Archive for May, 2010

What if women ran Wall Street?

Kijong Kim | May 13, 2010

Michael Scherer at Time has a fascinating story on three women in Washington–Sheila Bair, Elizabeth Warren and Mary Schapiro–who have risen from the ashes of the financial meltdown. If nothing else, the crisis has at least helped put some women in charge of Wall Street.


Dean Baker on the ‘credit squeeze’

Thomas Masterson |

Dean Baker debunks the myth that sluggish growth is caused by banks not lending money to small businesses. Long story short: it’s the recession! Businesses (especially small ones) are looking less like good credit risks because they have less revenue. What bank would be lending more in this atmosphere? A foolish bank.


Prometheus bound

Taun Toay | May 11, 2010

Any time you talk about a contagion, it’s sensible to ask: where did the infection come from? The European debt crisis may look like it started in Greece, but really it began with the Stability and Growth Pact, the final framework of the European Monetary Union (EMU) that gave us the euro. That agreement is just too rigid to allow for the kind of fast, coordinated action necessary in a crisis. And because it launched the joint currency without any kind of federal transfer system, it made the new currency unsustainable. The euro’s founding framework thus contained the seeds of instability.

What’s really surprising about recent developments is that the imbalances in the euro-zone have caught the world by surprise. The recent trillion-dollar rescue package calmed the markets, at least for now, but it also highlights the level of imbalances in Europe. The fact that this rescue package took the better part of four months to construct underscores that the monetary and fiscal institutions in the euro-zone are not conducive to a single currency. The euro bailout is the product of what a federal government could construct in days. The austerity measures that will accompany the program at the hands of the IMF and a politically reticent Germany will do little more than choke off growth and fuel political discontent in Greece. While that may make investors happy for now, faith will quickly shake when protests rock reforms or stagnant numbers surface among the PIIGS.

The level of the required bailout should raise more concerns than it ameliorates, as investors look around at where risk is held. The popular recent analogy to U.S. toxic assets is not a perfect one, especially as the euro-zone has fewer institutions capable of stepping in to calm markets. At the end of the day, Europe has put its currency union ahead of its political union. Until Europeans are willing to cede greater autonomy to a federalized body (a development as likely as the formation of an EU soccer team), this process of fear and bailout is doomed to repeat itself. The question is whether the next of the PIIGS to follow Greece to the slaughter will be too-big-to-save.


European Union’s mega-loan fund is no panacea

Dimitri Papadimitriou |

From the way markets reacted, the trillion-dollar rescue package hurled by European leaders at the continent’s growing debt crisis might well have been code-named Panacea. Stocks rose all over the place while Greek bond yields tumbled on Monday. But this is far from the end of the story. The rescue package alleviated the growing Eurozone liquidity crisis, but the solvency crisis remains. While the acute problem (liquidity) was a serious threat, so is the chronic problem of excessive indebtedness that besets Greece, Portugal, Spain and Ireland.

The rescue plan cannot address the central problem, which is that countries with very different fiscal cultures (and earnings potential) are yoked to the same currency. The idea was that this would help the profligate keep in line, but instead it’s shaping up as a way for them to ship their liabilities to their fitter neighbors. How long will voters in rich countries stand for this? Perhaps not much longer than the voters in the debtor countries will stand for the austerity measures imposed on them.

The entire rescue plan presumably rests on the assumption that, with more time, the Eurozone’s problem countries can get their fiscal houses in order—and Europe can somehow grow its way out of trouble. But Greece and some of the other major European debtors are seriously uncompetitive. And the medicine of austerity may not work, if only because the patient may refuse to take it.

The countries in question are democracies, after all, and it is far from certain that Greece and the others will cut spending and raise revenue enough to make a difference. Austerity means stagnant wages; in Greece, public sector paychecks are supposed to shrink 10% along with pensions cuts and increases in the retirement age. But April inflation in Greece was the highest in the Eurozone — a rate of 4.8%. Higher taxes will continue to make life more expensive for people earning less money. It’s a volatile mix.

What is missing is a policy mechanism that provides a way to even out trade imbalances by recycling the surplus of counties such as Germany, Netherlands and France to the deficit countries for pro-growth direct investment. Germany did this with East Germany. If it can be accomplished, it’s one way Greece and the others can become competitive enough to secure their future through higher exports. This is in concert with the same adjustment mechanism that many Levy Institute Strategic Analysis reports (see for instance this one) have been suggesting for many years at the global level with regard to China in solving the problem of global imbalances.

It’s hard to see a positive European outcome from the rescue plan, given the perverse incentives in place. Higher taxes in Greece will only mean more tax evasion (see Gennaro Zezza’s insightful post on this). The bailout will only make it harder to convince people in Greece, Portugal and the other problem debtor nations that failing to change will result in disaster. Since the real rescue is of European banks that hold all this debt, we have once again a transfer of money from thrifty taxpayers to imprudent banks, making moral hazard more hazardous.

The markets may not like to hear it, but sooner or later Greece will have to restructure its debt; one or more of the others will probably have to do the same. Their structural primary deficits are simply too large to come into balance with all the deflationary austerity measures. Growth, in these countries, will be negative at least for the next two years after the current year. Meanwhile, the smart money is headed for the exits.


Not just jobs, but the right kind

Dimitri Papadimitriou | May 10, 2010

The good news on U.S. employment is that we added 290,000 nonfarm jobs in April. The bad news is that unemployment rose as well, to 9.9%, because more people entered the labor force and many more returned to seeking work.

So unfortunately, the employment picture remains grim, with a level of unemployment we might have found horrifying just a couple of years ago. Many of us agree that the government has a role to play in creating more jobs, but nobody is paying much attention to the best kinds of jobs Washington should create.

As it turns out, they’re not the kinds of high-paying jobs most of us would want. But they are the kind that would help the most people—and get taxpayers the biggest bang for their buck.

How can the government accomplish these twin goals? My Levy Institute colleagues Rania Antonopoulos, Kijong Kim, Thomas Masterson, and Ajit Zacharias studied this question and came up with a surprising answer. The best jobs for Washington to create don’t involve repairing bridges and digging subway tunnels, worthy as those initiatives may be. Nor do they involve wind power or other green technologies, although those too are fine undertakings.

No, the best jobs government could possibly create are what we’ll call “social sector” jobs—roughly speaking, work taking care of people. We’re talking about home health-care aides, child-care workers—relatively low-skill, low-wage work that nonetheless is fantastically cost-effective, hugely important, and a highly equitable use of government funds. continue reading…


A crisis of evasion

Gennaro Zezza | May 8, 2010

I’m Italian, and I’m an economist, so as European leaders work feverishly to save the Euro, I’ve been wondering: what would happen if the feared contagion occured and my own country saw its finances melt down just as Greece’s have? The short answer is that this would generate a fatal shock to the Euro, given the size of Italian public debt and the fact that a large share is owned by other Euro countries.

Of course, such an event is by no means a foregone conclusion. But I can’t help noticing an ominous correlation. The country in Europe with the biggest untaxed, or “shadow,” economy as a proportion of GDP is Greece. Next is (gulp) Italy. Then Portugal and Spain. On the chart below, in fact, the bars look unsettlingly like dominoes.

How big is the shadow economy?

Much of the problem in these countries in Europe, in other words, is tax evasion. As the chart shows, the size of the shadow economy in Italy and Greece is much larger than in other developed countries, inside and outside the Euro area.

Massive tax evasion helps produce large public-sector deficits. Let’s make some simple back-of-the-envelope calculations: if the shadow economy is adding 25 percent to GDP, with income going untaxed, and if the average tax rate on such income is a conservative 20 percent, recovering such tax revenues would imply an additional 5 percent of GDP in tax revenues, which would bring down the Italian 2009 deficit to zero. As deficits cumulate into debt, prolonged tax evasion could explain – by itself – the whole of the Italian public debt, now projected at 118.4 percent of GDP.

Attacking these deficits by raising taxes or freezing wages in countries where the shadow economy is so large could encourage further tax evasion, placing an ever-greater burden on an ever-shrinking proportion of law-abiding citizens who pay what they are asked. If Europe’s troubled public finances are ever to be set right, Greece, Italy and other nations with large underground economies must find a way to collect the taxes that now go unpaid.

(Figures in the chart are from F. Schneider, Shadow Economies and Corruption all over the World: New Estimates for 145 Countries)


Employment report: a mixed bag, but stimulus is helping

Thomas Masterson | May 7, 2010

The Bureau of Labor Statistics released its monthly Employment Situation Report this morning. The headlines will announce an increase of 290,000 in nonfarm payroll employment and a jump in the unemployment rate to 9.9%. While employment grew, the labor force grew faster than usual, with 195,000 lured back into looking for work by better prospects in the job market. Even without these re-entrants, the labor force grew by 610,000 in April. So while trends are pointing in the right direction, the unemployment rate will continue to look bleak for quite awhile. continue reading…


The “hidden” benefits of the Citigroup bailout

Greg Hannsgen | May 6, 2010

With the recent financial turmoil in Greece, the press has turned its attention away from the bailouts of Citigroup, AIG, Fannie Mae, Freddie Mac, and other major U.S. financial corporations. Less than a month ago, though, Gretchen Morgenson noted in the New York Times that a Treasury Department estimate of the costs of the main financial bailouts probably understated their total costs to the economy. Around the same time, federal officials and others pointed to the government’s investment in Citigroup as a relatively successful venture that could make a profit—perhaps $11 billion plus $8 billion in interest and fees. (The company’s stock has fallen somewhat since then.)

Bailouts are of course intended to benefit the economy as a whole, and it is certainly hoped that such benefits will greatly exceed the return to the government on its investment. A large part of the return went to investors who have increased their wealth by owning the shares of Citigroup since it was saved by the government. The market capitalization of Citigroup is now very roughly $90 billion, after subtracting the U.S. government’s stake of about $32 billion. (The latter figure may overstate the size of the government’s share, because it may include stock that has been sold by the government this year.)

Predictions of a good return on the Citigroup bailout are good news. But since the bailout appears not to have been a zero-sum game (a win-win situation was possible), the lion’s share of the benefits to the company as of now (15 months after the government’s last investment) did not go to the government. In fact, a $90 billion windfall of sorts went to shareholders, even as the government incurred large costs for other bailouts. continue reading…


Financial regulation vs. financial innovation

Thomas Masterson |

The Washington Post reports that, testifying before a panel investigating the financial crisis, Henry Paulson “cautioned against overreaching on financial overhaul legislation now before Congress that he said could stifle innovation in the markets.” Well, we certainly wouldn’t want to do that! After all, financial innovation has been great for the economy right? Maybe not, but as Yves Smith notes, it has certainly been good for the finance sector and for financial innovators, as both empirical and theoretical studies argue. This suggests to me that Paulson, former head of Goldman Sachs, may not be thinking of the good of the society as a whole when he worries about the impact of financial regulation.

That being said, I don’t think any financial regulation coming out of Congress is likely to have much bite. Indeed, the Federal Reserve may have already had the regulatory power to avert the crisis but failed to exercise it, according to Bill Black (this post lays out his argument with links to video of his testimony on Lehman Brothers). This should come as no surprise, since the regional Federal Reserve boards are elected by bankers. Tom Ferguson points out that Obama was the candidate of finance, getting more of his early donations from them than any other candidate. If finance owns Congress (as Dick Durbin memorably said), the Federal Reserve and the White House, where is effective financial regulation realistically going to come from? continue reading…


Was the crisis a crime?

Daniel Akst |

(This is the testimony of Levy Institute Senior Scholar James K. Galbraith before the Senate Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010.)

Chairman Specter, Ranking Member Graham,  Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession.  Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including “rational expectations,” “market discipline,” and the “efficient markets hypothesis” led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on,  and that widespread fraud therefore could  not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft-pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the bubble.  They continue to do so now.  At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word “naughtiness.”  This was on the day that the SEC charged Goldman Sachs with fraud. continue reading…