The new edition of The Atlantic contains this interesting map, showing how changing median incomes and demographics have divided the United States into 12 distinct geographic areas, each contributing to an overall picture of increasing economic inequality. (It may be helpful to use your browser’s “zoom” feature as you look at the map.) For example, our institute is located in a county described by the map as a “monied burb,” while I grew up in a county that the authors have labeled “boom town.” I would venture a guess that many readers who are familiar with these counties will be surprised to see how they are labeled. We take the new map and other efforts like it with a grain of salt, but as something to provoke thought about how things are indeed very different than they used to be.

I’ve emerged this morning to report on some of what’s transpired recently. I’m not referring to whatever might have happened yesterday and overnight at major centers of research in neoclassical macroeconomics, such as the University of Minnesota. I’m referring to a new book by John Quiggin entitled Zombie Economics: How Dead Ideas Still Walk Among Us, which was published late last week by Princeton University Press. While this book is not meant to be on the cutting edge of research, it will hopefully help to bring popular discussion of mainstream macroeconomics and its foibles up to date, adopting a welcome skeptical attitude to this controversial subject.

The book deals in part with developments in macroeconomics that began in the 1970s, with the emergence of the New Classical approach to macroeconomics at places like the “U,” as it is sometimes known in the Twin Cities. This new type of macroeconomics quickly became associated in the public mind with ideas like “rational expectations,” a technical assumption that seemed to lead to some preposterous conclusions, including the claim that monetary policy had no effect on unemployment and economic output. Its adherents often saw the Keynesian economists of the day as moving down the tracks just a little more slowly than themselves. It is fair to say that at the time, other mainstream schools of macroeconomics had lost a great deal of their momentum and had found themselves increasingly on the defensive. Much more recently, some key members of the New Classical school have been among those objecting in the media to stimulus packages and the Federal Reserve’s “quantitative easing.”

Some of the best previous critical work about the New Classical school of macroeconomics has been done by Esther-Mirjam Sent, who wrote The Evolving Rationality of Rational Expectations: An Assessment of Thomas Sargent’s Achievements (Cambridge University Press 1998, paperback 2008). This book is far more technical than the new one by Quiggin, and is largely a case study in the history of economics. (By the way, Quiggin’s book also contains some arguments about academic economics that might be tough going for a reader who has not taken at least one or two economics courses.) Few interesting and accessible discussions like this new one exist for those who just need an entertaining introduction to the main new orthodox approach to macroeconomics that has emerged during the past 30 or 40 years. The theories covered in the book are now accepted by many antagonists of the New Classical school, including some who style themselves as Keynesians.

Zombie Economics has some especially interesting discussions of the author’s own research (some of it coauthored with Simon Grant) on the privatization of government programs from the perspective of public-sector economics and especially public finance. This topic may be important next year as debate begins in earnest over proposals to be considered by the new Congress. Quiggin’s critique of the case for privatization also touches on the “equity-premium puzzle,” an important topic in finance, as well as claims about the social costs of the business cycle, which Robert Lucas and many other economists believe to be negligible. The book also has some interesting observations on economic inequality, the Efficient Markets Hypothesis, and other matters relevant to the Great Recession, the housing bubble, and the financial crisis.

There has been a bit of a barrage of articles and columns arguing that recent macroeconomic ideas are largely to blame for policy mistakes that led to the 2007–08 financial crisis. The book argues effectively in favor of this thesis, but it also provides a broader and deeper perspective on exactly what the various theories are than is available in most of the mainstream media. When it comes to providing a better understanding of the financial crisis, Quiggin is a fan of behavioral economics, as well as the late Hyman Minsky, who was mentioned in our last post.

There are a few gaffes in the book, and I have some differences of opinion with the book’s arguments on economics and public policy. This makes me hesitant to recommend the book unconditionally, but the book’s flaws are minor and will probably not be important for most potential readers. I am glad that I read Zombie Economics, and I found much to learn from in it, despite the fact that I have done much research in macroeconomics from a critical perspective.

Of course, the books discussed above are available at the usual booksellers and perhaps your local library.

Hyman P. Minsky, the renowned financial economist, macroeconomist, and Levy Institute distinguished scholar, was born 91 years ago today. A short bio of Minsky, along with links to many of his publications, can be found here. Minsky’s papers are collected at the Minsky Archive, which is housed at the institute. In April, we will be holding our 20th Annual Hyman P. Minsky Conference in New York City. I hope you enjoy these links to information about an economist who was and is very important to this institute.

There is no alternative to free-market capitalism, Margaret Thatcher used to say, and about this, like so many things, she was wrong. In fact a variety of alternatives are functioning quite well, and a number of them are succeeding by operating according to the principles of the Solidarity Economy.

What is the Solidarity Economy? It’s a movement that has brought hope to a world disillusioned by capitalism and too often unaware that economic activity can be conducted with respect for human decency and the planet on which we live. Its five key principles are solidarity, sustainability, equity in all dimensions, participatory democracy and pluralism.

The Solidarity Economy isn’t a new idea, even for the United States. Economic practices that fall under the umbrella of the Solidarity Economy have been happening for a long time. They have been growing in recent years. Most people, often including the people practicing the alternatives, aren’t aware of how much alternative economic practice is already happening around them. The project of the U.S. Solidarity Economy Network (US-SEN, ussen.org) is to bring together the people who are practicing the principles of the Solidarity Economy (solidarity, sustainability, equity in all dimensions, participatory democracy and pluralism), disseminate best practices for achieving these principles, and encourage the deepening of economic practices along all these axes. continue reading…

Levy research scholar Thomas Masterson has co-edited a new book about the Solidarity Economy, a form of economic organization that emphasizes cooperation over competition and communal well-being over individual gain. From the back cover:

“So many of us wish for something more, something different—an economy that we can feel a part of, not that makes us feel like a disposable cog in a mindless, heartless, soulless machine. That something exists and it’s called the Solidarity Economy. It represents new ways of living, of working, of consuming, of banking, of doing business. It represents different ways of doing trade, aid and development between nations. This kind of economy starts from entirely different premises than those of the ruling model of neoliberal capitalism which enshrines individualism, competition, materialism, accumulation, and the maximization of profits and growth. The solidarity economy by contrast seeks the well being of people and planet. It holds at its core these principles: solidarity, equity in all dimensions, sustainability, participatory democracy, and pluralism (meaning that this is not a one-size-fits-all model).”

The Squam Lake Report (Princeton University Press) is a set of recommendations by 15 leading economists on reforming the financial system. Considering the magnitude of the recent financial crisis, it is surprising how little change the book proposes.

Certainly, the first step in devising a set of recommendations for reform is to understand what went wrong, something the authors set out to do in their first chapter. They list a number of factors that may have contributed to the crisis but take no stand on their relative importance. They believe that their recommendations will help make the system more stable, although not crisis-proof, even if they don’t completely understand the origins of the current crisis. While a few of the recommendations are intended for guiding the financial system towards stability, most are only useful for when a financial crisis has already erupted.

Perhaps the best recommendation is for a systemic regulator with an explicit mandate of maintaining financial stability. As financial institutions are increasingly involved in activities outside their traditional domain, having a systemic regulator makes sense. But the report recommends that the central bank be that regulator—which is logical, since the Fed’s discount window gives it a good view of financial institution balance sheets. The problem, at least in case of the U.S., is that the Federal Reserve had the authority to regulate key aspects of the financial system when the last meltdown occurred, but chose not to exercise that authority. For instance, the Fed had had the power to regulate all mortgage lenders since 1994.

The question now is whether the culture of deregulation that has prevailed at the Fed for at least the past 25 years will allow it to transform itself into a good regulator. The FDIC has a better track record of being tough on the financial sector, and may well be better suited for the job.

The report is also big on transparency. For instance, it proposes that large financial institutions, including hedge funds, “report information about asset positions and risks to regulators each quarter.” Having better-informed regulators is certainly important but only goes so far. The magnitude of fraud during the last crisis demonstrates the difficulty of relying on information reported by the institutions themselves and underscores the importance of active regulation (The Repo 105 transactions used by Lehman, Citibank and Bank of America were merely the tip of the iceberg in the accounting gimmicks used by these institutions to mask their true positions.) The authors don’t seem to recognize the role of fraud in the financial sector and offer no recommendation on how to deal with it.

A whole chapter of the Squam Lake Report is devoted to regulating retirement savings, which is timely and appropriate considering that pension funds have been among the biggest losers in the current crisis. The crux of the Squam Lake proposal is to require investment products offered in defined contribution plans to have a standardized disclosure of costs and risks, to increase deductions from workers’ pay and to restrict default investment alternatives to low-fee, diversified products. These are sensible ideas but won’t insulate retirement savings from a crisis, because in a crisis asset classes (except for Treasuries) tend to crash in unison. At such times, diversification doesn’t help.

Furthermore, diversification (already required by federal pension law) was a major contributor to the bubble economy of the past decade as pension funds hunted for financial products uncorrelated with stocks. Overall, I don’t see merit in their pension reform proposal. The best solution would be to eliminate tax advantages for pension plans and instead boost Social Security to ensure that anyone who works long enough to qualify will receive a comfortable retirement. See Nersisyan and Wray (2009) for more on the trouble with the pensions.

The report also calls for higher capital requirements for major institutions, another reasonable idea that wouldn’t have helped much last time around, when the market for asset-backed securities froze and their prices collapsed. Under such circumstances, only impractically high capital requirements would have made any difference. Besides, an institution can face liquidity issues even if it’s highly capitalized. Bear Stearns, before its collapse, had enough capital but couldn’t finance its asset positions for want of willing lenders.

The report also recommends that financial institutions issue long-term debt instruments that convert into equity under specified conditions. This would automatically recapitalize banks if they got into trouble. But again, higher capital levels cannot prevent a crisis. Besides, one of the proposed conversion triggers is the declaration by the systemic regulator that the financial system is in a crisis. But a crisis is not always so easy to spot. When Bear Stearns failed, some people said the problem wouldn’t spread. Later, the consensus was that it wouldn’t go beyond subprime mortgages. If the regulator proclaims at soe point that there is a risk of a systemic crisis, this itself might freeze the markets and make institutions unwilling to lend to each other. Giving the disease a name, in other words, might well kill the patient.

Although a whole chapter of the book is devoted credit default swaps (CDS), there is no recommendation that would make CDS safer for the financial system. The authors oppose limiting CDS trades to entities that hold the underlying security on the basis that this will make derivative markets less liquid, raising costs. They propose merely to encourage financial institutions to clear CDS and other derivative contracts through clearinghouses as well as to trade them in exchanges (rather than making such arrangements mandatory).

Again, the response seems wholly inadequate to the scale of the hazard. Derivatives create counterparty risk out of thin air and vastly magnified the recent crisis. Without CDS the subprime mortgage industry couldn’t have grown to the proportions it did. Getting rid of CDS would make it hard for financial institutions to hide risks from regulators, and make investors more cautious when investing in asset-backed securities.

Despite their deliberations, the Squam Lake economists overlook some important aspects of the financial structure that ought to be reformed. Securitization and off-balance sheet activities that were largely to blame for the current debacle are not even mentioned. It wasn’t until securitization that the shadow banking sector exploded. Securitization creates major incentive problems by separating risk from responsibility. Off-balance sheet activities allow financial institutions to avoid capital requirements and use more leverage. And while the authors seem to recognize the costs associated with having too-big-to-fail institutions that are systematically dangerous, they have no prescriptions for what needs to be done about them.

The authors are acutely conscious that regulation often has unintended consequences, yet as they implicitly recognize (by proposing regulations), this doesn’t mean there shouldn’t be rules. What should these rules look like? continue reading…