He is not being realistic. There is almost certainly not going to be another stimulus program of any magnitude as long as the recovery, anemic though it seems to be, doesn't give way to a 1937-style second depression. And there aren't, in all likelihood, going to be any significant spending cuts; the perfection of interest-group politics will see to that. There is no way, it seems to me, that adding 30 or 40 or 50 million people to the health insurance roles (in the event that an ambitious health care program is enacted after all) can avoid an increase in the costs of health care borne by the government, because those people will demand more care once they have insurance. There won't be offsetting cuts in Medicare because the old people won't stand for any reduction in their treatment options. There aren't going to be big tax hikes, either, to pay off the debt; neither political party dares to raise taxes, beyond letting a small part of the Bush tax increases expire on schedule in 2011. Because spending won't fall or taxes rise, the public debt will rise, so the interest on it will rise, and its rise will be compounded by higher interest rates as the debt grows. Rising interest expense will combine with rising Medicare and Social Security costs to further compound the debt. It looks as if, mainly by virtue of the Bush deficits and the costs (in reduced tax collections and increased welfare expenses, bailouts, and stimulus), the public debt will reach $10 trillion in a couple of years.

I conclude that there probably is only one way out of our fiscal dilemma, apart from default, devaluation, or runaway inflation, and that is to increase the rate of economic growth to the point at which a growing public debt falls, or at least does not increase further, in percentage of GDP. But measures to increase economic growth must satisfy four criteria: that they not interfere with the economic recovery; that they not put the government in the futile position of trying to pick tomorrow's industry winners and investing in them ("industrial policy"); that they not cost too much, as that will contribute to the deficit, because the costs are likely to be incurred before the benefits are obtained; that they be politically feasible.

With these constraints in mind, I suggest the following candidates for stimulating the growth of the economy.

1. Remove all limits on the immigration of highly skilled workers, or persons of wealth. (This should be done gradually, so as not to increase unemployment while the unemployment rate remains very high.)

2. Decriminalize most drug offenses in order to reduce the prison population, perhaps by as much as a half, which will both economize on government expenditures and increase the number of workers. (Again and for the same reason, phase in gradually.)

3. Curtail medical malpractice liability, which increases medical costs gratuitously (because the courts are very poor at identifying actual malpractice) and, more important, engenders a great deal of very costly, and largely worthless, "defensive medicine."

4. Augment the admirable efforts being made by the Obama administration to improve public education.

5. Increase investment in the treatment of mental illness, which disables people during their productive years.

6. Simplify the federal tax code.

This list is merely suggestive, and could surely be improved. It is meant to suggest a more productive alternative to the current efforts at comprehensive health care reform, unpromising job subsidy and mortgage relief programs, and ambitious financial regulatory reform--all measures that are likely to slow the recovery by making the economic environment more uncertain and our fiscal problems more acute.

The unemployment rate is weighing very heavily on the economy, and on our politics as well. People are getting impatient: the unemployed, of course, but also the people who worry about losing their job, the people who do not count as unemployed because they have given up, the people who are employed and expect to remain employed but have seen their wages, their hours, or their benefits--or all three--slashed. The government has almost given up trying to do anything serious to speed economic recovery and reduce the unemployment rate. The Republican Party has waged an effective campaign against the $787 stimulus bill that was enacted back in February '09 and that is now regarded (mistakenly, as it seems to me) as an economic as well as a political failure. It was a disappointment and only a partial success. It was late in coming, poor in design, slow in execution, poorly explained by our articulate president and his economic advisers, and ineptly defended with unsubstantiated claims about the number of jobs saved. And it has collided as it were with other deficit sources, which has fed concerns with the long-run health of the economy.

The $787 billion has not yet been fully spent, so there will be stimulus spending this year. But predictions are that unemployment will remain at about 10 percent. That doesn't mean that the stimulus was or is a failure, for without it, the unemployment rate would probably be higher, though no one knows how much higher.

The administration's attempts to quantify the effect of the stimulus on employment are unconvincing and no longer widely believed. With unemployment expected to persist at such a high level, indicating a great deal of unused productive capacity in the economy, there is a case for further stimulus, and it is being vigorously pressed by liberal economists such as Paul Krugman. But the administration appears to have lost its case for stimulus spending in the court of public opinion. The only additional stimulus spending will be, it seems, essentially empty gestures of concern. To that camp belongs the $33 billion job-subsidy program that the president has proposed to Congress. If it is enacted, employers will be entitled to a $5,000 tax credit per worker hired if the hire increases his number of employees, and to an additional subsidy for raising wages by more than the rate of inflation, but the total amount of subsidy is limited to $500,000 per employer.

The program is unlikely to have an appreciable effect on employment. It is too small. It will either be gamed (as by firms that fire and then rehire), or the procedures created by the legislation to prevent gaming will entangle the program in red tape, delaying its implementation and perhaps rendering it largely ineffectual, like the program to encourage mortgage modifications. It will not be targeted on industries and areas of the country in which unemployment is highest.

But the biggest problem with the job-subsidy program is that it is fundamentally misconceived. The Keynesian theory of stimulus (the only theory that makes economic sense) is that if private demand for goods and services falls substantially below the economy's productive capacity (as it has done), government can replace the shortfall in demand by increasing its own demand. It can buy roads and airports and military equipment with borrowed money (so as not to take money out of people's pockets, in the form of taxes, and by doing so depressing private demand). And it can borrow cheap, because consumers are saving more than usual, and with demand weak, businesses are borrowing less than usual. So the private demand for credit is weak, and interest rates therefore low. The surge in government demand increases production, and increased production results in increased employment.

The job-stimulus plan is not aimed at increasing demand, and therefore is unlikely to increase employment. For example, if a company is producing 1,000 widgets a year with a work force of 30, and it adds a 31st employee and thereby earns a $5,000 tax credit, the company's total costs will have risen by the wages and benefits that he pays the new employee minus the $5,000. But his sales will not have risen. Participating in the job-subsidy program will actually reduce his profits (revenue minus cost).

The job-subsidy plan can be understood only in political terms. The country is riled up about the unemployment rate, and so, demands that the government do something. So it is doing something, just not anything that will affect the unemployment rate. If as we all should hope the rate falls, the administration will claim credit, pointing to the job-subsidy plan.

Politics aside, the mounting federal deficit should worry the advocates of major new stimulus spending more than it does. The deficit this past fiscal year (which ended on September 30, 2009) was $1.4 trillion, and the administration itself is predicting a deficit in the current fiscal year of $1.6 trillion, which will bring the nation's public debt (the critical component of the national debt) up to $9.1 trillion. The administration continues to unsettle the general public and the business community alike by vowing to continue pressing its ambitious (and immensely costly) health-insurance plan; and Medicare and Social Security spending continues on a seemingly inexorable upward path. Without being able to predict the future beyond a few months, no one can be confident about knowing what measures, if any, can prudently be taken to promote economic recovery and reduce unemployment.

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I'm sure that's not true. Bernanke is an academic, not a banker. One can criticize many of his decisions, as I have done, but his mistakes, if that is what they are, do not suggest a bias in favor of the banking industry. The reason it looks that way to people who are not well informed about depression economics (which is most people, including not a few macroeconomists) is that beginning in the fall of 2008, his focus has been on restoring the banking industry (including not only commercial banks but also shadow banks, which is to say companies that provide close substitutes for banking services without being regulated as commercial banks) to a level of solvency at which the banks will feel comfortable lending in a risky environment--risky because defaults are way up because of the depression. He (more precisely, the Fed in cooperation with the Treasury Department and the Federal Deposit Insurance Corporation) has done this by (1) encouraging the absorption of the major shadow banks, like Goldman Sachs and Merrill Lynch, into the commercial banking industry, either by acquisition by a commercial bank, as in the case of Merrill, or conversion to a bank holding company, as in the case of Goldman, to reduce the risk of further catastrophic bank failures like that of Lehman Brothers in September 2008; (2) flooding the banks with cash through open market operations (basically buying short-term Treasury securities from banks); and (3) purchasing other securities, such as mortgage-backed securities and Treasury bonds, to keep down interest rates (the greater the demand for fixed-income securities, the higher the price and therefore the lower the yield because the income of each security is, by definition, fixed).

These measures have succeeded to the extent of averting insolvencies of major banks and thus keeping the credit industry alive, and by doing so has prevented an even worse depression than we are experiencing. But a side effect is that some banks, most notoriously Goldman Sachs, cursed with a tin ear for public opinion, have made very large profits in the midst of the depression. By borrowing cheap (because interest rates are so low both because of Fed policy and because lenders are confident that the government will not allow big banks to fail) and using the borrowed capital for risky trades (again in the confidence that the government will not allow a big bank to fail), the banks have been enabled to profit from the depression. This upsets people. But there is no clear alternative that wouldn't make the country as a whole worse off.

Unfortunately, the administration is incapable of explaining the situation to the American people. Maybe it feels they are uneducable in such esoteric matters. (I disagree.) But the consequence is to endanger Bernanke's confirmation. The administration is busy denouncing "fat cat" bankers; Bernanke helped the banks; ergo he prefers fat cats (Wall Street) to thin ones (Main Street). A false syllogism, but hard for the administration to refute, because it is busy bashing bankers.

Bernanke may or may not be the best person for the job. That is almost irrelevant. If he is not confirmed, the independence of the Fed will take a terrible hit, because the next nominee will have to make outright promises to Congress of bank bashing, and of keeping interest rates way down regardless of inflation risk, in order to be confirmed.

There is a disturbing report in The New York Times this evening: Senator Reid, the Senate Majority Leader, is reported to have said publicly that "he had decided to support Mr. Bernanke [for a new term as chairman of the Federal Reserve] with trepidation and only after he received a commitment that the Fed chairman would take additional steps to increase the flow of credit to middle-class Americans." (Emphasis mine.)

I take no position on whether Bernanke should be confirmed; it would be inappropriate for me to comment publicly on a federal personnel matter and anyway I don't think I'm sufficiently well informed to have a responsible opinion. But I am worried about his having committed--if he did, for we have as yet only Senator Reid's word for it, and there is no doubt room for misinterpretation and different interpretations--to taking additional steps to increase the flow of credit to middle-class Americans. The only ways in which the Federal Reserve can do that, I should think, is by either reducing interest rates further or using its regulatory authority to compel banks to start lending their excess reserves. (The Fed is paying interest on those reserves; by ceasing to pay interest, it might induce greater lending--or less, because it would be depriving the banks of a secure stream of income.) The problem is that more credit, implying more money in circulation, increases the risk of a future inflation.

Suppose six months from now banks are lending much more than at present, so that the amount of money in circulation is increasing, and the velocity (rate of circulation) is also increasing as people spend more. In those circumstances, there will be a risk of inflation. The Fed can control the risk by increasing interest rates, but that will slow economic activity. Suppose the unemployment rate is still high, and with the slowdown in economic activity caused by a tightening of monetary policy, it rises. There will be howls. Will Bernanke be able to stick to his guns, as Volcker did in 1982, when unemployment hit 10.8 percent? Or will his "commitment" to Senator Reid deter him? If it does, the inflation may get out of hand.

All this is speculation; I have no crystal ball or keen insight into Bernanke's thinking or character, let alone an ability to forecast the course of the economy over the next year (or, for that matter, of the next week). But I am troubled that a nominee for Fed chairman should commit himself to follow an "accommodative" monetary policy as a quid pro quo for confirmation. I hope Senator Reid misunderstood him.

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The significance of the Supreme Court decision is that the decision increases the political power of the banks by enabling corporate rather than just individual financing of ads advocating for or against particular candidates in elections. Congressmen may be reluctant to invite an avalanche of negative ads paid for by banks by voting for regulatory measures that might substantially reduce the profitability of banking.

The administration's tough approach creates the following political problem. On the one hand, in continuing the policy of the Bush administration, the administration has been enormously supportive of the banks, and this has enabled some of them to reap large profits despite the depression. On the other hand, it has been criticizing the banks as pigs, with increasing stridency. The more the administration ratchets up its attacks on the banks--escalating from verbal abuse ("fat cat" bankers) to draconian regulation--the more it plays the populist card and, conceivably, distracts the public from the health care donnybrook, but also, the more it retards recovery by distracting bankers and, if tough regulations are instituted, weakening the banks financially and thus discouraging them from increasing their lending. If as a result economic recovery slows, the administration will pay a political price, while if bank regulation flops as health care reform is flopping, the administration will be thought unable to govern effectively.

It is difficult for the administration to rebut charges of being soft on banks because of the continuity not only of policy but also of personnel between the Bush and Obama administrations. The principal theorists of Bush's response to the financial crash were Geithner and Bernanke, and they're still in place. (The third member of Obama's economic troika, Lawrence Summers, is not as prominent publicly as either Geithner or Bernanke.) Geithner is identified in the public mind with hated Wall Street. Bernanke is identified with keeping interest rates way down is encouraging bank speculation (and high profits) just as the Fed was doing (with his support) in the early 2000s. The turn to Volcker is politically adroit, especially in the wake of the increasing skepticism of the Obama administration on the part of independent voters.

In retrospect, from a purely political perspective at least, the administration would have been better off with a different Secretary of the Treasury and a different Federal Reserve Chairman. Not that it could have removed Bernanke; but by deciding to reappoint him, the President in effect ratified Bernanke's policies. Appointing Volcker to succeed Bernanke might have been better from a political standpoint. Volcker is at once a commanding and a reassuring figure, and cannot be accused of being too friendly with hated "Wall Street."

Enough about politics. The Volcker plan deserves careful consideration. It's a shame it was not taken seriously by the administration from the start; the loss of a year is serious, maybe calamitous, because the plan cannot be adopted overnight. Its evaluation, detailed design, and execution will take years.

The plan is being described in some quarters as "the return of Glass-Steagall." The Glass-Steagall Act, passed in the 1930s depression and repealed in 1999, provided that no company could be both a commercial bank and an investment bank. J. P. Morgan's bank had been both; the Act forced its division into Morgan Stanley (investment bank) and J. P. Morgan (commercial bank). The Act did much else besides; and barring commercial banks from engaging in investment banking in the conventional sense of underwriting new issues of securities would not have averted the financial collapse of September 2008. Even before the repeal of Glass-Steagall, moreover, its thrust of separating commercial banking from other financial activities had been blunted by statutory amendments and regulatory (or rather deregulatory) initiatives. It is the spirit rather than the letter of Glass-Steagall that Volcker wants to revive.

Volcker's basic idea is to insulate traditional commercial banking services from risky modern financing practices. Traditional commercial banking services consist of providing a place to park a person's money (a deposit account and safe-deposit box), making mortgage and commercial loans, administering the payments system (essentially, the system whereby a check written on one bank causes an increase in the payee's account in another bank), providing standby (back-up) credit, and buying and selling Treasury securities and other ultra-safe securities. Banks are either local or have local branches, so that they can engage in "relationship" lending--lending based on knowledge of the creditworthiness of particular borrowers, especially individuals and small business. (Big business has other methods of financing besides commercial banks, such as the issuance of bonds or commercial paper, or by drawing on retained earnings.)

As Volcker recognizes, commercial banks, although they no longer account for more than about 20 percent of all lending, play an essential role in meeting the credit needs, especially (by virtue of their ability to engage in relationship banking) of individuals and small businesses, and also by virtue of administering the payments system and providing back-up credit to issuers of commercial paper and other big-business borrowers. Furthermore, they play an essential role in the Federal Reserve's management of the money supply and control of interest rates, because the Fed in normal times varies the money supply by buying Treasury securities from commercial banks or selling Treasury securities to them. (In the first type of transaction, the Fed increases the amount of money in bank balances and in the second, it reduces the supply of money by retiring the money that it receives in the sale.) This makes it easy for the Fed to increase the banks' liquidity, and thus the availability of credit, in the event of an economic downturn. But this will not work if the banks are insolvent.

Volcker's idea is that if the commercial banking system as a whole is insulated from threat of insolvency, even a wave of bankruptcies of other lenders will not have disastrous effects on the financial system and hence the larger economy. The commercial banks will be the sturdy spine of the finance system, which (with the aid of the Fed) will step up its lending if other parts of the financial system, such as the "shadow banks" (financial firms that provide close substitutes for conventional bank services), fail. Federal deposit insurance is already a big step in this direction, because it reduces the likelihood of a run on a bank. The fact that bank regulators have very broad discretionary powers over banks and can close a bank down if they think it likely to go broke, without waiting for actual insolvency, are additional safeguards. But if the bank is simultaneously engaged in high-risk financial activities, such as originating mortgage-backed securities or engaging in speculative trading with its own capital, the conventional safeguards won't be effective; the banks may still go broke en masse.

That's the thrust of the Volcker Plan, though the version just embraced by the administration is somewhat more limited. The plan (in the form in which I think Volcker himself envisions it) has a lot to commend it, but it has three big drawbacks, which need to be addressed.

The first is that limiting the services that commercial banks can provide is apt to result in a continued shrinkage of commercial banking relative to other finance, possibly to a point at which commercial banking is no longer a large enough industry to constitute the spine of the financial system.

The second and related point is that the commercial banking industry probably is not large enough to fill the hole created by a collapse of the shadow-banking industry. It was the collapse of Lehman Brothers, which was not a commercial bank, that precipitated the most acute phase of the financial crisis of 2008. So the shadow banks need tighter regulation. Whoever regulates the shadow banks (at present, regulation is divided among the Federal Reserve, because the main shadow banks have either been converted to bank holding companies or acquired by banks, the Securities and Exchange Commission, and the state insurance commissioners), however, is likely to be in continuous dispute with the commercial-banking regulatory authority or authorities. The commercial banks will want the shadow banks reined in as tightly as they (the commercial banks), and the shadow banks will resist.

The third problem is the sheer complexity of the giant multiservice banks and the difficulty of carving them up by removing the parts that do not engage in traditional commercial banking.

A possible fourth problem is that there may be significant economies of scope in the combination of differential financial services with commercial banking. But I emphasize "may be;" I don't think there's good evidence one way or another. This uncertainty is a compelling reason for a very careful, nonpolitical study of the Volcker Plan, rather than a rush to adopt and implement it. The sharply negative reaction of the stock market to the announcement of the plan would ordinarily hold little significance. But now that common stocks are a big part of people's wealth (whether in the form of direct ownership of shares or indirectly through pension plans, college-savings plans, and other investment vehicles), any drop in the stock market reduces people's assets, making them reluctant to spend; and any curtailment of spending slows the pace of economic recovery. There is a social value, therefore, to "reassuring" the stock market that any restructuring of the banking industry will proceed in a deliberate and thoughtful manner (as undoubtedly intended by Volcker), rather than in a spirit of vengeance against "Wall Street."

The big news of the day is the president's apparent embrace of Paul Volcker's proposal to "restore Glass-Steagall," which is short-hand for confining commercial banks to traditional commercial banking activities, and specifically bar them from trading on their own account. I do not know how serious the proposal is or what support it will garner in Congress; maybe it's just an attempt to change the subject from health care in light of the result of the Massachusetts senatorial election. In my new book I argue that Volcker's proposal deserves serious consideration--which is not to say that it is the solution, but that it may be.

I will return to this issue in future post. For now I want to link Bernanke's self-defense, the subject of my last post, to the Angelides investigation and the proposed bank tax.

By refusing to acknowledge a role for the Fed's monetary policy in the financial crisis, and by acknowledging only in a perfunctory and backhanded manner the regulatory laxity that also played a key role, Bernanke feeds the theory that "greedy reckless" bankers caused the crisis. That theory is also likely to emerge from the investigation being conducted by the Financial Crisis Inquiry Commission, headed by Phil Angelides. Its first public hearing was in the style of congressional investigatory hearings, designed to humiliate designated culprits called as witnesses. The first witnesses were the heads of the major banks--not Bernanke, Geithner, Rubin, Greenspan, and other contributors to the crisis. The order of witnesses suggests a preconceived judgment that the bankers are to blame.

There is a political problem with blaming the banks, however, and that is that the Treasury and Bernanke have invested hundreds of billions of federal dollars in the banks, that the new administration is thoroughly complicit in these policies, and that Bernanke by continuing to keep interest rates very low (albeit with greater justification than in the early 2000s) has enabled some of the banks to reap huge profits. As I mentioned in my last post, borrowing at low interest rates is no fun if you can only lend at those rates. But there are always opportunities for risky loans or other risky investments, and when there is an implicit government guarantee against a company's failing the company can borrow at very low interest rates even though it is making risky investments, because its lenders feel secure by virtue of the government guarantee. So it faces a steep "yield curve" (the upward-sloping curve that relates the maturity of a loan to the interest rate--the longer the maturity, or the greater of some other risk factor, the higher the rate) and can make a lot of money.

The government's policy toward the banks may well be sound in the present economic conditions. The banks took a big hit in 2008 and continue to carry a lot of bad loans. Government policy has enabled them not only to survive but, in many cases, to thrive. It has not, however, stimulated enough lending to power a vigorous economic recovery. The banks are hoarding huge cash reserves, partly because their balance sheets remain impaired, partly because loan demand is down because there is little appetite for private investment. But if the government were not lending a helping hand, the banks would be lending even less and the economic recovery would be even slower.

The government has failed to explain to the public (it would doubtless be difficult to explain) how its largesse toward the banks and the profits that that largesse has enabled have served the public interest. Instead, the government is busy denouncing the bankers as "fat cats." If they are fat cats, why has the government been stuffing them with money?

That is a hard circle to square. The proposed bank tax is an attempt. Absurdly named the Financial Crisis Responsibility Fee in order to underscore its punitive character, it is a small tax on large banks' borrowed capital (other than deposits). It would yield about $10 billion a year and is due to last until the Treasury recovers the $117 billion that it is believed it will lose as a result of the bank bailouts. The fee has no regulatory rationale; it is too small to affect the banks' behavior significantly. It is merely a hostile gesture.

The harder the government comes down on the banks, the more they will be inclined to hunker down, to hoard (which is what firms and individuals alike do when they face a hostile and uncertain economic environment), and to shift attention from running their firms to dealing with their public image and political vulnerabilities. 

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On January 3, Fed chairman Ben Bernanke gave a long speech entitled "Monetary Policy and the Housing Bubble," in which he argued that the Fed's low interest rate policy in the early 2000s, which he supported, was not a significant factor in the housing bubble and resultant financial collapse. His arguments are unsound, self-serving, and harmful to economic recovery and financial regulatory reform.

John Taylor, in an op-ed in The Wall Street Journal on January 11, notes a number of the errors in the speech. Other errors have been pointed out in economists' blogs. The basic argument that Bernanke makes is that forecasted inflation at the outset of the 2000s was so low that pushing the federal funds rate way down (in fact, into negative territory in real--that is, inflation-adjusted--terms) was a prudent measure for stimulating the economy. And, Bernanke adds, although reducing the federal funds rate did lead to an increase in mortgage rates (even though the federal funds rate is short term and the mortgage rates long term at least in traditional 30-year fixed-payment mortgages, as distinct from the adjustable-rate mortgages that became popular during this period), the increase was too small to explain the extraordinary increase in housing prices. (So at least Bernanke acknowledges a link between short-run and long-run interest rates; his even more defensive predecessor as chairman of the Fed, Alan Greenspan, does not.)

The Fed's forecast was inaccurate (Taylor points out that private forecasts contradicted it). But accurate or inaccurate, the result was a huge increase in investment in housing, which pushed up housing prices. The increase in prices was inflationary. Negative interest rates are likely to cause inflation by flooding the economy with money, raising the ratio of money to output. The Fed was fooled because the flood of money, rather than creating a large surge in the consumer price index (in part because cheap foreign imports kept prices of most goods down), created asset-price inflation--and the principal asset inflated was housing. The Fed wasn't looking for asset-price inflation, and didn't see it.

Housing is a product bought primarily with debt (a long-term mortgage for between 80 and 100 percent of the market value of the house), so a fall in interest rates pushes up housing prices by increasing the demand for housing. It also leads to a reduction in mortgage standards, because when housing prices are rising, defaults decline, making risky mortgages less risky. In addition, very low interest rates stimulate lenders to make risky loans in order to maximize yield; hence house financing increasingly took the form of subprime mortgage lending. (When interest rates are very low, low-risk loans are not very profitable, and it is attractive to increase yield by making riskier loans.)

A housing bubble is extremely dangerous, as the Japanese learned in the 1990s. Mortgage debt is enormous, and entangles the banking industry deeply in the housing industry. Not all housing bubbles trigger collapses of the banking industry, of course, but a competent central bank would be alert to warning signals of a possible housing bubble. The Federal Reserve, first under Greenspan, then under Bernanke, was not alert; it was asleep.

Bernanke's claim that abnormally low interest rates cannot explain the entire increase in housing prices suggests a misunderstanding of the bubble phenomenon. A bubble is a self-sustaining increase in asset prices. People see prices rising, assume they will continue rising at least for a time, and jump on the bandwagon. An external stimulus, such as a continuing drop in mortgage interest rates, is not required to keep the bubble expanding. Bernanke acknowledges that "for a time, rising house prices became a self-fulfilling prophecy," but he argues that what got the bubble started was not low interest rates but the deterioration in lending standards. He does not acknowledge the possibility that low interest rates accelerated an existing trend to higher house prices, that rising house prices by reducing defaults led to riskier lending, that the search for yield in an environment of low interest rates also contributed to the increase in risky lending, and that these factors--all stemming from too-low interest rates generated by unsound monetary policy--were, in combination, responsible for the bubble.

Bernanke exonerates monetary policy, and places blame instead on the lenders for risking lending, on the "global savings glut" (the increase in the U.S. monetary supply because of large purchases of Treasury securities by China and other countries that have large dollar reserves because they export much more than they import), and on imperfect execution by bank regulators (including the Fed) of their authority to prevent risky lending. Higher interest rates that would have burst the housing bubble would also, he argues, have slowed economic activity in general, and better regulation of risky lending practices would not, and so his preferred combination would be very low interest rates with stricter regulation of banks (and other lenders). But stricter regulation of lending would have reduced the amount of credit available in the economy, which would have slowed economic activity. As for the availability of foreign capital, while it facilitated investment in housing, it did not disable the Fed from raising interest rates, as it finally did, to burst the bubble--after the bubble had become so large that its bursting was a disaster.

I am unclear why Bernanke is so defensive about monetary policy, while acknowledging (albeit very briefly) failures of regulation for which he also bears considerable responsibility. The regulatory failure, however, is shared with other regulatory agencies, such as the SEC. And the regulation of the money supply (and hence of interest rates) is the very core of the Fed's responsibilities; if it is incompetent at that task, it may require some profound overhaul.

Another regulatory failure goes unmentioned. Even if the Fed's monetary policy was not responsible for the bubble, the Fed should have been alert to the possibility of a bubble, and should have taken measures either to burst it before it got too large, or to insulate the banking industry from the consequences of a burst. The Fed--Greenspan's Fed, Bernanke's Fed--was asleep at the switch.

The timing and content of Bernanke's speech cannot be separated from his uncomfortable position of being up for confirmation by the Senate for a second term as chairman of the Fed. He bears, in my opinion, a considerable responsibility for the current dreadful state of the economy, not only by his lack of foresight concerning the housing bubble and his complicity in Greenspan's mismanagement of monetary policy, but in his failure to grasp the severity of the looming financial crisis even after Bear Stearns collapsed in March 2008. The result of that failure was that he was taken by surprise when the other financial ninepins fell in September and failed to grasp the importance of keeping Lehman Brothers from collapsing. He then regained his balance. But much damage to the economy had been done.

It is natural, especially while the Senate's determination whether to confirm him is pending, that Bernanke should avoid accepting blame for the economic mess we're in. But it has the bad effect of feeding the populist theory of the economic depression--that it was the work of greedy and reckless bankers. Of course it was the collapse of the banks that triggered the depression, and the collapse was the proximate result of decisions made by the bankers. But as I argue in my new book (in fact in both books), the bankers were doing what businessmen always do, which is to try to maximize profits within the framework of permissible profit-maximizing conduct created by government. Because government regulation of the money supply and of lending practices was defective, the bankers' pursuit of profit maximization led the economy over the brink. If the framework is not reformed, we are at risk of experiencing a future financial crisis of equivalent severity to this one. Bank taxes and limitations on bankers' compensation may assuage the public anger stirred up by a populist theory endorsed by government officials, but they will not prevent future crises.

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Now that the book is completed, I can resume blogging, and will post my first new entry tomorrow.

Let me say something about my new book. It is twice as long as "A Failure of Capitalism: The Crisis of '08 and the Descent into Depression," which was completed at the beginning of last February and published in April. The new book both goes in greater depth into issues discussed in the last book and covers much new ground. More is understood now about the causes and the course of the financial crisis that crested in September 2008 and precipitated a sharp general decline of the economy as a whole both here and abroad. The issue of causality is central to the reappointment of Bernanke as chairman of the Federal Reserve, to the rising wave of banker bashing, to the just-begun investigation by the Financial Crisis Inquiry Commission, and to pending and proposed legislation (most recently the proposal to impose a "Financial Crisis Responsibility Fee" on the largest banks). I am in sharp disagreement with the populist theory, embraced by the Administration, that the principal blame for the financial crisis should be assigned to "fat cat bankers." Bigger culprits, in my opinion, are unsound monetary policy and lax banking regulation, with an assist from the economics profession.

In addition to exploring the causes of the crisis in greater depth than in my earlier book, the new book brings the story of the crisis up to date by examining in detail the relevant developments, both economic and political (and they can't be separated) since the inauguration of President Obama. This is a story of ambitious recovery measures, of mixed success, and of ambitious governmental proposals of dubious merit for preventing a recurrence of the conditions that resulted in the financial collapse. I emphasize in the book that although the economy is beginning to recover from the depths of the current depression (as I insist our economic situation should be called), the immense costs that have been incurred to fight the depression, the lost tax revenues, and the Administration's ambitious long-term social programs, all taken together, have deepened the concerns that I expressed in the earlier book about the nation's economic future.

I had thought when I agreed with my publisher on a deadline for the new book that by the end of 2009 the shape of recovery would be clear. It is not. We simply cannot respomsibly gauge the pace of the recovery. Nor is it even clear whether we are better off with a fast recovery or a slow one. A fast recovery could create an acute risk of dangerously high inflation. A slow recovery could greatly increase the size of the federal deficit, threatening all sorts of economic and political harms, with eventual unacceptable inflation only one of them. I am particularly concerned with the danger of social and political turmoil if high unemployment and related economic pathologies persist.

We are now in the third year of a depression. The economic crisis continues to occupy center stage despite all the other news assailing us. Tomorrow I will blog about developments so recent that I could not include them in the new book.

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?