I stay away from debating whether regulation or taxes beat cap and trade on limiting CO2 emissions, because I don’t think it is something to be settled theoretically. Or — worse — speculatively, say, on the grounds that we distrust markets more than we distrust the state. Or vice versa. As far as I’m concerned, both markets and the state are undesirable, because we collectively can’t control them effectively. So, we need to disolve them, which can only result from a long series of revolutions. So, for the time being, the issue ultimately boils down to empirical measure and — on the practical side — a lot of trial and error.

If you know the supply (or marginal cost) and demand (or marginal benefit) functions, private and social (i.e. without and with the external effects), then you can always determine the socially optimal level of CO2 emissions, level that you can then split into shares and allocate them to people, who can then trade them in a market. If people follow the script of their market functions (i.e. if the assumptions that underpin market functions hold), then the amount of emissions would be capped at the socially optimal level.

Similarly, if you know the supply and demand functions, you can always determine a Pigouvian tax (or subsidy) to induce producers to reduce emissions from the privately optimal level to the socially optimal one. All is required is setting the tax (or subsidy) at an amount equivalent to the size of the net external cost at the privately optimal (but socially inefficient) level of emissions. That forces emitters to internalize the net external cost, who then willingly limit their production to the socially optimal level.

Quick and dirty actions to solve practical problems beat no action at all in the hope that a perfect solution will fall from the sky. The practical experiences of taxation and cap and trade need to be studied very carefully — something I’ve not done. But from afar I can see a few thorny practical issues, even if measuring the level of emissions were simple:

How on earth do you determine the private and social supply and demand functions? For example, the location and shape of estimated supply and demand functions is highly sensitive to the period of time considered. Basically, choose a sufficiently long period of time, and you can always make the elasticities arbitrarily large. With arbitrarily large elasticities, very tiny taxes (or subsidies) would — in theory — do the job. So, what is the relevant period of time? This wrecks all approaches, including plain regulation (i.e. telling emitters how much CO2 to emit, period). And this is separate from the technical, empirical issues of estimating market functions (well, their elasticities, from which you can integrate costs and benefits).

Another issue I find daunting is that supply and demand, private and social, are continuously shifted by a bunch of factors without prior notice: technology, consumption patterns, prices of virtually everything else. Basically, a perfect regulator would have to re-calibrate dynamically, continuously (or at least with such frequency that the benefits of recalibration are not offset by the associated transaction costs), the socially and privately optimal levels. Otherwise, there’d be garbage-in garbage-out with any of the approaches.

Then the practical issues of administering the approach, in the face of the profit motive, the incentives of public servants, the motivations of the public, etc.

By the way, I haven’t seen anybody challenging what I believe is a fundamental presumption under cap and trade as is, namely that the national shares of allowed CO2 emissions are to be allocated to the emitters only. (Am I right that this is the presumption?) I’d expect to hear left-wing economists denouncing this as sheer theft. The rights of ownership over the atmosphere are assumed to belong exclusively to the main CO2 emitters? How about the rest of us? To start with, I would expect cap and trade allocating permits to everybody following a simple egalitarian rule: one (equal) share per person. We can then decide whether to trade it in the market or make origami figures with them.

I’m sure that something like this would be easier to implement than land reform in Mexico. If it worked, we could then confidently extend the practice to the myriad of other net externalities resulting from capitalism — environmental and social. For example, if manufacturers produce gadgets along with garbage and sick workers; if TV, Frito Lay, and Pepsi produce pleasure along with stupidity, obesity, and consumerism; if banks produce whatever they produce along with crashes that ruin our lives; etc., then as rank-and-file users of the natural and social environment, we are entitled to the same allowance of permits to destroy nature and society as everybody else.

It would not be the end of markets and the state, but at least we’d be talking!

About a year ago, I sketched a plan to get the banks back into health.  Its principle was simple:  Instead of handing out massive amounts of cash to the banks with tons of toxic assets clogging their balance sheets, in the hope that that they restart lending, hand the money directly to the so-called “subprime” borrowers so that they continue to service their mortgages.   At the time, it sounded utopian, even silly — because the political clout to push for it, let alone to force its implementation was non-existent.  Even now, the political force that is required to place this plan in the agenda is still in its embryonic stages, but I believe it is gradually building up.

In this post (in my otherwise neglected blog), I just want to report that — aside from Joseph Stiglitz — there’s another reputed economist just coming around to my approach: Steve Keen.   The neat thing is that, unlike me, who only enunciated a principle and sketched the idea, Keen has taken the trouble to model and calibrate carefully the effects of the alternative plan.

And, in regards to the build up of the political force referred above, I will refer you to Arianna Huffington’s review of Michael Moore’s new movie, Capitalism: A Love Story.

[Image borrowed from The Black Commentator: http://www.blackcommentator.com.]

Arthur Schlesinger, Jr. tells the story of FDR approached by people who wanted the U.S. to increase its involvement in confronting Hitler in Europe.  FDR replied to them:

“I agree with you, I want to do it, now make me do it.”

This is how the president tacitly assigned to them the task of bringing their case directly to the U.S. people, at the time hesitant about taking a bigger part in the European conflict.  If the national attitude towards the conflict shifted, FDR would “follow” suit.

If we check our hopes and illusions at the door, it is far from clear at this point the extent to which Obama is truly committed to promoting a progressive agenda in the U.S. and the globe.  The opportunity is definitely there.  But, consider — for example — his choice of economic cabinet.   The people he’s recruited are, to put it mildly, not known as strong reformers.  In the management of the economy, people like Austan Goolsbee, Tim Geithner, Larry Summers, and — in the background — Robert Rubin, people who have advocated the type of policies associated with the lead to the current economic disaster, have been tapped and are actively shaping up Obama’s economic plan.

Others, like Joseph Stiglitz, Paul Krugman, James Galbraith, and Dean Baker, have been largely ignored, in spite of the fact that they were critical of the policy climate that led to the current crisis, and that they have been forceful advocating measures to fight the crisis that place the broader public interest, the interest of working- and middle-class people, at the center of these policies.

In today’s New York Times, Paul Krugman continues to speak his mind about the timidity of Obama’s plans, in stark contrast with the urgency of his words.  Basic arithmetic indicates that, in the current conditions, a less than 1 trillion dollar “stimulus” is insufficient to move a 15-trillion dollar economy and tax cuts (especially tax cuts for large businesses) are largely wasted resources, because their “bang for the buck” is significantly smaller than that of a dollar directly spent.  (Apparently, even strongly pro-establishment Democrats of the Nancy Pelosi type oppose Obama’s intention of not phasing out the tax cuts for the rich that W. Bush passed!)  Yes, there’s uncertainty, but — precisely — the nature of economic uncertainty during a crisis is such that timidity in the response is the greater evil.

The excuse, as Krugman suggests, seems to be political.  Like Krugman, I’m deeply skeptical of Obama’s alleged approach.  It seems, for what we know, that Obama wants to have a large majority behind his actions, including a solid support in Congress, which requires compromising with staunch Republicans.  By temperament — the press has been telling us — Obama prefers a pragmatic focus on solutions, rather than political confrontation.

That is fine as long as the interest of the majority of working- Americans is truly the top priority.  As a tactical stance at this point, there’s nothing wrong in principle with opening the tent to more people.  But, if history is any guide, the special interests that oppose the economic security of working Americans, the reform of our disfunctional health care system, the reform of our foreign policy, etc. won’t be pacified with friendly gestures.

If Obama begins to compromise to them, always at our expense, they will only confirm that stiffening their opposition works.  Just like in economics, tax incidence is avoided by those more willing to walk away from a market deal, and falls on those forced to take it; in politics, the stubborn prevails and the compromising paints himself into a corner.  This is not an argument in favor of partisanship for partisanship’s sake.  It’s an argument in favor of partisanship to advance the public interest.

Ultimately, it is not an ideological disagreement, but the clash of their vested interests against the needs and interests of the majority of Americans which makes the right wingers so stubborn that only the effective derailment of the popular effort that gave Obama his victory, can pacify them.

Obama has said that he’ll listen to the people.  During his campaign, he emphasized that his election was not about him, but about us, rank-and-file Americans.  We need to test his claim continuously, from the get-go.  Let’s press on.  After all, we’re fired up and ready to go.  So, let’s bring the discussion to our relatives, friends, neighbors, coworkers, and everybody willing to engage in a conversation with us.  Let’s use all means at hand to impress upon the new administration that we’re stubborn in demanding satisfaction to our needs as working- and middle-class Americans.

Let’s make him do it!

[UPDATE 1/10/2009: Christina Romer and Jared Bernstein, from Obama's economic team, have estimated the impact of Obama's plan (AARP) on employment.  Since they admit that the impact of the plan as presented is rather underwhelming, they seem to be asking us to make them do more.]

[UPDATE 1/13/2009: John Nichols, a The Nation correspondent, has followed Obama closely.  Here's his view on how to push him to the left: http://www.commondreams.org/view/2009/01/12-9]

In an October 2008 paper, V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe (Fed Minneapolis, CCK) found no evidence of a crunch affecting interbank credit or borrowing by Main Street.  They argue that Main Street’s cost of borrowing is not as high as a quick look at spreads would suggest; that we should look at the levels instead.

In a November 2008 paper, Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, and Judit Montoriol-Garriga (Fed Boston, CDFM) replied in detail to the arguments in the CCK paper and concluded that Main Street is indeed being hit by a credit crunch.  I am just starting to read the latter, but I didn’t find the CCK view convincing to begin with.  I’ll say why below.

My sixth sense tells me that the political implications of what CCK are arguing are relevant.  What they are really suggesting with their paper is that large public efforts to get the economy moving are not called for, especially those directed to support employment.  It’s the old let-the-markets-sort-things-out shibboleth.

From my standpoint, the main issue is the net (dynamic) distributional effect of the measures taken and to be taken (by the new administration) with the alleged aim of shoring up the financial and non-financial sectors of the economy.   Among the different possible ways in which the financial sector can be rescued, I believe that, on equity as well as on efficiency grounds, it can be argued that the best approach is the direct relief to working- and middle-class borrowers via methods that put the public interest first at the expense of the captains of finance that drove us into the ditch.

I’ll just say, to be more specific, that I favor the outright nationalization of, at least, the weakest banks, followed by the re-negotiation and direct extension of new loans to lower income individuals and small businesses by the nationalized banks.  With Fannie and Freedie re-nationalized, the mortgage market can be fixed and revived provided the political will is there.

Following Michael Moore, I also favor a similar type of nationalization of troubled industries, like car making, and the realignment of priorities  of those companies to serve the public interest, particularly in the areas of environmental sustainability and workers’ interests.

Having said that about the politics of the issue, I now return to the empirical debate mentioned above.

In the CCK paper, I find one argument utterly unconvincing, namely that spreads (the difference between the interest rates at which banks, business, or people borrow and the baseline interest rates, those of assets deemed relatively risk-free by the markets, like the federal funds rate or LIBOR) are not informative of the existence of a credit crunch.

It seems to me that  the exact opposite is true. I expect all rate levels to be dragged down to some extent by the monetary policy reactions to the crisis: lower federal funds rate and discount (the latter being the rate at which U.S. banks can borrow from the Fed). The issue is how the risk, term, liquidity, and information structures of the interest rate react to monetary policy moves.  And, at that, the spreads tell the story.  And spreads for the credit instruments available on Main Street have gone through the roof.  The flight to quality (i.e. the flight to Treasuries) is the credit crunch!

A credit crunch doesn’t mean that liquid wealth (money) won’t find any parking spot at all.  It simply means that all regular parking spots are suddenly deemed unbearable by lenders and that the hurdle rates at those spots vis-a-vis the seemingly riskless rate increase accordingly.  Parked in Treasuries, wealth will earn the baseline interest as small as it may be now.   So, it’ll be like cash (not entirely, because it’s not fully liquid, but almost), except that it will earn some token interest.

On the other hand, loaning wealth to yours truly would be an act of unbelievable foolishness.  Evidence of the credit crunch is not that the overall rate at which I’d be borrowing now is relatively low (assuming that the market where I can borrow exists, a rather heroic assumption nowadays), but the difference between what I’d have to pay in interest and what the federal government does pay in interest.

In any case, if the tons of base money (the additional reserves the Fed loans to banks via discount window or that end up in the banks whenever the Fed buys Treasuries in the open market) that the Fed has been injecting into the banking system as of late had already translated into streams of credit to average Joes like me, then we’d be observing them in the data on deposits or measures of the money stock (M1 or M2).  Here, I only see a minuscule jump in deposits, M1 and M2 in September and October.

http://www.federalreserve.gov/releases/h8/current/

http://www.federalreserve.gov/releases/h6/Current/

On the other hand,  take a look at what happened to bank reserves:

http://www.federalreserve.gov/releases/h3/Current/

In words, in September and October 2008, bank reserves went straight up.  More specifically, they more than doubled and more than tripled, respectively.  On the other hand, total deposits and M measures in the same periods only experienced a tiny increase.  Up to the latest data point available, reserves have been building up much faster than total deposits or Ms have gone up.   That does it for me.

I understand that businesses have other ways to raise cash than issuing commercial paper or knocking on a banks’ door.  But these aggregate data show clearly, to my lights, that banks have not been lending at anything near the pace at which they have expanded their reserves.  Have other forms of cash raising picked up the slack left by debt?  The state of the stock markets in the last few months doesn’t suggest that.  So, chances are, Main Street businesses are under strife while banks have frozen lots of new credit lines, and recalled old ones, as fast as they have been able to, and now sit on a bunch of idle base money.

How can this be?  Don’t banks lose the “risk-free” federal funds rate by holding reserves beyond what they are required to hold, since reserves are just electronic credits recorded on the Fed banks?  Well, a zero interest rate still beats the negative returns that banks fear if they were to loosen their purse.

To translate into new deposits (money in the economy), the base money injected by the Fed needs to be loaned, thus expanding total deposits and the Ms via the multiplier mechanism. It didn’t happen. It’s not happening.  The money multiplier has dropped.  And since credit is the lifeblood of the “real” economy nowadays, this situation must be having “real” effects as documented by the press on real time.

Conclusion: There was, back in the fall of 2008, and — although it’s eased a bit since the fall — there continues to be a credit crunch.

Michael Moore offers a plan to deal with the auto industry troubles in ways that would advance the public interest.  I find it well-informed and sensible.

I know that, because he’s Michael Moore, a “controversial” documentary maker, serious economists and journalists — that is, economists and journalists under serious pressure to feign objectivity (objectivity of the type that is in fact impossible in a society as unequal as ours) — would have to find some fault in Moore’s logic or facts, or else.  Well, I couldn’t find anything objectionable in Moore’s plan.  Readers are of course welcome to voice their own objections (or agreement) in the Comments section.

Here is Michael Moore’s plan to deal with the auto industry disaster:

http://www.michaelmoore.com/words/message/print.php?messageDate=2008-12-03

This is an old lecture delivered by Salih Neftci at the New School on credit risk and the crisis.  (Click the tab labeled  “Play Full Program” to see the entire lecture.)  It’s still a very useful presentation when looking back at what triggered this mess.

I took all of Salih’s courses in econometrics, macroeconomics, finance, and financial engineering at the CUNY GC.  Excellent instructor.  Nice man.  Funny jokes.  Full disclosure: He once wrote a great letter of recommendation for me that got me a finance professorship.  So, I’m very grateful to him.

In a class, I once asked him point blank: “If you are so smart, how come you are into finance and making bucks?  How come you’re not into politics, trying to change the world for good?”  That rattled him a bit.  He babbled about how some women in his family, including his mother, had all been into politics at great cost.  He then said that politics only rarely improves on things.  He then stopped himself, unhappy with his own answers, and continued the class.

That is a propos of this passage in Krugman’s latest column:

Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

I agree with Paul Krugman.  What a waste of our society’s dearest resources!

Krugman’s Nobel lecture is on here (Windows Media Player):

http://nobelprize.org/mediaplayer/index.php?id=1072

His slides are here (pdf):

http://www.princeton.edu/~pkrugman/nobelslides.pdf

Do not miss Salon.com’s interview of Paul Krugman.  A quick comment:

Krugman is good at clarifying for the general public what I regard as Keynes’ main insight in the General Theory, namely that specific disproportions in the economy, e.g. sectoral bubbles, dislocations in particular markets caused by unexpected shocks in technology or policy, etc., can turn into nasty economy-wide crises only because, as a result of widespread, self-reinforcing fears about future business conditions, there’s a sudden, generalized flight to liquidity.

This is a massive coordination problem.  Coordination problems are common to capitalist markets, not only — as in this case — to financial markets.  They are a manifestation of the inherent conflict at the root of every capitalist society between an increasingly interdependent economy and private ownership.  Keynes’ genius was to realize that, like other coordination problems facing the capitalists, the Gordian knot could be cut by the decisive action of the government.

In this interview, Krugman paraphrases Keynes’ “magneto” metaphor in the Great Slump — “If you’ve got electrical problems with your engine, that doesn’t mean you should junk the whole car” (I think Keynes referred to a ‘wagon’).  And then he throws this one-two punch:

It’s true that classical economics says that we should let market forces do the work; but classical economics also says that severe recessions can’t happen.  This idea that we must not intervene is based on a worldview that is refuted by the very fact that the economy is in the mess it’s in.

Insisting on this point is called for, not only because regular people have for long been bombarded with the Austrian view that recessions (and depressions) are necessary to purge or clear the dead wood that has cluttered the system, but also because some people in the left apparently buy into the argument.

The Obama transition is asking for your ideas on how to deal with the crisis.  You can give them some feedback here:

http://change.gov/page/s/economy

Now on to the other part of my post.  Recently, I was discussing the public records of two economists.  Let me refer now to Austan Goolsbee and Robert Rubin.

Goolsbee is the University of Chicago economist recently appointed by Obama as chief economist and staff director of the president elect’s Economic Recovery Advisory Board. Goolsbee will also be a member of the Council of Economic Advisors (CEA), which helps develop the president’s economic policy.

It is in his record, that in a March 29, 2007 New York Times op-ed, right when the subprime crisis was starting to burst, Goolsbee not only denied a crisis was coming, but he also made a forceful argument in defense of subprime mortgage lending.  The practice of subprime mortgage lending, compounded by the securitization of those mortgages, is at the root of the ongoing crisis that Goolsbee is now apparently ready to help resolve.  If we are to believe in Goolsbee’s March 2007 argument, with subrprime credit, the innovative genius of free markets was doing what it typically does — enhance our social welfare.  I searched on Google and couldn’t find any news on whether Goolsbee has changed his views regarding subprime lending.

Regarding Robert Rubin, here’s what New York Times columnist Frank Rich just wrote:

http://www.nytimes.com/2008/12/07/opinion/07rich.html