Somewhere in the World There Must Be Someone Who Understands the Unemployment Insurance Seasonal Adjustment Factor

But it sure ain’t me:

Looking at this time series, the seasonal adjustment does look a little crazy, but I promise– it’s not that bad.  Let’s go to the ten-year:

So, yes, that spike looks huge, but historically, it’s only really big.  Obviously, it’s possible that the seasonal adjustment should be different in recessions.  We could test for this– we could set up a Markov-switching model with trigonometric terms, and allow switching in those terms to see whether the adjustment should be smaller or larger in recessions.  It’s possible that this wouldn’t be terribly enlightening, as different recessions can be very different, but it wouldn’t take too terribly long, and I’m sure Brad has some graduate students he could put to work.

I’m open to suggestions as to what rules of thumb should be applied to UChicago economics.

Questioned yesterday at an AEI-sponsored discussion of green jobs, Smith admitted that her modeling actually shows that even with the climate policy in place:

“When you look out to 2050 there’s a doubling of the GDP.”

Wow. I’m not sure how “a doubling of GDP” amounts to the suicide-bombing induced economic meltdown the Chamber likes to portray. Was this a momentary aberration on Smith’s part?

I’ll answer this one.  A doubling of GDP over the next 40 years would correspond to an annual average growth rate of about 1.75%.  Over the past 40 years, the annual average growth rate has been about 2.93%.  Using that as a baseline, a doubling of GDP by 2050  would correspond to a complete failure– the cost of climate action would, on average, subtract almost 1.2 percentage point from annual growth, year after year.  

Fortunately, there’s good reason to believe that this wildly overestimates the actual cost.  So why not just refute Smith’s claims?  Doing so would avoid this:

Apparently not, since Smith went on to say that:

“The real issue isn’t whether we’re going to tank the economy. Its, is this something we’re willing to spend for? You’ve got to look at what are we getting for that and is it worth doing?”

In other words, all of Smith’s research and damning presentations aren’t about saying we shouldn’t do a climate policy, or that it will kill the economy. Rather, that we should make sure we get the best value we can.

Hmmm…I’d have to say that if the cost of getting the US to fight global warming is that we double the GDP, well, that sounds like a pretty good value to me.

No.  She’s saying that maybe action on climate change isn’t worth doing.  She’s probably wrong– but address that, don’t distort her words– and don’t try to spin a dismal growth rate as a positive, especially when you  have good reason to believe that the real cost of action on climate change would be far lower.

There is, however, a class of cases where the argument against government ownership is not as straightforward. In these cases, cost reductions for which private suppliers have stronger incentives have potentially deleterious effects on the non-contractible quality. For example, private prisons might abuse prisoners by hiring cheaper guards and failing to train them, private hospitals may refuse to treat patients on whom hospitals generally lose money, private schools might substitute less effective teachers’ aides for more expensive teachers, and so on. In such situations, strong incentives may lead to inefficient outcomes or, put differently, the efficient producer might need to have soft incentives. Ironically, the government sometimes becomes the efficient producer precisely because its employees are not motivated to find ways of holding costs down.

 

The modern case for government ownership can often be seen from precisely this perspective. Advocates of such ownership want to have state prisons so as to avoid untrained low-wage guards, state water utilities to force investment in purification, and state car makers to make them invest in environmentally friendly products. As it turns out, however, this case for state ownership must be made carefully, and even in most of the situations where cost reduction has adverse consequences for non-contractible quality, private ownership is still superior.

While the failed auto bailout plan never constituted ownership per se, it certainly would have entailed the exercise of control rights.  After all, one group in Congress pushed for requirements that would have forced automakers to invest in environmentally-friendly products– exactly what Shleifer pointed out ten years ago, but without explicit ownership.  Another group pushed for major concessions on the part of the unions.  It should not be a surprise that these two groups were mutually exclusive and that their proposed requirements hewed closely to their ideological priors.  What few people have mentioned, though, is that government regulation is in part at fault for the current situation.  I’ll go into it in depth in a later post, but it shouldn’t be hard to see that the composition of the automakers’ fleets at the time of the oil price spike was in no small way defined by CAFE standards– and not in a way that was helpful to the American auto manufacturers.

This is just to say– it’s not at all clear that any restrictions on the conduct of business by the recipients of any bailout are in the best interests of either the firms receiving the funds or their creditors.  While the government has the right to impose restrictions on the money it lends, in doing so, it will more likely attempt to pander to the biases of particular constituencies than it will achieve any useful purpose.

Congratulations, Dr. Krugman. Perhaps, given your work in international trade, international finance, and financial (specifically currency) crises, it’s not surprising that you’d be recognized during one of the largest international financial crises in history… particularly given that you’ve been sounding warning bells since several years ago. It is, I think, a little surprising that your work on currency crises went unmentioned. I will say, however, that I am delighted to see that you’ve been cited for his work in economic geography, a topic that is dear to my heart. I have an enormous amount of respect for your academic work, though at times I think your popular writing hasn’t cleared the same high bar you’ve set elsewhere in your career.

I cannot wait for the ideologues to accuse the Nobel committee of being driven by politics, and for the anti-economic folks to point out that the prize is not technically a Nobel. We might not be able to predict business cycles accurately, but some things we’ve got nailed.

Possibly. If I had to bet at even odds, I’d bet against near-total seizure of global credit markets, but it’d be a closer call than I think I want to admit to myself.

If it does fail, however, it’s likely to do so sooner rather than later, and it will do so because the bailout wasn’t extensive enough– it didn’t give enough probably-unconstitutional authority to Henry Paulson (or, as was never seriously discussed, someone else, a point to which I will return later). My great concern is that the crisis hits Europe with full force, bringing down a major European bank or two– not banks on the scale of Fortis, but larger ones that couldn’t be easily bailed out by their home countries’ banks. This scenario that keeps me up at night starts with the TED (Treasury-Eurodollar) spread, which is the interest rate spread between the inter-bank borrowing rate (as represented by the three-month LIBOR, or London Inter-Bank Offer Rate), and the cost of “riskless” lending (as represented by three-month T-bill interest rates). The TED spread is an indicator of risk in credit markets: as the risk of borrowers defaulting on their debt rises, lenders require a higher rate of return to justify taking the risk of lending to those borrowers. At the moment, it is quite high. This increases the risk that firms that rely on short-term borrowing to cover debts won’t be able to meet their obligations, and will go bankrupt as a result, creating chain reactions that ripple through the economy as their creditors are unable to meet their obligations. Obviously, this has already occurred with the highly-leveraged investment banking firms in the US, but it could spread to other sectors of the U.S. economy, which is what the bailout plan is supposed to avert. Unfortunately, to the extent that the crisis spreads to related sectors of foreign economies, the bailout plan won’t do a thing to help. Given the difficulty of passing the plan through the House the first time, what are the chances that the Treasury secretary is going to be able to get the second $350 billion if he spends the first half rescuing foreign banks? I consider this a real threat; the fact that every student learns the lesson of Smoot-Hawley, that passing protectionist tariffs in the face of a massive downturn in the economy will only make things worse, does not mean that politicians will not make slightly-different-but-equally-crippling populist mistakes.

It’s for this reason that I’d like to give Mr. Paulson the benefit of the doubt. It’s entirely likely that some of the very smart people over at the Treasury considered the possibility of foreign bank failure and a populist backlash against using U.S. taxpayer funds for a bailout and added the language to the “Paulson Plan” that stated:

“Sec. 8. Review.

“Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”

Of course, such language would also provide certainty to the markets– a government bailout in limbo, awaiting a decision on a motion for summary judgment on an appeal, etc., etc., would be worse than none at all. What the Treasury clearly didn’t anticipate, however, was that there would be such a powerful backlash to their brazen grab for power. Were the administration more credible, the Treasury’s proposal might have had a chance. As things are, any talk of a crisis from the administration sounds an awful lot like “The Boy Who Cried Wolf”, and it would clearly have been a wiser move to give much of the authority sought by Mr. Paulson to an explicitly bipartisan oversight board constituted in such a way as to be insulated from political pressures.

So– back to my nightmare– we’re in a situation where major global banks could fail, and the U.S. would be unable to do anything. It’s natural to ask, why wouldn’t other countries be able to step in to save their own banks? The answer is twofold: first, when dealing with very large global banks, like RBS or Deutsche Bank, they’re so large relative to their home countries’ economies that the fiscal constraint would be crippling, as there’s simply a lack of necessary capitalization; second, it’s not clear that the European Central Bank or its member nations have the authority or competence necessary to take coordinated action on the necessary scale. Thus, we face the possibility this week that major European banks will fail, seizing up credit markets and causing a global economic contraction, as the only bailout plan that can pass is one that is too weak to actually help.

And that is why the quality of governance in relatively stable times matters more than the hot-button social issues used to manipulate the populace– it sets the constraints of governance in times of crisis.

I don’t think that this is a temporary shift. It’s my opinion that markets tend to systematically underestimate risk for a number of reasons, not least of which is a lack of data. By way of example, it turns out that while it’s relatively easy to estimate the probability of a 100-year flood, it’s much more difficult to estimate the term risk of massive defaults on a package of securitized 30-year loans, because the data we have available simply doesn’t allow for a sample of similar width, nor do we have data for a similar length of time. Given this, and given how closely intertwined the world’s financial institutions are, a phenomenon augmented by the proliferation of instruments to distribute risk– the fact is, none of the major investment banks could actually state its net position at any given point in time– it’s silly to expect that sufficient information exists in the market to accurately price in those events on the tails of the probability distribution. Moreover, the lack of transparency in the shadow banking sector, due in part to the complexity of the instruments being used, but also in large part due to the fact that the instruments are traded primarily in bilateral agreements rather than in an open market, further complicates efforts to understand any one firm’s exposure to a given form of risk, let alone the ripple effects that could occur as a result.

If I’m right about the above, then it’s worth considering also that the same interdependence that frustrates any attempt at isolating a single firm’s risk profile also means that when one firm is in need of capital to remain solvent, it’s likely not the only one. The availability of funds through repo loans and other standard instruments is thus prone to feedback loops that can amplify any disturbances larger than some (unknown) magnitude. As a result, I’d argue that the entire model of investment banking that finally vanished this evening was inherently unstable, and that while we will see a return of many of its elements, they will not take on the same form as they did before. Most notably, we should look for more transparency in formerly opaque instruments, possibly including a central clearinghouse for many types of transactions, and a much more conservative approach to debt financing. While I can’t pretend to know what the future regulatory environment will look like, I do think that such changes would be a positive step in reducing the risks posed to the greater economy as a result of disturbances in the financial sector.

A Chaotic Sunday Opens Wall Street’s Week
Moral Hazard’s Exit
Leaves Investors
To Sort Out the Mess
By ANNELENA LOBB
September 15, 2008; Page C1

Investors are going to be staring in the face of moral hazard when markets open Monday.

The collapse of Wall Street firm Lehman Brothers Holdings Inc. coupled with a restructuring of insurer American International Group Inc. and a deal by Merrill Lynch & Co. to sell itself to Bank of America could cause a decline, particularly among financial stocks, when markets open.

Despite serious efforts by potential bidders and Lehman, a deal never came together over the weekend, largely because the federal government refused to put up any cash. After backstopping Bear Stearns, Fannie Mae and Freddie Mac, the Treasury and Federal Reserve said no more.

The government’s logic was that if investors were bailed out again, they would expect a bailout every time, and the so-called moral hazard would disappear, making people willing to take massive risks in the belief they would be saved.

No. That is not what ‘moral hazard’ means. Moral hazard is, as Wikipedia so eloquently puts it, “the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.” Thus, in this case, it wasn’t a risk that moral hazard would disappear; it was instead a risk that a bailout would create moral hazard, by insulating investors from the consequences of risks they had taken on, and thus encouraging similar risky behavior in the future.