1. Could the bonuses be compensating for the risks of a career in finance?

2. Shouldn't Goldman want to limit the bonuses paid its employees?

1. Consider actors' careers. A handful of actors have huge incomes. Most actors have such meager incomes that they abandon acting as a career. The lucky handful are like lottery winners. The only way you can motivate people to buy a lottery ticket is to have a big jackpot for the winner of the lottery. Similarly, the only way you can motivate people to attempt a career in acting is to provide a jackpot for the tiny handful of aspirants who succeed.

Could finance be the same? It is, after all, a risky business. The question is what happens to employees of Goldman Sachs or other financial firms if they engineer or approve a very risky deal, and the deal is a flop. Are they exiled from the industry? Do they end up as waiters? If so, the huge incomes of successful financiers would be justified as compensation for the risk of failure. My impression is that the failed traders, deal makers, etc., do not end up as waiters, or in other relatively impecunious jobs (I say "relatively" because waiters in elite restaurants are well paid by ordinary standards). Their training and experience equip them for a variety of good jobs in the financial industry. They can look forward to a soft landing, and therefore it is unlikely that the high incomes of the most successful financiers are compensation for the risk of failure.

It is true that anyone who is risk averse will seek compensation for taking risks, but the people who gravitate to risky occupations are unlikely to be risk averse. Put differently, as long as there is an ample supply of risk preferrers, an employer will not have to pay a premium based on risk aversion. And, as I have just suggested, the career risks in being a trader or deal maker for a major financial firms like Goldman Sachs are probably very small.

2. A "monopsony" is the converse of a monopoly. A monopolist reduces output in order to push price above the competitive level. A monopsonist reduces his purchase of an input in order to drive the price of the input below the competitive level. If a firm faces an upward-sloping supply curve--meaning that the more it buys, the higher the prices it must pay--then if it buys less, thus moving down the supply curve, it will pay lower prices for its inputs. Suppose the input in question is labor. If the relevant labor market is competitive, monopsony won't be feasible; workers offered a lower than market wage will quit and work elsewhere. But suppose all the firms in an industry conspire to reduce their hiring; then wages will fall because the affected workers will not have good alternatives.

So why don't financial firms welcome pay caps, or, in Goldman's case, since it isn't subject to the caps, voluntarily compress the compensation they pay? There are three answers. The first is that if the firm does so, its best employees will quit and work elsewhere. This is not as compelling an answer as it seems, since demand for financiers has fallen and, more important, because Goldman Sachs is regarded as the world's premier financial company and (therefore) immensely profitable, so it is unlikely to hemorrhage employees merely by cutting bonuses; and if it loses some, it should be able to replace them.

The second answer, which is related, is that without industry-wide pay caps, a reduction in wages is not an equilibrium; Goldman Sachs might be able to get away with limiting its employees' compensation in the short run, but in the long run it would lose superior employees to competitors. It might therefore flaunt its huge bonuses in the hope that this would power the movement for industry-wide pay caps.

But third (and a compelling reason for doubting that Goldman wants industry-wide pay caps), we know that the top managers of large corporations are not perfect agents of the shareholders--the nominal owners of the corporation. A pay cap might be in the interest of shareholders, but it would not be in the interest of the top managers, since it is they who would be subject to the cap, either alone or together with traders and other subordinate employees.

(Photo: Getty Images/Mario Tama)

Their argument, if understood as I think the authors intended it to be understood as a root-and-branch criticism of Keynesian deficit spending as an anti-depression weapon, is not as compelling as it may appear to be. The fact that personal consumption expenditures didn't increase after the stimulus program was enacted is inconclusive, because, had it not been for the transfers, they might have fallen (though as I have emphasized in previous blog entries the initial stimulus spending was so limited that it is doubtful that it could have had much effect on consumer expenditures). The fact that the increase in military spending was unrelated to the stimulus law doesn't mean it wasn't an effective form of stimulus. And the fact that the rate of decline in business investment slowed in January may have been in anticipation of the stimulus, as it was certain by then that there would be a stimulus program.

The narrow criticism of the Administration's touting the successes of the stimulus program is that it emphasizes actual expenditures, which have been as yet (and certainly during the second quarter, when the rate of decline of GDP fell markedly) both modest and heavily weighted to transfers; and that criticism, which I have emphasized in my blog entries, I continue to believe is sound. The program may, however, still have had an important positive effect on business and consumer psychology. Economists both left and right systematically neglect the psychological dimensions of a depression, properly emphasized by Keynes.

An exception, however is Daniel Indiviglio, who is not an academic economist, and who in his blog entry argues that:

"Perhaps knowing that the government was throwing $787 billion at the economy in order try to reduce the pain of the recession helped the sentiment of business as well. Maybe businesses decided that the economy can't possibly continue to suffer given such extraordinary government intervention, so built more plants, ordered more equipment and ramped up inventories in the hopes of imminent recovery built on that government action."

In the same vein, with regard to the transfer payments, he argues that the "money must be going somewhere, so where is it going? Maybe it's being used to pay down debt; maybe it's being used for investment; or maybe it's just being saved. I would argue that, though not consumption, those are still actions that ultimately help a stumbling economy get a little healthier. Having more money in your pocket certainly makes you feel better, and consumer sentiment matters a lot during a recession, even if that doesn't translate to immediate consumption. Maybe people would have saved even more and spent even less without the payments, for example."

Those are excellent points.

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)

"Because of serious errors of monetary policy, excessive deregulation of the banking industry, a belief there would never be another depression, a failure to understand the full significance of the bursting of the housing bubble, and mistakes in responding to the financial collapse of last September (such as allowing Lehman Brothers to collapse and thinking the banks' problem was one merely of liquidity, rather than of solvency) by the troika that managed U.S. economic policy in the final two years of the Bush presidency--Ben Bernanke, Timothy Geithner, and Hank Paulson--the economy took a disastrous dive.

"Still, by the end of October, the members of the troika had regained their composure and taken a series of measures that avoided a complete collapse of the banking industry and a liquidation of General Motors and Chrysler.

"When the new Administration took office in January, the troika remained in charge of economic policy but with the substitution of Lawrence Summers for Paulson. Economic policy since then has been largely continuous with the policy of the previous Administration, not surprisingly given the continuity of the economic leadership. The stress tests and other measures relating to the financial sector taken by the new Administration would undoubtedly have been undertaken by the previous one had its time in office not expired. Even a large stimulus program might well have been launched by the previous Administration, despite vociferous Republican opposition to the program when it was proposed by a Democratic President and Congress. That opposition reminds me of the dog who barks ferociously at passersby when he is behind a fence, but take away the fence and he quickly becomes quiet. When the stimulus program was proposed, the economy was in dire straits and the bank bailouts and related measures focused on the financial sector (such as pushing down the federal funds rate almost to zero) had not arrested the decline. And it's not as if the Bush Administration had been averse to spending and deficits.

"On the whole the measures taken by the two Administrations have probably contributed to the bottoming out of the economic downturn, though it is impossible to measure their impact relative to the impact of natural economic forces, such as the depletion of inventories, the modest expansion in exports, the wearing out of some durable goods, and falling prices, which have lured timid consumers out of their burrows. It is impossible to separate out the effects of the different recovery measures or determine which Administration did more to save the economy--a meaningless question since it is uncertain whether either Administration did anything important that the other would not have done." 

But this of course is not how politicians speak. President Obama in his speech of September 14 on the economic crisis acknowledged that "Congress and the previous administration took necessary action in the days and months that followed. Nevertheless, when this administration walked thorugh the door in January, the situation remained urgent." And so "this administration...moved quickly on all fronts, initializing a financial stability plan to rescue the system." (I assume "initializing" is a misprint for "initiating.") The implication is that, the previous Administration having failed to stop the rot, the new Administration had to move quickly to create a financial stability plan. In fact all the new Administration did, apart from the stimulus and an ambitious but not terribly successful mortgage-relief plan, was to continue the policies of the previous Administration.

The speech goes on to describe the recovery program, and while acknowledging that "the work of recovery continues" states that"we can be confident that the storms of the past two years are beginning to break." The implication is that they are beginning to break because of the Administration's recovery program, but actually they are beginning to break as the result of the natural recuperative strengths of the economy plus the combined efforts of successive administrations.

The speech then turns to the causes of the economic crisis, and naturally there is nothing there about failures of government policy, in which Bernanke and to a lesser extent Geithner and Summers were implicated. Such an acknowledgment would strike a discordant note, and not only because the President has announced that he is reappointing Bernanke as chairman of the Federal Reserve and because Geithner is his Secretary of the Treasury (not only held over, but promoted from his job as president of the Federal Reserve Bank of New York.) The Administration wants to enlarge the powers of the Fed, yet the Fed under Alan Greenspan was a major cause of the economic crisis because of its bubble-blowing monetary policy, and the Fed under Bernanke failed to detect or arrest the crisis until it was almost too late; acknowledgment of these errors would raise questions about the appropriateness of rewarding the Fed for its failures by giving it enhanced powers.

Blame has to fall somewhere so in the President's speech it falls on the "reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kill and bloated bonuses. Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall." But of course American taxpayers will be there next time to break their fall, because according to Bernanke the bank bailouts were necessary to avert a second Great Depression and will be necessary to do the same thing the next time we're in the same fix. And nobody in a position of authority on "Wall Street" takes risks without regard for consequences. The problem is that they do not have regard for consequences for the economy as a whole, because that is not the business of business. That is the business of government. But rich people are the natural scapegoats for economic distress.

The rest of the speech is a summary of the Administration's program of financial regulatory reform, announced in the Treasury report of June 17. One thing that is new, however, is a confusing discussion of "resolution" authority. The term refers to the streamlined bankruptcy process that the Federal Deposit Insurance Corporation uses on insolvent commercial banks and thrifts. The big "nonbank banks" like Lehman Brothers that got into such serious trouble last year were not commercial banks, so that when the government refused to save Lehman Brothers it had to declare bankruptcy. Since its assets were scattered all over the world, it found itself in separate bankruptcy proceedings in different countries, causing severe problems of coordination that have yet to be overcome.

That is a pity, but the suggestion in the speech that if only there had been authority to "resolve" the insolvency of the nonbank banks the taxpayer would have been spared having to bail them out doesn't make sense. Especially with regard to Lehman, because it received no taxpayer money. But it also doesn't make sense with regard to the nonbank banks that did receive bailouts. Broke is broke, whatever the mechanics of liquidation or reorganization; and if you don't want to have an insolvent banking system you have to bail out the broke banks. No one thinks bankruptcy a bad way to "resolve" a bankrupt auto manufacturer; the bankruptcies of GM and Chrysler were orderly and prompt--yet the government still poured in tens of billions of dollars to save them from liquidation.

Moreover, whatever changes we make in our procedures for winding up a bankrupt financial institution will not deprive foreign countries of control over the assets of such an institution that are located in foreign countries.

Another curious novelty in the speech (I think it's a novelty) is the suggestion that bonuses for senior executives should be subjected to a vote by the company's shareholders. What would that do? Probably the senior executives would substitute higher salary, more stock options, bigger severance packages, and other forms of compensation, for bonuses. And that would prevent the next financial crisis?

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)

Let me repeat what I said in my blog entry yesterday, what I said in my book, what I have said repeatedly: I support the stimulus. Although it is badly designed and I believe has not been energetically implemented, it was on balance a good thing to do; and it may have had positive effects as early as the second quarter of this year. And I have no animus against Dr. Romer, whom I have never met, but whose academic work I respect. My criticism was that the argument in her recent talk that the stimulus was just right and had big positive effects last quarter is unpersuasive. And I raised questions about whether academics in government ought to make a clear distinction between academic and political standards of proof.

Now to Professor DeLong's points:

1. Romer in her talk says that $100 billion in stimulus funds were distributed by the end of the second quarter. I called this "a suspiciously round number." This infuriates Professor DeLong, who calls it libelous, but his nonadjectival response is to claim that the actual number is $89 billion. I think that makes my point.
   
   
2. His second point has greater merit. I had said that $100 billiion (of course I should have said $89 billion), being less than two-thirds of one percent of GDP, was too small to be likely to have reduced the decline in output from an annual rate of 6.2 percent in the first quarter of the year to 1 percent in the second quarter. He says that the proper comparison is between one quarter's GDP and $100 billion (which should of course be $89 billion, as by this point he has forgotten), and that is half right. It is only half right because not all the $89 billion received in the second quarter was spent in that quarter. Money received and deposited in June, for example, was not all spent in June; nor, for that matter, was all the money received in April spent by the end of June.
   
   DeLong contends, moreover, that 60 percent of the $89 billion was in the form of tax relief and the other 40 percent in payments to states. In other words, the entire expenditure consisted of transfer payments rather than public-works projects. Since these transfers are transitory rather than permanent income to the recipients, it is likely (and this is confirmed by estimates of the amounts saved from the Bush tax credits of spring 2008) that most of the money was saved rather than spent.
   
   If one assumes generously that one-half of the $89 billion will have been spent (rather than kept as savings) by the end of the third quarter, or $45 billiion, and that the GDP for the second and third quarters will sum to $7 trillion, the stimulus money distributed in the second quarter will have lifted spending by approximately two-thirds of one percent, which was my estimate, though differently arrived at. DeLong assumes that the entire $89 billion was spent (not saved) in the second quarter. That is unsupportable.
   
   If one assumes that by the end of the second quarter only some fraction of $89 billion had been spent--surely less than 50 percent, when one considers not only amounts saved rather than spent but that much of the money would not have been disbursed until June, the last month of the quarter--it seems extremely unlikely that the expenditure reduced the rate of decline of output from a 6.2 percent annual rate to a 1 percent annual rate. And nothing in Romer's talk, or DeLong's blog entry, permits an estimate of how much the disbursements affected the rate of decline of output.
   
   
3. DeLong cites two bits of evidence to suggest that Romer was aware of and tried to correct for the problem of multiple converging causes for the drop in the rate of decline of output between the first and second quarters. The first is that states that have received a relatively small share of the stimulus are doing poorly, and the second is that countries that responded to the global depression with large stimulus packages are doing better on average than was expected six months ago. But of course other things were happening in those states and those countries besides stimulus, and the other things have to be corrected for, which as far as I know has not been attempted. Much was happening in the United States as well, and the question is the incremental effect of $89 billion in stimulus disbursements (not spending, for much of the disbursements would have been saved rather than spent) in the second quarter, and of that there is nothing in Romer's talk or DeLong's blog post to base an estimate on.
   
   DeLong does not comment on my criticisms of Romer for describing the stimulus package as just right or, a related point, for assuming that recipients of the tax cuts provided for in the package will treat these as permanent rather than transitory increases in income. I am sure that DeLong thinks the stimulus package was too small and too weighted toward transfer payments rather than public works.
   
   

DeLong's post supports the concern I've expressed about economists going on holiday when they write for the general public. No one reading his post would dream that he was a professor at a distinguished university. I repeat a passage from my June 10 blog entry about DeLong: "It seems that DeLong, like Paul Krugman, is a high road / low road thinker/writer. He does sober academic writing part of the time and irresponsible popular writing the rest of the time. That's a common enough pattern, but when it is found in macroeconomists, specifically those who write about the business cycle rather than less ideologically charged macroeconomic topics, it makes one wonder how trustworthy their 'scientific' writings are."

Romer answers the question in her title: "Absolutely." And despite the reference to "five months" in the subtitle, her focus is on the second quarter of 2009 (April, May, and June) and her claim is that the stimulus had a dramatic effect on output and employment during that quarter. I do not think her analysis is responsible, and I am concerned with the fact that academic economists, when they become either public officials or public intellectuals (like Paul Krugman), leave behind their academic scruples. (This is one of the themes of my book Public Intellectuals: A Study of Decline [2001])--and Krugman was one of my examples of the phenomenon.)

Let me make clear at the outset that I support the stimulus, though I wish it had been better designed. I support it for two reasons. The first is that, given the state of panic of the economy last winter, and the limited efficacy of the measures already taken to arrest the economic plunge--the expansion of the money supply and the bailouts of the banks and the two failing automobile manufacturers (Chrysler and GM)--the government had to make a dramatic commitment to try all means of arresting the plunge. It could not just say, "We've tried everything we think might work; it's not working; so we'll just have to tough it out." That would have been destructive of business and consumer confidence, and would have accelerated the downward spiral that many thought could have brought the economy to the depths it reached in the 1930s depression.

Second, there is a pretty good theoretical case, and some empirical backing, for deficit spending on public works as a means of combating a depression. Output (GDP) is the sum of personal consumption expenditures, investment (including savings), and government expenditures. When personal consumption expenditures and investment decline, so that (if government expenditures are constant or falling) total output declines, which in turn results in layoffs, which further reduce income and therefore output, thus triggering a downward spiral, an increase in government expenditures can arrest or at least slow the downward spiral by replacing some of the decline in private consumption and investment.

Now unfortunately the stimulus was poorly designed and has been (so far as an outside can judge) lazily implemented. Only about a third of the stimulus funds is for public works. Two-thirds are for tax credits and other benefits (including the popular "cash for clunkers" program) and for state governments. The problem with the two-thirds is that there is no guaranty that transfer payments will be put to productive use; they may be saved, directly or indirectly. Suppose a state uses the money for tax relief; then it is in effect putting money in people's pockets, and the recipients may decide to save, rather than spend, the bulk of what they receive. The personal savings rate has been rising, and additional cash received from the stimulus program may go largely to increase personal savings beyond what they would otherwise be. Or, in the case of the "cash for clunkers" program, the major effect may be that people buy cars a little sooner than they otherwise would, in which event auto sales may be depressed a few months from now; or they buy cars in lieu of other products, and the increase in auto sales is offset by a decrease in other sales.

In contrast, when the government pays a road contractor to build or repair a road, we know that the money is going to be spent to hire workers and buy materials, and so employment will rise.

Conservative economists argue that the effects of the stimulus in increasing output and employment will be undone by the fears of businessmen and consumers concerning the addition to the national debt of $787 billion in deficit spending. Those fears, these economists argue, will cause businessmen and consumers to hoard, knowing that their taxes will have to rise in the future (and their wealth therefore be lower--hence the need for greater savings now, so that they can use their savings to maintain their standard of living when the higher taxes take effect) to pay back the $787 billiion. Most economists, however, believe that it is unrealistic to suppose that people have enough information about the future to adjust their current behavior to expectations of higher taxes, inflation, devaluation, or other possible consequences of an increase in the national debt. There is too much uncertainty.

The point is not that people are irrational, but that they just don't have the information that would enable them to decide what adjustment in savings and consumption they should make today to optimize their economic situation if and when the national debt has to be paid down through higher taxes, inflation, or other measuires.

But Romer actually gives some credence to the unrealistic picture of the far-sighted consumer or businessman by arguing that recipients of tax credits authorized by the stimulus bill will spend rather than save the tax-credit money because they will assume that the credits are permanent. (The significance of this assumption is that people are more likely to spend a tax reduction that they think is permanent than a temporary reduction, because it would be a bother to adjust their spending patterns temporarily only to have to change them back when the surge of money--what economists call "transitory income"--runs out.) They will assume the credits will be permanent, she says, because the Obama Administration is committed to middle-class tax cuts. In fact no one knows whether the tax credits, enacted as part of a temporary measure--the stimulus--will be permanent; and it is extremely doubtful that many people are acting on the expectation that they will be.

Romer argues in her talk that by the end of the second quarter of this year, $100 billion of stimulus money had been spent. That is a suspiciously round number, and it is unclear how it was arrived at; but let us assume it is accurate. She then argues that this small expenditure--about two-thirds of one percent of the Gross Domestic Product--is responsible for the fact that the decline in GDP fell (on an annualized basis) from 6.2 percent in the first quarter of the year to 1 percent in the second quarter (though the latter figure is likely to be readjusted upwards).

This assertion is groundless. No one has the faintest idea what effect the stimulus has had. My guess is that it has had some positive effect, because of its confidence-enhancing character that I mentiioned earlier and because some of the $100 billiion--though no one seems to know how much--has been spent rather than saved. But it is impossible to determine the net impact of the stimulus on GDP or employment because so much else has been happening to stimulate an economic recovery. Some people have had to dissave--turn savings into expenditures--because their income has fallen (maybe because they have become unemployed) below the level necessary to cover their basic expenses. Some people have had to replace durables that wore out. Foreign demand for U.S. products has risen some. (Dissaving, replacing durables, and export growth if the domestic currency loses value are standard nongovernmental spurs to recovery from a depression.) And the government has been doing a lot to stimulate recovery besides the stimulus--has in fact expended or guaranteed trillions of dollars in an effort to increase the amount of lending, which is essential to economic activity.

Disentangling the various factors that are responsible for the reduction in the rate of decline of output in the second quarter is probably impossible, but in any event has not, to my knowledge, been attempted--and certainly not in Romer's talk.

This raises the question of the ethical responsibility of academic economists, such as Romer (and Krugman, and Lawrence Summers, and many others), who write for the media or join the government, either to adhere to academic standards in their nonacademic work or to make clear to the public that they are on holiday from those standards and that what they say in their public-intellectual or governmental careers should not be thought identical to their academic views. As an academic, Christina Romer was a respected student of the business cycle, and actually expressed skepticism, no longer in evidence, about the efficacy of stimulus programs in arresting economic downturns. The statement in her talk that she thinks the allocation of moneys by the stimulus bill is just right is hard to credit as her professional opinion. But as chairman of the Council of Economic Advisers, she is a spokesman for the Administration, and I would guess that her public statements are vetted by the President's political advisers.

(Photos: Flickr Users David Paul Ohmer and borman818)

Macroeconomists deploying the rational-expectations hypothesis and finance theorists deploying efficient-markets theory have exaggerated the amount of information that people can obtain about future values. Lack of information forces people to fall back on poor proxies--such as assuming that other people know what they're doing, and imitating those people--which can lead to asset-price bubbles. This kind of "herding" behavior ("momentum" trading, as it is often called when one is talking about the behavior of stock prices) is sometimes thought irrational, but I disagree; it's often a rational second-best solution to a problem of unobtainability of good information.

The Wharton article cites an earlier article by eight European economists (known as the "Dahlem Report") on the failure of the economics profession to foresee the financial crisis: David Colander et al., "The Financial Crisis and the Systemic Failure of Academic Economics" (Kiel Working Paper No. 1489, Feb. 2009), . As the authors succinctly state, "The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deper roots of this failure to the profession's insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets."

The report makes the important point that "as the crisis has unfolded, economists have had no choice but to abandon their standard models and to produce hand-waving common-sense remedies." There is indeed a striking contrast between the formalism of modern economic models of the economy and the advice that economists have been giving since the crisis erupted. Essentially they have advised the use of remedies that have been known and applied since the nineteenth century--or in some cases have disparaged those remedies--but neither side of the debate within the profession has provided quantitative evidence to support its advice.

When evidence is lacking, in economics as in other fields, the tendency is for responses to be shaped by preconceptions, and when the problem being responded to involves high ideological stakes, as the current economic crisis does, the driving preconceptions tend to be ideological. Though there are exceptions, generally if you know whether an economist is liberal or conservative you know whether he favors or opposes the $787 stimulus plan that Congress enacted in February and is slowing being implemented, and whether he worries more about unemployment than about inflation. This is not the sign of a mature science. 

"Everyone seemed to be doing their [sic] own job properly on its own merit" but no one realized that the individual activities of the "many bright people" was creating a risk to the solvency of the entire global financial system. On the contrary, people were lulled into believing that "financial wizards" had purged risk from the system.

There is no reference in the letter to the economics profession, although one of the authors is an economics professor (Besley--Hennessy is a political historian) and the only economic models referred to appear to be "value at risk" models for calculating the risk of loss from an individual transaction.

Yesterday, another letter to the Queen, this one dated August 10 and signed by ten English and Australian economists, was released (it can be read online at http://www.docstoc.com/docs/9919280/queen2009b), also responding to the Queen's question of last November but taking issue with Besley and Hennessy's letter. The August 10 letter states that "their overall analysis is inadequate because it fails to acknowledge any deficiency in the training or culture of economists themselves." The nub of their criticism is that "in recent years economics has turned virtually into a branch of applied mathematics, and has...become detached from real-world institutions and events." They criticize economics education as excessively narrow, "to the detriment of any synthetic vision," and fault Besley and Hennessy for saying nothing about "the typical omission of psychology, philosophy or economic history from the current education of economists" and for mentioning neither "the highly questionable belief in universal 'rationality' nor the 'efficient markets hypothesis.'"

A more focused criticism would, in my opinion, be more effective. The Queen was asking about the failure to foresee the financial collapse of last September, rather than about the health of modern economics in the large. That failure was I think due in significant part to a concept of rationality that exaggerates the amount of information that people have about the future, even experts, and to a disregard of economic factors that don't lend themselves to expression in mathematical models, or are intractable to formal analysis. The efficient markets theory, when understood not as teaching merely that markets are hard to beat even for experts and therefore passive management of a diversified portfolio of assets is likely to outperform a strategy of picking underpriced stocks or other securities to buy and overpriced ones to sell, but as demonstrating that asset prices are always an adequate gauge of value--that there are not asset "bubbles"--blinded most economists to the housing bubble of the early 2000s and the stock market bubble that expanded with it. In modeling the business cycle, economists not only ignored, because difficult to accommodate in their mathematical models, vital institutional detail (such as the rise of the "shadow banking industry," which is what mainly collapsed last September)--often indeed ignoring money itself, on the ground that it doesn't really affect the "real" (that is, the nonfinancial) economy. They also ignored key concepts in Keynes's analysis of the business cycle, such as hoarding and uncertainty and business confidence ("animal spirits") and worker resistance to nominal (as distinct from real) wage reductions in depressions. Lessons of economic history were ignored, too, leading to a belief that there would never be another depression, let alone a collapse of the banking industry. Even when the collapse occurred, in September, many macroeconomists denied that it would lead to anything worse than a mild recession; the measures that the government has taken to recover from what has turned into a depression owe little to post-Keynesian economic thinking; and the economists cannot agree on what further, if anything, should be done, and which of the government's recovery measures has worked or will work.

Besley and Hennessy's letter, when first published, was described in some quarters as a letter of "apology" by English economists. It was not that; nor is the August 10 letter--the latter is a denunciation of mainstream economics.

The notion of a profession's apologizing for its failure in a letter to the monarch is charming, however. It would be an apology to the nation, personified in its monarch. The English monarch does not exercise political power, but does personify the nation, and it is easier to write a letter to a person than to a nation.

The English economics profession failed the United Kingdom; the American economics profession failed the United States. Not that the profession should be equated to its macroeconomic and financial divisions. The study of business cycles is only a small part of modern economics. Other areas of economics bear significantly on the study of business cycles, such as labor economics, without being implicated in the failures of response to the current crisis. But the control of the business cycle had until the present crisis been regarded as a principal triumph of modern economics and justification for regarding economics as the queen of the social sciences. We have no monarch; the President is not a personification of the nation but rather the head of the national government; there is no one to write the letter of apology to. No matter. The urgent need is for the part of the profession that concerns itself with business cycles to acknowledge its inadequacies and reorient its training and research.  

In "G.D.P. R.I.P." (Times), Eric Zencey points out that Gross Domestic Product (or, what is similar, Gross National Product) is not a good measure of economic welfare. One reason is that it doesn't include nonmarket output, such as household production. If a woman who has been a full-time housewife (a "household producer," an economist would call her) takes a job in the market, her full salary in the job will be counted in GDP; the loss of her household production, which is a real loss in economic value, will not be subtracted. Volunteer work--any work done "for free"--is not counted in GDP at all, even though it has economic value. Also not counted properly is purely remedial work. Hurricane Katrina caused an enormous loss in housing values, but the expenditures on rebuilding New Orleans are fully counted in GDP with no subtraction for the loss of asset values.

Nonmonetary income and loss can, in principle, be monetized, but without the precision necessary to provide a welfare measure that could be determined on a quarterly basis and yield consistent estimates. So we are stuck with GDP. But Zencey's critique has an interesting implication for the current economic situation--which is that the fall in GDP since 2007 exaggerates the actual decline in output. Some people who lost their jobs substituted household production. The sum of their monetary and nonmonetary income fell, for otherwise they would have quit earlier rather than waiting to be fired. But it did not fall to zero.

It is tempting to take the next step (as some economists have done) and argue that really there is no such thing as unemployment; the unemployed are simply people who are working for something other than a wage--such as leisure, if they're treating unemployment as vacation time, or the nonmonetary returns from taking care of their children, preparing meals, making homne repairs, or producing other nonmarket goods and services. But in most cases I believe these are minor offsets to the reduction in money income brought about by involuntary unemployment, and ignore moreover the considerable nonmonetary costs of unemployment--in anxiety, fear for the future, embarrassment, and humiliation. Moreover, these costs are also born by people have not lost their jobs but fear that they will. On balance, my guess is that the fall in GDP during a depression or severe recession understates rather than overstates the loss in real income, which includes the peace of mind that is lost when a person is fired or fears that he or she will be fired.

In "Corporate Earnings Are No Sign of Recovery" (Journal), Zachary Karabell makes an important point that I had not seen before. He notes that the stock market has risen a good deal recently, and he attributes it to surprisingly strong corporate earnings. Nothing new, so far. But then he points out that much of the strength in corporate earnings is coming from foreign earnings, which do little for domestic production and hence employment. Foreign earnings must be distinguished from export earnings. Exports are of products made in the United States, and whenn demand for our exports grows this stimulates domestic production and hence employment. Foreign earnings are earnings on production by American companies abroad. That production stimulates employment in foreign countries, not in the United States. From the standpoint of shareholders, earnings are earnings, wherever derived, and so the stock market doesn't care if they are earned abroad. But to the extent that the increase in stock prices is reflecting increases in foreign earnings (Karabell does not offer statistics on the importance of foreign earnings in the current earnings of American corporations), it is not a harbinger of economic recovery in the United States.

But this conclusion has to be qualified in the following respect, which I have emphasized in my book and in my blog. Because much of Americans' savings nowadays is in the form of direct or indirect ownership of stock (in brokerage accounts, retirement plans, college savings plans, health savings plans, and other investment vehicles), an increase in stock values, by increasing the market value of Americans' savings, makes them (makes us) less likely to divert income from consumption spending to saving, and so increases spending, which in turn increases output and employment.

In "Averting the Worst" (Times), Paul Krugman argues that government has saved us from "a second Great Depression." He points out that in the fall of 2008, economic indicators were falling at a rate comparable to the early days of the Great Depression of the 1930s. Now it is doubtful that they would have fallen as far, even if the government had done nothing. Unemployment is worst in industries like manufacturing and construction, since both the purchase of durable goods, and construction projects, are easily deferred. Unemployment in government and in services was much less in the Great Depression than unemployment in manufacturing and construction, and that is true in today's depression as well. But the difference is that manufacturing and construction account for proportionately far fewer jobs today, and services and government for proportionately for far more, than in the 1930s. In addition, we have unemployment insurance, deposit insurance, and (relative to the early 1930s) high income tax rates. Unemployment insurance buffers the loss of income from unemployment, income tax declines with income rather than operating as a fixed cost, and deposit insurance provides considerable protection to bank solvency by discouraging runs.

Still, there was an acute danger of a deflationary spiral last fall and winter, and it could have carried the economy very low, as I explain in my book. The bank bailouts and the Federal Reserve's aggressive monetary policy (for example, pumping cash into the economy by buying private debt and long-term Treasury debt, after pushing down short-term rates nearly to zero with little effect on the amount of money in circulation) undoubtedly had a positive effect on the economy. Less certain is the effect of the auto bailouts and the stimulus package. Krugman says that a reasonable estimate of the effect of the stimulus, though little of it has been spent so far, is that it has saved a million jobs, but he does not explain how he derives that estimate, and I do not believe that the number can be estimated responsibly. Still, his conclusion that "the government has played a crucial stabilizing role in this economic crisis" is almost certainly correct. Of course in doing so it has run up enormous debts which it now wants to compound with a trillion-dollar (and that's just the beginning) health-care program that no one seems to know how to fund. And Krugman neglects to point out that it is government, through unsound monetary policy and lax regulation, that is mainly responsible for the depression that government is now trying to pull us out of. 

There are too many comments for me to be able to respond to each one individually, but I will note some points that deserve emphasis, and respond to a few individual criticisms.

I like the comment (by Indy, June 26) that analogizes higher reserve and capital requirements for financial firms that create systemic risk (that is, that could bring down the financial system as a whole if they went broke) to strict building codes for earthquake- and hurricane-prone areas. The problem, as the comment points out, is that if the first line of defense--the reserve and capital requirements--fails to avert a collapse (just as building codes can fail to prevent serious damage from an earthquake or a hurricane), there would need to be "tremendous discretionary powers vested in some agency to respond and shut down [risky financial] activities in order to forestall a crisis." Vesting any agency with such powers is problematic, especially the Federal Reserve (where the Administration wants to vest them) because it would undermine the Fed's properly prized political independence. The comment also suggests that if the agency drafts contingency plans to deal with a future crisis, those plans should be made public so that the business community knows where it stands and can plan accordingly.

In a July 5 comment, the same commenter (Indy) expresses skepticism (as did I) that the proposed consumer financial protection agency would "promote significant changes in behavior among consumers...It is one thing to say 'people should save more, spend and borrow less' and another to add 'and they "would' if only they were better informed in simplified, easy-to-understand ways." Indy adds that "observing the magnitude in which consumer saving, spending, and borrowing behavior has changed recently during the economic downturn (and without any significant change in the types of financial products offered or the manner in which they are marketed) leads me to believe that economic conditions matter much more than anything the proposed agencies and new authorities can do." I agree.

UjK points out (July 13) that consolidating federal regulatory agencies or abolishing the financing of such agencies by fees imposed on the regulated firms will not eliminate shopping for lax regulators as long as banks can continue to choose whether to be regulated by state or federal banking agencies. This argues for preempting state banking regulation, but that is a radical step that will not be taken--at least not until the next financial meltdown.

Indy (July 20) wishes to distinguish between macroeconomic theory and practice, arguing that the failure of the macroeconomists was not noticing what was happening in the housing market. That was a serious failure, but I think the theory itself is defective because of the neglect of Keynes's theory of the business cycle, which I discussed in a blog entry on July 27. That entry gave rise to several interesting comments about the Austrian theory of business cycles. Members of the Austrian school of economics, such as Friedrich Hayek, argued that depressions can arise from unsound monetary policy--a policy that forces down interest rates, creating an artificial boom. Obviously I am sympathetic to that argument. But my impression (no more than that) is that, at least in the 1930s and perhaps still, Austrian economists do not advice any interventions designed to stop a depression--they regard the depression as just punishment for the unsound policy that precipitated it. That seems to me to give too little weight to the immense costs that a depression can impose on a society. But I am no expert on the Austrian school, and invite correction.

Greg Ransom, in a July 28 comment, calls my suggestion that liberal and conservative macroeconomists ignored Keynes until the banking collapse of September of last year "not only false, it's ridiculous." He argues that the tax credits in the spring of 2008 were a Keynesian stimulus and that the Greenspan-Bernanke policy of low interest rates in the early 2000s were Keynesian. I disagree. I tried to explain that what passes for Keynesian theory nowadays (or at least until the crash of last September), left or right, bears little resemblance to Keynes's actual theory of the business cycle, which emphasizes the role of uncertainty, of fear or lack of confidence, of the hoarding of cash in lieu of productive investment, and of recovery through deficit spending on public works (which he believed produced a multiplier effect on income)--not tax credits or other transfer payments.

The debilitating effect of depression-induced uncertainty on economic activity is well expressed in the very next comment, by gman (July 28): "As a small business owner I can tell you that this [my summary of Keynes's theory] describes today's reality. Our most recent fiscal year ended with record sales and profits, but trended downward during the last six months. Both our customers and suppliers are doing the same thing as we are--waiting. As a consumer, I am doing the same thing. The uncertainty is tremendous. Will any short-term recovery be snuffed out by a rise in interest rates? As far as I'm concerned, the recovery doesn't exist until we see what happens to interest rates once demand for credit returns."

Indy (July 28) has a long comment criticizing the mortgage-relief program. It is persuasive, but too long to quote, so I merely remind readers interested in the program of the comment.

Another interesting comment by Indy (August 1) criticizes the "cash for clunkers" program. He (if it's a he, as I am guessing) points out (something I had missed, perhaps because I don't like old cars) that many of the cars eligible for the program are so old that they would probably have been traded in within the next couple of years even without the inducement provided by the program. He expresses concern that, in that event, there may be a plunge in sales in a year or two, at which event there may be pressure for a new "cash for clunkers" program, and so on ad infinitum. It is a danger with the overall stimulus program. As he puts it, if "spending does not accomplish the goal of changing investors' moods and consumers' behaviors, then it merely brought forward government demand by means of debt which has to be paid for eventually out of future consumption...Without changing behaviors, without being able to get there in the absence of huge and extraordinary government expenditures, and without any obvious future 'growth engine' in the economy to remedy the huge amount of unemployment, getting to 0 doesn't seem to be such a cheery occasion."

My blog entry of August 1--"When Does a Recession or a Depression End?"--provoked several comments, including one by anne on August 3 in which she tells me: "Come down from your ivory tower and you'll realize there isn't a single person on 'Main Street' who defines 'recovery' as jobless, or ties it to GDP. Most people outside of Washington and Wall Street define 'recovery' as becoming gainfully employed in a job that will show real increases in income over time, not in a job that provides stagnant wages over decades." But as Max (August 3) replies to anne: "Isn't that the point that Posner was trying to make? That the ivory tower economists aren't using 'recession' and 'depression' in ways that really reflect the impact the economy is having on ordinary people's lives?" Yes, it is my point.

Pwnce (August 4) says that my statement that "singling out a particular class of taxpayers for higher taxes will be highly resented and strongly resisted" (as in the suggestion of a 1 percent surtax on persons earning over a million dollars a year, to pay for the Administration's proposed health care program) "makes no sense" because all progressive income taxes by definition single out particular classes of taxpayers to pay higher taxes. That is correct, but I see a difference, if perhaps only in a greater appearance of class conflict, between altering marginal rates in a progressive income tax system and imposing a special tax on the wealthiest people.