Evolution of Oversight

Key moments in the history of US financial regulation:

1789: Under the new federal government, banks are chartered by state legislatures or Congress.

1829: New York becomes the first state to adopt a bank obligation insurance scheme, based on a concept employed by the Hong merchants in Canton, China.

1863: The Office of the Comptroller of the Currency is established to oversee national banks set up to issue the currency used to finance the civil war.

1913: The Federal Reserve System is created and assumes responsibility for state-chartered banks and bank holding companies.

1933: The Federal Deposit Insurance Corporation is established to insure deposits after 9,000 banks fail in the Great Depression.

1934: The Securities and Exchange Commission is created.

1989: The Office of Thrift Supervisionbegins oversight of savings and loan industry.

2009: Tim Geithner, Treasury secretary, calls for regulatory overhaul and greater federal supervision.

Are recessions the inevitable payback for good times?

A thought provoking piece on business cycle by Paul Krugman:

A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle—a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking—not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive—not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love. 

Powerful as these seductions may be, they must be resisted—for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality—with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression—with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world's depressed economies at this very moment.

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity—of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes—investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles. Anyone who has watched the ups and downs of, say, Boston's real estate market over the past 20 years can tell you that episodes in which overoptimism and overbuilding are followed by a bleary-eyed morning after are very much a part of real life. But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole? Don't say that it's obvious—although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought—a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles—was John Maynard Keynes' realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone—horrors!—printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors. But moderates and liberals are not immune to the theory's seductive charms—especially when it gives them a chance to lecture others on their failings.

I believe Keynes had it right: Often, if not always, "it is ideas, not vested interests, that are dangerous for good or evil."

Return of Economic Populism

The Economist has an excellent article explaining different forces that have driven American Politics for last 80 years.

http://www.economist.com/world/unitedstates/displayStory.cfm?story_id=13375986&source=hptextfeature

Oil Mergers

Investment Bankers must be so happy. 

http://www.economist.com/business/displayStory.cfm?story_id=13381530&source=hptextfeature

Neuroeconomics

Andrew Lo of M.I.T. has demonstrated that if stock traders make a series of apparently good picks, the dopamine released into their brains creates a stupor that causes them to underperceive danger ahead. This new field of Neuroeconomics sounds fascinating. To learn more on biological roots of financial crisis,see

http://blog.wired.com/wiredscience/2009/01/financebiology.html

Economics of Books

Some people are not very happy with Google's initiative.

http://online.wsj.com/article/SB123819841868261921.html

Deflation Threat Subsides

                                                      Click on the pic to enlarge it.

The blue curve is the yield on an inflation-adjusted bond and the red one is the yield on a nominal bond of approximately the same time-to-maturity. The negative inflation compensation that showed up a few months earlier (when the blue line was well above the red) has shrunk to about zero. These relative yields are moving back toward a more normal, and healthier, alignment. This should give Ben Bernanke some sleep.

The Aullure of Academia

http://www.thecrimson.com/article.aspx?ref=526762

Why Super Smart Economists support EFCA?

Refusal of secret ballot voting is anti-democratic. Yet some of the finest economists have publicly endorsed Employee Free Choice Act(EFCA) which does just that(explained in the previous post) . So why are people with stratospheric IQ supporting such a dumb act. The main reason is they believe that strengthening unions will increase wages of working class that has for long stagnated  in real terms. To achieve this end they are willing to use any means including denying secret ballot voting which is the basic right of every worker. Jadgish Bhagwati, one of the best International Trade experts gives his line of reasoning for defending this act,though he accepts that denial of automatic secret ballot is hard to defend.

http://www.tnr.com/politics/story.html?id=a4edc34f-7670-4e85-a43d-16f3023f2b35

However, I am not convinced. It's a little presumptuous to say that once unions get this act passed they will no longer demand other things like restrictions on free trade. AFL-CIO has for long advocated that free trade hurts the working class and would surely do everything to make sure that trade talks do not move ahead unless they get significant concessions.

Corporate America Wins an Important Victory But the War is Coming

The return of a democrat to White House has proven to be a blessing for labor unions so far. In fact, Barack Obama announced that he considers unions not a problem but part of a solution.Also,President Obama issued an excutive order that permits federal agencies to require union labor for work on federal contracts. This is good news for union workers, bad news for non-union workers, and bad news for taxpayers, who will pay more for what the government buys on their behalf. In my judgment, it is bad news from a macroeconomic perspective since one of the causes of long-term unemployment is unionization. To appease unions, democrats introduced a bill called "card check" or more precisely Employee Free Choice Act. What this bill actually does is it enables a simple majority of workers to sign up for a union and so as to avoid the subsequent holding of a secret-ballot election. Keeping the violent history of labor unions in mind, it's hard to defend that this is equivalent to free choice. Rational individuals have argued that this is anything but free. The Unions will use their coercive power to get simple majority. Against this background what chance does business has to protect its turf. For now this bill has been blocked in senate due to a republican filibuster.But for how long.

http://online.wsj.com/article/SB123811027597352881.html

Federal Reserve and Economic Crisis

Ever since this crisis has blown out of proportions, everyone including the media has been looking for scapegoats or as they call it 'people/institutions responsible for this crisis'. Several institutions like Fannie,Freddie, SEC and most importantly Federal Reserve have been accused of sitting at sidelines, ignoring warning bells and even fueling this speculative bubble.Federal Reserve always had a bad reputation among Right wing economists. In the famous "The Monetary History of United States 1863-1960", Milton Friedman and Anna Schwartz argued that 'The Great Depression' was in fact caused by Fed. So to explain the cause of this crisis,commentators once again turned to role of Fed in creating financial/economic crisis.  One man whose legacy has been tarnished,probably forever, is Alan Greenspan, Chairman Federal Reserve, 1987-2005. The Maestro suddenly became a pariah. He became an immediate target of both the Right and the Left. Economists with conservative leanings charged that by keeping interest rates too low for too long,he fuelled this speculative bubble. Left wing economists feared that US may slip into Japanese style deflation and to avoid that outcome were in favour of low interest rates during 2002-05.Hence, their line of attack focusses on his disdain for more regulations. They claim that it's FED's responsibility to check excessive growth of sub-prime loans and their failure to regulate sub-prime loans caused this crisis. Since he has been under attack from all sides, it has now become conventional wisdom that Fed caused this crisis. So is Fed responsible for this crisis? If so, to what extent. Alan Greenspan strongly refutes this claim

 http://online.wsj.com/article/SB123672965066989281.html

So Wall Street Journal asked other experts their opinion as to whether FED is guilty or not.

Here is their reponse

http://online.wsj.com/article/SB123811225716453243.html

Geither Proposes Overhaul of Current System

But there are some who oppose it.

http://online.wsj.com/article/SB123811070760052941.html

Krugman reconsiders his favourable opinion of Capital Markets

Economics Nobel Laureate and NY Times columnist Paul Krugman provides a scathing critique of Modern Financial System.

http://www.nytimes.com/2009/03/27/opinion/27krugman.html?_r=1

Is it time to give up on Markets?

Nobel laureate Gary Becker doesn't think so.

http://online.wsj.com/article/SB123759849467801485.html

Popularity of Economics

David Colander,chair of the economics department at Middlebury College on why Economics Major is so popular. http://www.viet-studies.info/kinhte/Economic_Major_CHE.pdf

Basic Lessons Forgotten

Anyone having a basic knowledge of economics will tell you that burden of tax does not always stay where politicians try to put it. President Obama is turning out to be a classic tax and spend democrat. Recently, he proposed to limit the tax deductibility of charitable contributions and claimed that this will transfer $7 Billion from charitable institutions to federal govt. To understand the folly of this argument, click here 

http://www.washingtonpost.com/wp-dyn/content/article/2009/03/24/AR2009032402462.html

The Zimbabwe hyperinflation ends

Probably.

http://news.bbc.co.uk/2/hi/africa/7962998.stm

Fed's new moves

The original announcement caused a dramatic move but since then yields have been drifting up, every day, including today. Rates are already very low. And the huge amount of increased federal borrowing is a potential serious problem for lowering rates. And potentially an even more serious problem is foreign investors deciding the yield does not provide a good investment given the risks of inflation . It will be interesting to see what happens with rates.

For more, pls see http://latimesblogs.latimes.com/money_co/2009/03/mortgage-refi-h.html

What should we use as Risk free rate?

The cost of credit default swaps (CDSs) for 10 year US Treasury bonds reached an all-time high, trading at as high as 29 basis points after the collapse of Lehman Bros.. In this regard, what should we use as the risk-free rate?

Traditionally yield on government bonds has been used as the risk-free rate. But when the government bonds are themselves not really risk-free (as the CDS rates show), what should we use? One measure I can think of is to use the yield on treasuries and subtract the CDS price from it.

Of course, this method assumes that the CDS on the government bonds has been priced properly by the market. Can you let me know how we can do better?

Confessions of a Right Winger

A distant relative of mine tells me how early his dislike for Soviet Union started:

Long ago, Soviet Russia decided that a good way for them to propagate propaganda in India would be to distribute magazines at subsidized rates. My father had taken the bait and subscribed to all such magazines available - Soviet Union, Soviet Woman and Misha. All of them were available at dirt-cheap rates (don't exactly remember them). It was so cheap that buying the magazines and giving them to the raddiwala was almost a profitable business.

This is the extent to which the Russians went to propagate their propaganda. And sadly, in those days, the world was yet to hear about anti-dumping duties.

For some reason, I never liked these magazines. My father would sit with me and make me read Misha. He would help me set up and play some of the games mentioned in that. Even then, I never managed to appreciate the magazine, and most of it went straight into the raddiwala's hands. However, given the extremely low cost, my father didn't particularly mind.

It was a jobless summer afternoon - as jobless as you would expect a seven-year-old kid without siblings during summer vacations would be. The postman had just dropped off the post - two fairly heavy books. The latest editions of "Soviet Union" and "Soviet Woman". I don't clearly remember, but looking back, it seems like I wasn't in a terribly good mood that afternoon. And so I set to work.

I decided to tear the two magazines to pieces. Each and every page of them. I tore it out carefully from the book, and using my hands, tore each page into innumerable shreds. I must have either had tremendous determination, or tremendous patience, or both, for these books were fairly big. However, I diligently sat down and did my job. And I wouldn't budge until I was done with each and every page.

I think seven (or maybe I was eight then, but I tend to believe I was seven. Even my super-strong long-term memory can't give me a clue on this) years is an early age to display your political leanings. However, watching me having diligently and efficiently torn down the Soviet Union and Soviet Woman to pieces, I think my parents were convinced that I'd grow up to be a right winger.

Computer Science and Economics

Left-wing economics is idealistic, and the basic assumption is that everyone is a good guy, and he will work in the best interests of the system.

On the other hand, the basic assumption behind right-wing economics is that everyone is inherently a bad guy, and will work only for his own benefit. Hence, systems have to be devised so as to align a person's selfish interests with the system's interests.

To put it in other words, left-wing stuff is ideal. It assumes best case performance, or marginally below best case performance, from all players in the system. Similarly, in assuming that everyone has only a selfish motive, right-wing economics does what can be called a worst-case design.

Training in Computer Science inherently teaches you to think about the worst-case possibilities in everything.

In this context, isn't it surprising that so many people from a computer science background are leftist?