Spain becomes the 4th EU country to get bailed out

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 7:41 am

Yesterday, the EU agreed to provide Spain with a 100 billion Euro ($125 billion) rescue package.

The money will go into a fund called FROB (Fund for Orderly Bank Restructuring) modeled loosely after the US TARP prgram.  The Spanish government will be responsible for paying back the loan, but they are constrained in how they can use the money; essentially, it has to be used to recapitalize their banks.

It appears this will calm the markets, but for how long?

Why is “calming the markets” always the proximate (and often the ultimate) goal?  Spain has an overall unemployment rate over 24%, with unemployment levels hovering around 50% for the young.  GDP growth was negative in 2009 and 2010, barely positive in 2011, and now has gone negative again for the first half of 2012 with consensus estimates for all of 2012 coming in around -1.5%.  The housing market is in shambles after a boom and bust.  Where are the plans to address crisis-level unemployment and jump start economic growth?  Where are the plans to fix the housing market?

It’s interesting to note the similarities between Spain and Ireland, both of which pursued fiscally responsible policies prior to the financial crisis.  Spain ran budget surpluses in 2006, 2007, and 2008.  In 2009, Spain’s public debt was under 60% of GDP, well below the EU average.   Even now, after the crisis, it only stands at around 68% of GDP.  Like Ireland, Spain is not a tale of fiscal profligacy, it’s a story of a country that experienced the collapse of an asset price bubble followed by a banking crisis.  Awhile back, Paul Krugman noted that Rogoff and Reinhart got the correlation between public debt as a % of GDP and economic crisis correct, but they had the causation reversed.  An economic crisis causes public debt to skyrocket, not vice versa.  Spain is a perfect example.

Where do we go from here?   What will the political repercussions be, both in Spain and in the rest of the EU?  Will Ireland and others demand a renegotiation of their bailouts to remove or reduce the austerity measures attached to them?  What impact will this have on the Greek elections?  Will the contagion spread to Italy next?


Microfoundations of the crisis

Posted in Economics, General Musings at 3:08 pm

Lots of interesting discussion all around regarding neoclassical economics and DSGE models (see recent blog postings by Krugman, Keen, et al).

Let’s cut to the chase:

Between November 2007 and October 2009, the unemployment rate increased from 4.7% to 10.0% and the size of the workforce shrank by almost 9 million jobs.  Many businesses closed or ran idle as sales plummeted.

What exactly caused almost 9 million jobs to be lost over a period of less than two years and output to tumble?

Did workers suddenly decide that they valued leisure over labor to a much higher degree than they previously thought and so voluntarily chose to stop working?

Did workers suddenly decide that they wanted significantly higher wages and so priced themselves out of the market?

Did real capital (plants, equipment, etc.) suddenly become less productive?

Was there some sudden change in technology that rendered production techniques LESS efficient?

Did the available physical quantity of some critical raw material suddenly plummet?

If the answer to the above five questions is “no, obviously not” then DSGE models not only failed to PREDICT the crisis, they are also incapable of EXPLAINING the crisis.

DSGE models rely on an exogenous shock to initiate a change in economic activity (downturn or upswing).  Neither a fall in house prices nor an increase in oil prices counts as exogenous, these are simply markets in action (examples of exogenous shocks here would be tornadoes destroying homes or embargoes against oil producing nations).  So where is the initial exogenous shock?

Once the initial shock (which still hasn’t been identified) occurs, DSGE models rely on various “frictions” to explain how the economy could remain in a depressed state for a period of time rather than immediately returning to a full employment equilibrium.  Sticky wages are probably the most frequent friction assumed.  Before we ask “why wages don’t fall during a recession” we should ask “why should wages fall”.  Every first year econ student is told that the price of labor (the wage rate) is determined by supply and demand and that supply is determined by the marginal disutility of labor (the work/leisure tradeoff) and demand is determined by the marginal productivity of labor.  Why should we simply assume that the “true” price of labor is suddenly lower than the market price and that the reason there’s a discrepancy is because wages are “sticky”?  What if there is no discrepancy and the market price for labor is correct (one would think this would be an economist’s first reaction)?  We are making the hidden assumption that pricing errors are the only thing that can cause a market to fail to clear.  Back to the question of supply and demand – if we are going to argue that the price of labor should be lower, we need to explain why, in terms of the marginal disutility and marginal productivity of labor.  In other words, either workers have suddenly become lazier or they have suddenly become less productive.  Which is it and why?

I would like the DSGE proponents to clearly articulate the cause of the above, without reference to money, finance, or anything else outside the framework of their models.  I want to see the “microfoundations of the crisis” if you will.


Ricardian Equivalence

Posted in Economics at 12:10 am

Krugman, DeLong, et al really need to hit this one head on.




I addressed this in what I thought was a much clearer manner some time ago:


To make it easier to grasp, I’ve put it all in one nice, easy to understand graphic:


This diagram is key to understanding the dispute between so called
freshwater economists and saltwater economists.  When the former argue
in favor of Ricardian Equivalence, they are arguing that any increase
in consumption today necessitates a decrease in consumption in the
future.  This is just another side of the argument that an increase in
consumption necessitates an equal decrease in investment or that an
increase in government spending necessitates an equal decrease in in
private sector spending.

Guess what?  They are right IF the economy is operating at capacity
(on the frontier in the above diagram).  They are wrong IF the economy
is operating below capacity (inside the frontier in the above

Freshwater economists make the assumption that the economy is always
operating at capacity (on the frontier).  This is also the reason why
they dismiss the Keynesian multiplier out of hand.  For an economy
operating at capacity, there is no multiplier effect, just a crowding
out effect, because the economy is already operating at its limit
given the existing constraints of resources and technology.

In effect, freshwater and saltwater economists are describing two
completely different worlds.  The former are describing a world in
which all available factors of production (labor, capital) are fully
employed.  The latter are describing a world in which there are
unemployed workers and idle capital.  We can save the discussion of
WHY there are unemployed resources for another day.  What matters now
is that we start with a model that describes the world as it is, with
the problem we’re trying to solve not assumed away.


Quick thoughts on yesterday’s Fed action

Posted in Economics, Politics and Policy at 6:45 am

The Fed is clearly aiming to do the minimum amount it thinks necessary in an effort to extend the effectiveness of its available tools.  The other components of the expected action – a cut in the interest rate on excess reserves and a commitment to maintain the size of its balance sheet for an extended period are coming, just not yet.  So are additional asset purchases.  This is a mistake, and is reminiscent of Fed policy in 2007 – a quarter point cut here a half point cut there, until they woke up to the severity of what was happening around them.


American Jobs Act

Posted in Economics, Politics and Policy at 8:14 am

The official release has a good breakdown and details, so no need to reproduce that here.



$447 Billion Total

$253 Billion in tax cuts/credits
$194 Billion in spending


Tax Cuts

- Extend last year’s payroll tax cut for another year and increase the cut from 2% to 3.1%.  $175 Billion
- Cut employers’ share of payroll taxes in half (from 6.2% to 3.1%) on the first $5 million in payroll (covers 98% of businesses).  Eliminate employers’ share of payroll taxes entirely for any new workers or raises for existing workers, up to $50 million per company.  $65 Billion
- Extend 100% expensing of new capital investment for businesses for one year.  $5 Billion.
- New tax credit of $5600 to $9600 for each veteran hired.
- New tax credit of $4000 for each long term unemployed person hired.

- Direct aid to states to prevent layoffs of teachers, police, and firefighters.  $35 Billion
- Modernizing public schools and community colleges.  $30 Billion
- Investment in roads, rails, and airports.  $50 Billion
- Infrastructure bank creation to attract private funds for additional investment.  $10 Billion
- Project Rebuild, putting people to work rehabilitating houses, businesses, and communities.  $15 Billion
- Expanding wireless broadband access to >98% of Americans.
- Reform and extension of unemployment insurance.  $49 Billion
- Worker training programs.  $5 Billion

There’s also a section on helping more Americans refinance at lower rates than are able to today.

My initial thoughts are it’s a decent plan.  Highly focused on capital improvements and front loaded.  Will have a positive impact, but is too small to reduce unemployment by more than about 1 percentage point over the next year and a half, and after that the stimulus effect peters out.  The obsession with “paying for” the plan almost immediately after it ends will hurt the economy at that point.  I don’t think a lot of politicians get the fact that stimulus is SUPPOSED TO increase the deficit, that’s how it works.  My biggest concern is that it will not survive Congress intact – House Republicans will insist on stripping out almost all of the spending and probably on scaling back some of the consumer (as opposed to business) tax cuts.


A simple solution to the housing market problem

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 4:02 pm

Forced debt to equity conversions have been proposed as a solution to make insolvent banks solvent again.  The idea is that some portion of a bank’s outstanding debt is converted into equity in order to restore a positive net worth (assets – liabilities).  There’s no reason why this same approach could not be taken with private homeowners.

Let’s look at a simplified example:

Home purchaser takes out a $100k bank loan to buy a $100k house.
Assets = $100k, liabilities = $100k, net worth = $0.

House price drops to $80k.  Now:

Assets = $80k, liabilities = $100k, net worth = -$20.

Undertake the debt to equity conversion:

Loan reduced to house market value = $80k.
In exchange, bank gets $20k equity = ($20k/$80k) = 25% ownership stake in house.

The homeowner essentially gives up 25% of future increases in home value in order to not be underwater now.

At some point in the future, the house will be sold.  When that happens, one of the following scenarios will play out.

Scenario 1 – House sells for <$80k.  Bank gets fraction of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 2 – House sells for $80k.  Bank gets all of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 3 – House sells for >$80k.  Bank gets all of its $80k loan back.  Bank gets 25%*(Home price – $80k) on its equity.  Homeowner gets 75%*(Home price – $80k).

At a sale price of $160k, the bank recoups all of its initial loan ($80k modified loan + 25%*$80k = $100k).  The bank makes a net profit on any final sale price over $160k.

The homeowner will also receive an option to buy out the bank’s equity at any point in the future for 25% * (Market value – $80k) plus some pre-determined premium.

This program would be open to all homeowners, banks would have no say in the matter.  Obviously, homeowners who are not underwater would not have any reason to participate.

Is this solution perfect?  No.

Is it preferable to a taxpayer-funded mortgage forgiveness program whereby the government pays banks to forgive a portion of underwater loans?  Yes.

Is it preferable to doing nothing and having the debt overhang doom the economy to a decade or more of below-potential GDP and high unemployment?  Yes.

I’m well aware of the difficulties involved.  The loan writedowns would impair bank earnings for a period of time (though there would now be future upside).  The impact on mortgage services, MBS, CDOs, and the holders of MBS and CDOs would be messy.  There would be lawsuits.  Again, it must be measured against the alternatives and not some utopian fantasy world where all debts will be eventually paid in full and no losses have to be taken.

What I’ve laid out above is a simplified, stylistic version.  All sorts of modifications could be made to improve it.  The percentage of debt converted could be increased to provide additional monthly payment relief.  The equity structure could be modified to give the bank a bigger percentage claim on the first $20k in price appreciation.  Other terms of the loan could be modified.  The point here is just to lay out a set of guiding principles; the details can be hashed out later.


Barro on “Regular Economics vs Keynesian Economics”

Posted in Economics, General Musings at 8:47 am

Very odd statement:


Barro’s “regular economics” describes a world that is always operating at 100% capacity with zero unemployed labor or idle capital.  Thus, resource and technology constraints mean that there is a real tradeoff between government spending and private spending and between current consumption and investment spending.

“Keynesian economics” describes a world that is not operating at capacity, and therefore has unemployed labor and idle capital.  In such a world, it is possible to increase government spending and private spending simultaneously, or to increase consumption and investment simultaneously.  In fact, doing so moves the operation of the economy closer to its capacity.

Which world best describes our current state of affairs?


Fed Announcement

Posted in Economics, Financial Markets, Politics and Policy at 7:25 pm

The Fed announced at 2:15 that it would hold the Federal Funds rate near zero for 2 years.

More significant was what it did NOT announce:

  • It did not announce it would keep rolling over its bond portfolio for 2 years.
  • It did not announce it would change the composition of its bond portfolio to longer maturity bonds.
  • It did not announce it would cut the interest rate (0.25%) it pays on bank reserves.
  • It certainly did not announce QE3.

The immediate market reaction was predictably negative – market consensus was for more action by the Fed.

However, that reaction was short-lived, and the market soon took off like a rocket.  Very odd.


Greek exposure and derivatives exchanges

Posted in Economics, Financial Markets, Politics and Policy at 1:53 pm

There’s a considerable amount of debate regarding the exposure of US banks to Greek sovereign default via their CDS protection sales to European banks.  See:





Yet some policymakers and industry participants still aren’t convinced of the need to move CDS trading to exchanges and bring transparency to the market?  Seriously?  We really didn’t learn anything from the 2008-2009 crisis.

A Greek Debtor’s Prison

Posted in Economics, Financial Markets, Politics and Policy at 8:42 am

Some key stats:

  • Debt-To-GDP of around 150%
  • Budget Deficit >10% of GDP
  • Current account deficit >10% of GDP.
  • GDP growth for Q1 2011 -5.5%
  • 15.9% unemployment rate
  • 2-Yr hitting a high of 30% and the 10-Yr hitting a high of 18%

With average interest rates around 20%, and around a 150% Debt to GDP ratio, Greece needs a primary surplus (government budget net of interest) of 30% to service that debt.  Yet tax revenues are falling at an alarming clip because of the decline in GDP.

What Greece needs, in order:

1. Economic growth
2. Lower interest rates

Austerity programs (lower spending, higher taxes) lead to lower economic growth in the short to medium term, with very little impact on interest rates over that time period.

The bailouts increased the debt to GDP ratio, and any softening effect they had on market interest rates was highly temporary.

Unfortunately for Greece, an absence of bailout funding means an almost immediate default on existing debt.  I agree that this would be a highly destabilizing event for the entire Eurozone if not the world, BUT – the architects of the bailout have no credible explanation for how Greece is to sustain its debt service over the next 2-5 years apart from simply ASSUMING that austerity will somehow magically lead to both balanced budgets and robust economic growth, which is NONSENSE.

Meanwhile, EU/ECB/IMF leaders’ primary concern is how to get Greece’s creditors to rollover short term maturing debt in a manner that does not trigger a “credit event”.  The fact that they are talking in CDS terms speaks volumes.  This is silliness.

The Greek Parliament ought to outright REJECT the asuterity measures that European banks are attempting to impose on them.  Tell the EU/ECB/IMF that they want to honor their debts but that the only way to do so is through economic growth, and ask for a plan that will increase economic growth to a level that makes current debt service sustainable.  Make it clear that the only other option to the “growth plan” is immediate default, French and German banks be damned.

The more Greece tries to balance its budget by cutting spending and increasing taxes, the more the budget deficit will actually widen as the economy slows and tax receipts decline.  Austerity is not the solution, it is a big part of the problem.  Likewise, exchanging existing government debt for new government debt, while interest rates continue to rise, only makes future debt service more difficult.  Stop the madness.

There’s a reason why we abolished debtor’s prisons a long time ago.  They effectively make it impossible for the debtor to ever repay his debts, and thus are to the detriment of both debtor and creditor.  Yet, what the European authorities have done is essentially put Greece into a debtor’s prison named Austerity.  They should release Greece if they are to have any hopes of being paid anything back.