Understanding Deficits during Great Recessions

Paul Krugman has a post on his NY Times blog which explains in very simple terms why government deficits make sense in situations like today, i.e. during a Great Recession. Here is the start of his post:

One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that’s not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets. (Sam and Janet who? If you’d grown up in my place and time, you’d know the answer: Sam and Janet evening / You will see a stranger … But actually, I’m thinking of the two kinds of agent in the Kiyotaki-Moore model.)


In this world, we’ll assume that no real investment is possible, so that loans are made only to finance consumption in excess of income. Specifically, in the past the Sams have borrowed from the Janets to pay for consumption. But now something has happened – say, the collapse of a land bubble – that has forced the Sams to stop borrowing, and indeed to pay down their debt.

For the Sams to do this, of course, the Janets must be prepared to dissave, to run down their assets. What would give them an incentive to do this? The answer is a fall in interest rates. So the normal way the economy would cope with the balance sheet problems of the Sams is through a period of low rates.

But – you probably guessed where I’m going – what if even a zero rate isn’t low enough; that is, low enough to induce enough dissaving on the part of the Janets to match the savings of the Sams? Then we have a problem. I haven’t specified the underlying macroeconomic model, but it seems safe to say that we’d be looking at a depressed real economy and deflationary pressures. And this will be destructive; not only will output be below potential, but depressed incomes and deflation will make it harder for the Sams to pay down their debt.

What can be done? One answer is inflation, if you can get it, which will do two things: it will make it possible to have a negative real interest rate, and it will in itself erode the debt of the Sams. Yes, that will in a way be rewarding their past excesses – but economics is not a morality play.

Go read the rest of his blog post to find out why and how government debt is in fact a solution to this problem.

Krugman has a wonderful way of explaining economics. Sadly the politicians don't listen to him. Worse, they grab the public microphone and shout the very wrong economic platitudes that Krugman warns against. Politicians make the problem worse, not better!

I thought a smart guy like Obama would grab the microphone like FDR did during the Great Depression with his "fireside chats" and explain to ordinary folk the situation the world is in and what needs to be done to get out of it. But sadly Obama has sold his soul to Wall Street like the rest of the politicians, so there will be no help coming from him. The American people are going to have to solve this problem themselves. And, as Paul Krugman points out, that means a "lost decade" because it is so hard for a disorganized people to do the right thing when the right thing seems counter-intuitive and especially when politicians are shouting in your ear their wrong-headed sound bites.

You might think that Obama would listen to a Nobel-prize winning economist. He hasn't. Obama didn't even listen to his CEA, Christine Romer. Instead he was in thrall to Larry Summers, Ben Bernanke, and Tim Geithner, the trio who worked hand-in-hand with the rabid right wing Republicans to create the problem by ignoring the housing crisis, by advocating "deregulate, deregulate, deregulate", and by coming up with half measures and the empty platitudes of the past in the face of the greatest economic crisis in 80 years.

Krugman on the Upcoming Apocalypse

Paul Krugman writes a NY Times op-ed that lays out his argument about how Obama has failed the American people and set the country up for a truly horrible disaster in the hands of the clueless Republicans:

If Democrats do as badly as expected in next week’s elections, pundits will rush to interpret the results as a referendum on ideology. President Obama moved too far to the left, most will say, even though his actual program — a health care plan very similar to past Republican proposals, a fiscal stimulus that consisted mainly of tax cuts, help for the unemployed and aid to hard-pressed states — was more conservative than his election platform.

A few commentators will point out, with much more justice, that Mr. Obama never made a full-throated case for progressive policies, that he consistently stepped on his own message, that he was so worried about making bankers nervous that he ended up ceding populist anger to the right.

But the truth is that if the economic situation were better — if unemployment had fallen substantially over the past year — we wouldn’t be having this discussion. We would, instead, be talking about modest Democratic losses, no more than is usual in midterm elections.

The real story of this election, then, is that of an economic policy that failed to deliver. Why? Because it was greatly inadequate to the task.

...

What we do know is that the inadequacy of the stimulus has been a political catastrophe. Yes, things are better than they would have been without the American Recovery and Reinvestment Act: the unemployment rate would probably be close to 12 percent right now if the administration hadn’t passed its plan. But voters respond to facts, not counterfactuals, and the perception is that the administration’s policies have failed.

The tragedy here is that if voters do turn on Democrats, they will in effect be voting to make things even worse.

The resurgent Republicans have learned nothing from the economic crisis, except that doing everything they can to undermine Mr. Obama is a winning political strategy. Tax cuts and deregulation are still the alpha and omega of their economic vision.

...

Is there any hope for a better outcome? Maybe, just maybe, voters will have second thoughts about handing power back to the people who got us into this mess, and a weaker-than-expected Republican showing at the polls will give Mr. Obama a second chance to turn the economy around.

I would say the chances of American saving itself from the upcoming apocalypse are as close to zero as anything I can imagine. The country is in a death spiral as best I can tell. It is a tragedy. It is like watching two trains coming together in a horrible crash all run in slow motion. You want to rush out and stop them but you realize there is nothing you can do. This is a tragedy that Americans have done to themselves because they refuse to honestly look in the mirror and realize that they have handed themselves over to ideologues and money interests that are quite happy to destroy the country as they loot it as part of a "winning strategy" for the Right. Tragic.

The Conjunction Fallacy

The foibles of human credibility always entertain me. Sure I fall for them too, but at least I try to be aware of them and limit my mistakes. The tragedy is that there are a lot of people who simply refuse to recognize the limits of their intelligence and the extent of their credulity.

Here's a bit from an article published in the NY Times on the Opinionator blog, a blog for philosophers and their ideas. This article is by the mathematician John Allan Paulos:

The so-called “conjunction fallacy” suggests another difference between stories and statistics. After reading a novel, it can sometimes seem odd to say that the characters in it don’t exist. The more details there are about them in a story, the more plausible the account often seems. More plausible, but less probable. In fact, the more details there are in a story, the less likely it is that the conjunction of all of them is true. Congressman Smith is known to be cash-strapped and lecherous. Which is more likely? Smith took a bribe from a lobbyist or Smith took a bribe from a lobbyist, has taken money before, and spends it on luxurious “fact-finding” trips with various pretty young interns. Despite the coherent story the second alternative begins to flesh out, the first alternative is more likely. For any statements, A, B, and C, the probability of A is always greater than the probability of A, B, and C together since whenever A, B, and C all occur, A occurs, but not vice versa.

This is one of many cognitive foibles that reside in the nebulous area bordering mathematics, psychology and storytelling. In the classic illustration of the fallacy put forward by Amos Tversky and Daniel Kahneman, a woman named Linda is described. She is single, in her early 30s, outspoken, and exceedingly smart. A philosophy major in college, she has devoted herself to issues such as nuclear non-proliferation. So which of the following is more likely?

a.) Linda is a bank teller.

b.) Linda is a bank teller and is active in the feminist movement.

Although most people choose b.), this option is less likely since two conditions must be met in order for it to be satisfied, whereas only one of them is required for option a.) to be satisfied.

(Incidentally, the conjunction fallacy is especially relevant to religious texts. Imbedding the God character in a holy book’s very detailed narrative and building an entire culture around this narrative seems by itself to confer a kind of existence on Him.)

That last bit about religious credulity should ring home with lots of people. But it doesn't. Most of them simply refuse to accept modern science and the understanding of the human mind's cognitive illusions and errors.

More on the Great Mortgage Foreclosure Fraud in the US

From a post by Thomas Levenson on his blog The Inverse Square Blog:

Everyone, and I mean everyone you ought to be reading, has been working through the mechanics and the meaning of the foreclosure fraud being performed on the nation by our biggest banks. For a quick overview, head on over to Rortybomb, just read your way down, and check out Naked Capitalism as well. I promise you, once you start down the trail of links, you’ll have days of infuriating study ahead of you.

But for all the justified outrage at the simple disdain for the concept of property rights and the rule of law* there’s something else being missed here, something that astute observers have commented on, but that seems to be a bit obscured as we all, understandably, rubberneck in horror at the trainwreck that the major banks have made of the foreclosure process.

And that is that the entire foreclosure endeavor is in fact a huge imposed cost on American homeowners and our economy; it almost certainly runs against the long-term interests of the financial system as whole, whatever the incentives may be for individual companies (and it may well be a long term fail for many of the short-term beneficiaries as well). Foreclosure as it is being practiced now is likely to be a net negative for homeowners now, to the point that subsidizing in some way those who got into trouble is economically rational, even if it might be galling to those who’ve paid up and gone about their business.

...

Expand your view to the country as a whole and you see that over the last decade, the banks lent recklessly, leveraged insanely, and then resorted to a range of unsavory-to-illegal manouvers to limit exposure to the consequences of decisions that, taken altogether, effectively bankrupted the US and much of the world’s financial system.

They have received enormous sums to prevent an overt bankruptcy, and in response have pursued tactics that do untold harm to thousands, perhaps millions of American citizens as they foreclose on the properties they recklessly exposed themselves to over the last several years. As they pursue those foreclosures, those banks have both deceitfully tripped some homeowners into default (see Kirk, above) while performing multiple frauds and failures to proceed in a legal fashion in a sequence of actions that looks suspiciously like a fee-maximizing game of delay.

Here is the asterisked footnote that really should be read to appreciate the anger:

*One of the weirdest things about the whole housing mess to me has been the wholesale abandonment by the alleged “conservatives” among us of any commitment to — or even basic understanding of — the idea of property rights, contract law, and the roles and duties of parties to contracts governing real property. We have McArdle outraged that folks who got their sums wrong walk away from mortgages — as if the banks did not have a full, contractually specified recourse, to take possession of property they were supposed to have exercised proper caution in evaluating. We have the Wall St. Journal dismissing as mere sloppy paperwork sustained, widespread and long-lasting fraud by the major banks in their attempt to pursue contractual remedies to which they are not entitled. It seems to me that there is nothing more likely to produce a long-term threat to the American real estate market than confirming the belief that one of the biggest risks in home purchasing is that your lending will f**k you over. Yet the Wall St. Journal thinks it appropriate to dismiss criminal conspiracies by banks as mere high spirits. Astonishing — but worth remembering the next time that paper opines on the sanctity and infallibility of “free” markets.

What slays me is the fact that Obama came into office and saw no need to enforce law or ethics on the mad bank crowd that destroyed the economy. Instead, he has put Main Street and the unemployed under a water torture of slow pain as years will pass before the economy finds its feet again. Meanwhile, 2009 was a "record year" for bonuses on Wall Street banks and 2010 promises to outdo that with an even bigger "record year" for bonuses for the scum and fraudsters who destroyed the US economy (and took down most of the rest of the world as well).

The Sad Lessons of History

Here's a bit from a post by Justin Fox on his Reuters blog:

Tim Geithner has proposed to his fellow G-20 finance ministers that trade surpluses and deficits be capped at 4% of GDP. ...

The sad irony in all this is that some other guy proposed limits on trade surpluses and deficits 66 years ago, and did it in a far more elegant and thought-through manner than Geithner has. And it was the U.S. that torpedoed the plan. ...

At this point Fox puts in a brief description of John Maynard Keynes' plan.

Brilliant, right? Not impossible-to-enforce targets, but a system with incentives built in that would have made big trade imbalances unattractive to both sides. There’s that little matter of creating a new global currency and getting everybody to accept it, but this was at the tail end of World War II. If the U.S. had decreed that the International Clearing Union was a go, the International Clearing Union would have been a go. But at the time, the U.S. ran big trade surpluses and assumed it would do so forever. Its delegates at the Bretton Woods meetings were vehemently opposed. So the idea went nowhere. Now Tim Geithner is pushing for clunky trade-surplus caps. It might be better if he just asked for a do-over.

That's the tragedy of history. The US was in a perfect position to put in place a world economic system that would have managed trade tensions. But it was an idea from a Brit. And the US lived under illusions that its trade surplus would last forever. So a chance at a world with a solid, safe future was thrown overboard.

Hmm... reminiscent of the plans to put nuclear weapons in the hands of an international organization, the UN, to prevent a nuclear arms race. But the US saw itself as the only holder of those weapons of mass destruction and believed it would take the Russians 15 years to develop a weapon, so they passed up the chance to divest the world of a terrible threat that would waste trillions of dollars over the following decades. Tragic.

History is filled with temporary "winners" who are convinced they are "God's chosen" and can never be displaced. They end up making mistakes like this. And we "little people" of the world are forced to live with the consequences. Sad.

How Obama Comes up Short

From Brad DeLong's blog, here is nice, simple, to-the-point critique of why the enthusiasm for Obama has melted away:

When it turned out that "post-partisanship" actually meant creating a consensus among wealthy people about how best to repair the damage of the Bush years without in any other way disturbing the status quo—well, who could blame independent voters for being disappointed?

People were sold the idea of "hope" and "change you can believe in" and got a political wheeler-dealer who put more effort into finding "middle ground" with intransigent Republicans than in actually leading the US out of the worst economic catastrophe since the Great Depression.

The surprise was that somebody who went from law school to be a "community organizer" could turn his back on the poor and unemployed. Most voters thought that by voting in the US's first black president they would get somebody who was for the underdog, somebody who understood that they system was tilted too far against the working and middle classes. It ends up that a guy born with a silver spoon in his mouth -- FDR -- had more sense of duty to the poor and disadvantaged than Obama, the son of a poor white woman who only got his Ivy college education through aid and favours from the elite. It ends up when he became president he was more interested in returning the favours to the elite than he was to help out those he grew up with. Tragic. Obama had a chance to become one of a handful of great American presidents. Instead, he will be remembered as mediocre-to-fair.

My fundamental complaint about Obama is that he isn't a leader. He hasn't shown a way forward from the current mess.

Here's a bit from a post by the economist Mark Thoma that substantiates my claim. The key bit is bolded:

I started this blog shortly after George Bush was reelected, and though many people assume that it was the presence of Republicans in power that was the primary motivation, that isn't the whole story. That was part of the motivation, no doubt, but there were two other factors that were more important. The first was how economic issues such as Social Security and tax cuts were being portrayed in the media, for example the false perceptions being generated about Social Security's long-run stability and the silly idea that tax cuts would pay for themselves that I heard so often.

But the biggest factor was that I felt Democrats were being misrepresented in the media. CNN in particular comes to mind. In the run-up to the election, it was the same people day after day representing Democrats in the media, and I did not feel they were doing a good job -- at all -- of representing the Party's views on economics or anything else. The voices I heard most often were far, far to the left of me, and, I thought, far too easy to dismiss. I wasn't persuaded by their arguments -- often wanting to tear my hair out when they didn't make the obvious rebuttal to crazy claims from the other side, and instead often sounded a bit crazy themselves -- so how could people on the fence be convinced that Democrats had better ideas? It was as though the TV shows would pick the most clueless, outlandish, easiest people to dismiss whenever they interviewed Democrats or pitted Democrats against Republicans. If only people knew who we really are, I would think, and what we actually stand for, certainly they would be persuaded. I never thought it would go anywhere, but starting the blog was part of the reaction to the feeling that Democrats in the silent majority needed to start speaking up and making their voices heard.

Now I'm frustrated again. Though I didn't always agree with it, prior to the Bush reelection at least there was a voice representing Democrats. Right now, there is no voice, at least not one I can hear. There are plenty of Democrats talking with loud voices, more than ever I'd guess, but there is no leadership to coordinate those voices and pull them into an harmonious whole with broad based appeal. We finally have control of the ship, and the captain is wandering aimlessly. What is Obama's vision? Where are we trying to go? What is the grander goal that is being served by the polices and strategies he is pursuing? Yes, he gives good speeches, but what is the single theme that runs through them all to coordinate and steer the party toward this larger vision? What is the big idea behind it all that is supposed to unite us? Without effective leadership, the unified vision the party needs to be successful will not emerge from the many strong voices seeking to provide the direction the party seems to lack.

The problem, however, is that I don't know if the centrist, bipartisan seeking, compromising Obama we have seen to date can actually embrace an encompassing vision. He seems afraid to be a Democrat, as though standing uncompromisingly for an idea will scare people away rather than attract them, and that needs to change.

Go read Thoma's blog. It's focus is on economics and it is excellent.

How Humans Think

We certainly don't think rationally. He use techniques and rules of thumb that simplify and speed up our decisions. Sometimes we use techniques that are just plain wrong: these are the "cognitive illusions" that result in our making consistently wrong decisions.

Here is an example of one called the Allais Paradox. It is presented by Jonah Lehrer in his blog The Frontal Cortex:

Suppose somebody offered you a choice between two different vacations. Vacation number one gives you a 50 percent chance of winning a three-week tour of England, France and Italy. Vacation number two offers you a one-week tour of England for sure.

Not surprisingly, the vast majority of people (typically over 80 percent) prefer the one-week tour of England. We almost always choose certainty over risk, and are willing to trade two weeks of vacation for the guarantee of a one-week vacation. A sure thing just seems better than a gamble that might leave us with nothing. But how about this wager:

Vacation number one offers you a 5 percent chance of winning a three week tour of England, France and Italy. Vacation number two gives you a 10 percent chance of winning a one week tour of England.

In this case, most people choose the three-week trip. We figure both vacations are unlikely to happen, so we might as well go for broke on the grand European tour. (People act the same way with lotteries: we typically buy the ticket for the biggest possible prize, regardless of the odds.)

Go read the whole post to understand why we fall into this trap. You can also look at the Wikipedia entry for other details.