the Federal Reserve System and thus are under the Fed's regulatory aegis--and not just the compensation of senior executives but of all bank executives. The proposal goes beyond the Treasury Department's June 17 white paper, which proposed regulation of compensation only of executives of "Tier 1 Financial Holding Companies," which is to say the handful of major banks and other major financial institutions whose failure might trigger a general collapse of the financial system. The Fed proposal is more ambitious--and highly dubious. Where will the Fed find staff for such regulatory oversight? What is the need to regulate the compensation practices of small banks? And given Lucian Bebchuk's sensible suggestion (about which I have blogged) that if senior executives are compelled to be compensated in ways that would penalize them if their company got into trouble and needed a bailout they will be motivated to prevent their subordinates from taking risks that might trigger such consequences, why does the Fed think it has to reach down and review the methods by which banks compensate traders, loan officers, and other non-senior executives? Why can't that be left to properly incentivized senior management?

It seems that the Fed, and the government more broadly (including Congress), is in the psychological state known as "denial." Or that it is behaving like the drunk who, criticized for looking for his lost change under a lamppost far from where he had dropped it, explained that he was looking for it there because the light was better. Congress, and much of the public and media, can understand the financial crisis only in populist terms, as the product of the machinations of greedy, reckless, overpaid, perhaps criminal denizens of "Wall Street." Systemic causes of the financial crisis, such as unsound monetary policy, deregulation, lax regulation, regulators asleep at the switch, unsound economic theories, complacency, quirks of the tax code, deficits, Chinese trade policy, mindless governmental promotion of home ownership, and so forth, are beyond them. The government is willing to play to the ignorant partly because in a democracy popular views must always be treated deferentially; partly because (in all likelihood) it doesn't think that the people, the Congress, and the media (except for the most sophisticated financial journalists) can understand a serious economic analysis; and partly because the populist account conveniently deflects attention from the failures in which the current economic leaders of the nation were complicit in the run up to the crisis--unsound trade policy, excessive financial deregulation, lax regulation, complacency, lack of foresight, lack of contingency planning.

Of course if the officials who screwed up said they'd screwed up, the people and the Congress would be reluctant to entrust them with responsibility for redesigning the regulatory system. So they must find scapegoats, and where better than on "Wall Street"?

(Photo: Flickr User eflon)

My lefty critics don't believe me when I say I support the stimulus. But I do, and I advocated it in my book A Failure of Capitalism, completed before the stimulus was enacted. I am a Keynesian, and I have sharply criticized conservative economists who oppose Keynesian deficit spending. I simply do not believe that it is possible to attribute the improvement in the economy to the actual spending of stimulus money through the end of the second quarter, because I believe the actual spending was small and that the significance of the stimulus program is more psychological than (as yet) economic.

I attribute Christina Romer's August 6 speech, and Vice President Biden's speech of September 3 on the first 200 days of the stimulus program, to the political imperative of shorting up public support for the stimulus. Oddly, the program is unpopular, and not only among Republicans. The reason for its unpopularity I believe is the Administration's health care plan. The unfunded and probably unfundable cost of the plan has riveted public attention on the nation's huge deficits. $787 billion in deficit spending obviously adds a lot to the deficit. The stimulus program probably should have been adopted last fall rather than in February of this year, and expedited more vigorously than it has been. Romer has warned in her academic writing (which incidentally I admire) that Keynesian measures for spurring recovery from an economic downturn tend not to be implemented until the downturn has reached its bottom and thus they risk overheating the economy by adding public demand when private demand is again growing. This should worry Romer, although because of the continuing credit crunch, continued stimulus expenditures may not in fact overheat the economy. In the postwar recessions that she discusses (particularly in a 1994 article with David Romer in the NBER Macroeconomics Annual), fiscal recovery measures came on top of monetary measures, namely reducing interest rates. When a nation's banking system is in bad shape, monetary measures lose much of their efficacy. The Federal Reserve has pushed interest rates way down, without stimulating much lending. The economy may well have considerable slack for months or even years to come, in which event stimulus expenditures will not cause inflation.

My criticisms of Christina Romer's August 6 speech (most recently in my blog posting of August 25) continue to draw criticism, most recently (as far as I know) from the economist Menzie D. Chinn, in an August 27 posting on Econbrowser--an excellent blog. Professor Chinn makes a series of criticisms of my argument, starting with saying I have "given up on accusing Dr. Romer of lying about the $40 billion figure." The reference is to her estimate of the tax benefits authorized by the stimulus bill that were granted by the end of the second quarter of this year (June 30). I never accused her of lying about the figure; I do not even question the figure. My point was the difference between authorizing or disbursing money and spending it. No one seems to know how much of the $40 billion was actually received by taxpayers, as opposed to reducing their future tax payments; and of the amount actually received by them, no one seems to know how much they spent rather than saved. These distinctions have eluded Professor Chinn, though I had emphasized them in my August 25 blog posting--the target of his criticisms. He seems to think that it is possible that all the $40 billion took the form of rebates, but as far as I know none of it did. A rebate would be a check to the taxpayer, as distinct from a tax credit. Bush's spring 2008 stimulus package consisted entirely of tax rebates; the Obama stimulus does not.

Professor Chinn says that even if none of the $40 billion in tax relief was actually spent by recipients of the relief in the second quarter, the remaining $60 billion of Romer's "more than $100 billion" was ample to increase GDP that quarter by two percent. But that assumes that all of the $60 billion was spent, and no one seems to know how much was; Chinn assumes it all was, which is false. A neglected point is brought out in an article by Michael Cooper in the September 5 New York Times. The article points out that federal stimulus spending can be nullified by state cutbacks. For example, a federal grant of stimulus money for mass transit has been nullified by reductions in state expenditures on mass transit. The question then becomes what was the consequence of those reductions? Maybe they enabled a state to rescind a tax increase, in which event state taxpayers would have more money in their pockets. And then the questions would be: how long does this process take, and how much of the additional money do the taxpayers spend rather than save?

Output (measured for example by Gross Domestic Product) is a flow concept, not a stock concept. The nation's housing stock, and its other assets, including stocks and bonds, are not part of GDP. What I said, in criticism of economists who deny that a stimulus program can have any beneficial effects, is that while it is true that if a dollar invested by government, say in hiring a road contractor to build a new highway, reduces private investment by a dollar, the government expenditure is unlikely to increase net output, but that I doubted that that would be the effect of the stimulus. If private investment and consumption are down because people and firms are hoarding cash for fear of what the future holds for them, government can in effect put those inert savings to work by deficit spending on public works.

This same economist, Mark Thoma, who like DeLong is notably abusive, resorts to the academic trick of reading a passage literally in order to make the author seem an ignoramus. I had said that one of the events in the second quarter that might have helped reduce the rate of decline in output and employment was increased foreign demand for U.S. goods, relative to the first quarter. Thoma says: "he [Posner] talks about foreign demand for US goods, but doesn't include NX in his definition of output." "NX" means net exports. That is to say that increased foreign demand for U.S. goods is a good thing, since exports increase national income, unless U.S. demand for imported goods grows more. That's true, and if that happened in the second quarter (it didn't) I would not have pointed to the increase in foreign demand as a factor favorable to U.S. output, hence a possible confounding causal factor with the modest stimulus disbursements in the second quarter.

My critics are leftwing economists, and I think they simply can't believe that I really support the stimulus program, that I am a Keynesian, and that I am a critic of conservative macroeonomists and finance theorists, though I do not accuse John Cochrane, a distinguished finance theoriest, as Thomas does, of not knowing freshman economics. 

Well, on to substance.

Romer's speech argues that the disbursements of stimulus funds through the end of the second quarter of this year (that is, through June 30) have had a big effect on economic output and employment. I said this was unlikely as a matter of theory, and that she had no persuasive evidence to back up her claim. And I raised the question of the ethical responsibilities of an academic who takes a government job and then makes a speech that although it deals with a subject that she had studied and written about as an academic is not a responsible academic analysis. My concern is enhanced by the statement of one of my critics that the Council of Economic Advisers, of which Romer is the chairman, has a sterling reputation for political neutrality and analytical rigor. Romer's speech does not bode well for the preservation of that reputation. Another critic argues that since it was just a speech, intended therefore to be heard rather than read, Romer should be permitted to have rounded off her numbers, and thus to have rounded off $89 billion (this critic's estimate of how much stimulus money had been disbursed by the end of the second quarter) to "more than $100 billion" (her language). This overlooks the fact that the speech was posted on the CEA's website, and is replete with footnotes, which I doubt she read aloud.

In fact, while I am on the subject of the amount of stimulus money disbursed so far, $89 billion seems too high. The government's official figure is $60 billion, and a recent estimate by msnbc.com is $58 billion. One of my fiercest critics estimates the figure at "about $60 billion," without however remarking the discrepancy between "about 60 billion" and Romer's "more than $100 billion.

Far more important than the amount of money disbursed is the amount spent. The distinction is essential. When an individual or for that matter a state treasurer (for the entire stimulus disbursements through the end of the second quarter consisted of transfer payments) receives a check, he has a choice between saving it or spending it, or doing some of both; and if he decides to save it, he has to decide whether to hold it in cash, deposit it in a bank account or a money-market account, buy stock, etc. The more of it he decides to save in a safe form, the less the stimulus he received will do to stimulate economic activity. Most economists believe that "transitory" (one-shot) income is mostly saved rather than spent; and the belief is confirmed by most studies of the effect of the $150 billion in tax relief implemented in the spring of 2008 to fight the then-nascent recession.

Romer's speech does not indicate what percentage of the "more than $100 billion" (or is it $58 billion?) had actually been spent rather than squirreled away during the second quarter. Moreover, given the inevitable lag between the disbursement and the expenditure of disbursed funds by the recipient of the disbursement, disbursements made toward the end of the second quarter could not have affected output and employment in that quarter.

Romer's failure to address these points would be understandable if she were not an academic student of stimulus programs; but she is.

When I read her speech the first time, I missed this startling statement: "the fact that consumption fell slightly in the second quarter after rising slightly in the first quarter could be a sign that households are initially using the tax cut mainly to increase their savings and pay off debt" (emphasis added). Well, if that's what they're doing, they aren't doing much to stimulate economic activity. I agree with Keynes that consumption is the motor of the economy (one my critics says that "consumption does not produce," which rather misses the point), and that what government needs to do when personal consumption expenditures drop is to increase government consumption--and that means public works, which employ people, and not transfer payments, which may not translate into proportionately increased consumption, or at least not without a lag. Romer says that public works (she calls them "direct investments," but the meaning is the same) "have short-run effects roughly 60 percent larger than tax cuts." She doesn't indicate where she gets the number, but it is further evidence that she believes that transfer payments are not as efficient in stimulating economic activity as public works are.

Critics have been particularly unsparing of my having expressed the so-called $100 billlion in stimulus disbursements as a percentage of annual GDP. I think it's a fair criticism--and so it is amusing to note the identical procedure in the second sentence of Romer's speech, where she states that the $787 billion is "roughly 5 percent of GDP." It is roughly 5 percent of this year's GDP. But it is to be spent over at least two years.

The most serious problem with Romer's speech is evidence. She thinks she has shown that the economy lost 485,000 fewer jobs in the second quarter as a result of the stimulus. There is no evidence for that, because she makes no effort to adjust for other developments in the economy that affected employment, including other parts of the government's recovery program. I don't criticize her or anyone for the absence of evidence concerning the stimulus program's early effects. As I said in my book, when the government attacks a depression with several different programs, it is very difficult and maybe impossible to disentangle the causal efficacy of each one. I also said, and I have repeated this ad nauseam without my critics noticing, that it was right for the government to try a variety of measures for arresting the economic decline, including the stimulus, even though the result would be that the relative effectiveness of the different measures might be impossible to determine.

One of my critics, after calling me "obnoxious," states: "Does no one see how ridiculous Romer is, to be arguing that no one should blame her for missing how bad the economy was going to be, in one paragraph, and then, almost in the next, arguing that she knows precisely what the effect of the stimulus has been, because she knows what the course of the economy would have been, in its absence?"

I mentioned that Romer's academic work had included findings (not mentioned in her speech) that stimulus measures employed against the recessions that the United States has experienced since World War II have not been effective, because by the time the stimulus is implemented the recession is over. My critics point out that because this recession is already longer than any of its predecessors, those academic findings are irrelevant. That would be true if the stimulus program had been enacted in December 2007, when the recession (or, as I prefer to call it, the depression) began. At this writing, it seems that economic growth is about to restart, yet more than $700 billion of the stimulus money remains to be spent. If economic growth turns out to be rapid, the effect of stimulus spending, on top of our huge deficits, may be to create significant inflationary pressures.

I hope this is something that Romer is beginning to think about, but I am doubtful, because she remarks at the end of her speech that the President is trying to "rebuild the economy better," for example by "urging health care reform to slow the growth rate of spending, tame the budget deficit, and provide all Americans with the [sic] secure health insurance coverage." The first two objectives are inconsistent with the third. And increasingly it looks as if any ambitious health care program that Congress passes will not be funded, and so will add to the national debt and inflationary pressures.

I would like to leave the last word to Lawrence Indyk. Mr. Indyk is a frequent commenter on my blog. His comments, whether critical or supportive (some are the former, some the latter) are invariably thoughtful and lucid. Here is his comment on my discussion of Romer's speech:

"1. Dr Romer gave a speech on August 6th purporting to assess the success of the stimulus up to that point. The analysis she presented to The Economic Club of Washington was quite different from what she would have said had she remained a private academic and not an agent of the current administration.

"2. This difference is, essentially, one of less rigor and, paradoxically, more certainty, than one would otherwise expect, or would otherwise be considered acceptable by peers in the profession. To put it simply, she expressed an extraordinary amount of confidence in her conclusion that the political plan which had been enacted was having, and would continue to have, very close to an optimal effect on the overall economic situation. In other words--it was a Goldilocks stimulus--just right, and working as planned.

"3. She did all this with the reputation of an accomplished and highly esteemed Economist, and therefore with an understanding that her audience would consider anything she said to reflect only the highest standards of objective accuracy. That is why, after all, she was chosen to make this defense of the stimulus plan. Despite this, the analysis she presented was cursory and her conclusions fairly weak.

"4. Though everybody knows it, she did not disclose ahead of time that she was now acting as a political figure and that the statement she was making was not some sterile and disinterested academic seminar, but specifically designed to have a particular political effect. Such a failure to make such a disclosure brings her professional integrity into question in terms of whether we should believe what she says on the basis of her academic reputation so long as she remains in the employ of the government.

"Well, now that the summary is finished, it all seems like much ado over not much to me. Consider paragraph 4 above. Does anyone actually expect Dr Romer to say otherwise? People have been eating similar political-through-professional content with grains of salt for a long time.

"And as for Professor DeLong's outrage (debates over details aside) is the mild charge being levied here really so unbelievable or abominable? No one has said Dr. Romer is incompetent or a bald-faced liar, merely that she speaks for the President, and it seems (as should be expected by all adults) that, while short of outright dishonestly, she is selectively emphasizing a narrative that is favorable to him." 

(Photos: Christina Romer White House Official Portrait and Flickr User Ed Yourdon)