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.

http://economistsview.typepad.com/economistsview/2012/01/delong-a-note-on-the-ricardian-equivalence-argument-against-stimulus.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+EconomistsView+%28Economist%27s+View+%28EconomistsView%29%29

http://delong.typepad.com/sdj/2012/01/a-note-on-determinants-of-aggregate-demand.html

http://krugman.blogs.nytimes.com/2011/12/26/a-note-on-the-ricardian-equivalence-argument-against-stimulus-slightly-wonkish/

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

http://www.disequilibria.com/blog/?p=47

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

http://www.disequilibria.com/ppfa.jpg

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
diagram).

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.

Some suggestions:

Get rid of all of the demands that aren’t related to the economy.  Issues like animal rights, gay marriage, and other social issues are creeping into the conversation.  They’re all fine issues that deserve a hearing of their own.  However, with regard to what is trying to be accomplished here, they’re a distraction.

Have both a short term agenda and a long term agenda.  We have a lot of short term problems right now.  Many are symptoms of longer term issues.  Both sets of issues have to be addressed, but sequence and priority is critical.

Keep the agenda points short and concise.  Limit the number of them.  Don’t get mired in the details.

Here’s a good starting point:

Short Term

• Focus on jobs.  The government should make jobs a top priority until the unemployment rate falls below 5%.  Bring the full power of fiscal and monetary policy to bear, and if necessary, pursue direct works programs.
• Focus on housing.  The housing market is fundamentally broken.  It needs to be fixed.  The economy will not recover until it’s fixed.  Doing nothing is not an option.
• Focus on education.  The economy of the future demands a better educated workforce.  People shouldn’t have to become lifetime debt slaves to acquire a college degree and a secure future.

Long Term

• Realign finance.  Financial institutions should exist to fund productive investment by matching savers/lenders with investors/borrowers.  The economy can’t function without a working financial system.  Unfortunately, it’s been turned into a casino where heads the big banks win and tails the taxpayers pick up the losses.
• Develop an industrial policy.  Historically, this has meant a combination of trade restrictions like quotas/tariffs with subsidies to business.  That’s not what we need now.  What we need is a policy that takes into account the needs of all stakeholders – importers, exporters, labor, management, business owners both small and large.
• Save the middle class.  This is what all of the short term and long term agenda points mentioned thus far lead up to.  A vibrant, growing, and upwardly mobile middle class is what has made America great.  For generations, people were inspired by the idea that their children would do better than them.  That idea is fading rapidly.  We need to change that.  It will take action – a large middle class is NOT something that just comes about naturally, it’s not a natural outgrowth of capitalism or any other ism; disabuse yourself of that false notion.

This is the sort of agenda that will resonate with the American people.  The statistics on the decline of the American middle class are indisputable.  When confronted with this, the 1% will have no choice but to remain silent or change the subject.  Keep pushing.

“The Chairman of the Federal Reserve and the Secretary of the Treasury have been meeting all night and are prepared to brief you on the situation as well as lay out their plan for avoiding catastrophe.  It involves extending unlimited liquidity lines to the ECB and other central banks as well as massive capital injections into the largest domestic banks.  We have the chairmen of the SEC and CFTC along with the president of the NYSE on standby to dial in.”

The answers to this question should be quite illuminating for a number of different reasons.  They will immediately demonstrate which candidates have a grasp of economic policy issues and which do not.  This represents a crisis situation that demands a solution, and will demonstrate candidates’ capability to respond to an emergency.  It is a specific question that demands specific answers, rather than ideology, handwaving, and spinning of past accomplishments.

http://www.whitehouse.gov/the-press-office/2011/09/08/fact-sheet-american-jobs-act

Summary:

$447 Billion Total

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

Highlights:

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.

Spending
- 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.

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.

http://uneasymoney.com/2011/08/24/barro-on-keynesian-economics-vs-regular-economics/

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?

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.