Free Brookings Papers on Economic Activity

Earlier today the fine folks at Brookings announced that they have made all past and current issues of Brookings Papers on Economic Activity free. You can find them here.

Some specific papers that readers of this blog might enjoy (all from the Spring 2009 volume):

Jim Hamilton on the “Causes and Consequences of the Oil Shock of 2007-2008

Christina D. Romer and David H. Romer on “Do Tax Cuts Starve the Beast? The Effects of Tax Changes on Government Spending

Phill Swagel on “The Financial Crisis: An Inside View

A List of the Top 50 Economic Theories

Last year, the Ivy Press asked me to help them with a popular book about the 50 most important economic theories. My primary task was assembling the top 50 list (assisted by suggestions from my readers); Ivy then found authors to write pithy essays about them.

The resulting book was published as 30-Second Economics: The 50 Most Thought-Provoking Economic Theories, Each Explained in Half a Minute. You can buy it for $5.99 over at Barnes & Noble, where it’s inexplicably attributed to someone named Emma Long (I have no financial stake in it).

Inevitably some good theories fell by the wayside, often for reasons unrelated to their importance. And the line between theory and concept got blurry at times. So please take the list in the spirit of fun mixed with seriousness.

And keep in mind, as I say in the introduction to the book, that

Important [economic] theories are not always right. So mixed among the most important theories you will find a few that are … wrong, despite their influence. See if you can find them.

Or maybe more than a few …

Here’s the list of the 50 economic theories that made the cut:

Continue reading “A List of the Top 50 Economic Theories”

IMF: The Lasting Effects of Financial Crises

Earlier this week, the IMF released a key chapter from the upcoming World Economic Outlook: Chapter 4: What’s the Damage? Medium-Term Output Dynamics After Financial Crises. As noted in the much pithier summary, the report concludes that:

The global financial crisis is likely to leave long-lasting scars on the world economy, but governments can act to stimulate a quicker revival and counter output losses … . The study finds that banking crises typically have a long-lasting impact on the level of output, although growth eventually recovers. Lower employment, investment, and productivity all contribute to sustained output losses.

Those conclusions are based on their review of financial crises around the world since the early 1970s. As shown in the following graph, the key finding is that after a financial crisis economic output remains below trend for years:

IMF - Lasting EffectsThe blue line shows, for example, that in the average country, output seven years after the crisis was about 10% below what would it would have been if the pre-crisis growth rate had continued.

The dotted red lines, however, highlight the enormous range of outcomes. At least one-quarter of the countries eventually had output that was above the level implied by the earlier trend; while another quarter eventually fell at least 25% below the prior trend.

The study slices and dices this result in numerous ways, trying to identify the factors that lead to better or worse outcomes. Some are bad news for the United States.

Continue reading “IMF: The Lasting Effects of Financial Crises”

Lessons from the Fall of Lehman

As you have undoubtedly noticed, this week marks the one-year anniversary of the fall of Lehman Brothers–the moment at which the financial crisis became a severe economic crisis.

I did an interview on Fox Business on Tuesday to discuss some of the lessons learned. (My wife’s comment  on the interview: “You need to straighten your collar next time.”)

Going in, I had two basic points I wanted to make:

  • First, the fall of Lehman Brothers was the moment that the abstract threat of “systemic risk” became tangible to many policy makers and the public. As we progressed from propping up Bear Stearns to taking over Fannie Mae and Freddie Mac, many observers began to suffer from policy fatigue, and, in some circles, there was concern that the scale of the government actions might be disproportionate to the alleged, but little-seen, risk of a systemic crisis. That changed when Lehman fell, and the dominoes started toppling.
  • Second, we still have our work cut out for us. The major items on our to do list include:

(1) Taking steps to avoid such enormous shocks in the future (e.g., by increasing capital requirements and reducing allowed leverage for financial firms).

(2) Fixing the problem of too-big-to-fail (or, if you prefer, too-interconnected-to-fail). Unfortunately, this problem has worsened, in many ways, since the crisis began. Some gigantic firms have grown even larger. And the necessary interventions to prop up the financial sector have reinforced the idea that the government will prevent these firms from failing in the future.

(3) Disentangling the government from private firms, so that it can again act as a referee, not as a player. That will take time given the enormous investment portfolio that the government has amassed in financial firms and the auto companies. It is heartening, however, that even Citigroup is beginning to ponder how to raise outside capital and reduce the government stake.

Wall Street Goes to Washington

A front page story in today’s Washington Post (“In Shift, Wall Street Goes to Washington“) documents the Capital’s rising importance in the financial world:

J.P. Morgan Chase for the first time convened its board in Washington this summer, calling the directors to a meeting at the downtown Hay-Adams hotel, then dispatching them to Capitol Hill for meet-and-greets.

Last month, a firm run by the billionaire investor Wilbur Ross hired the head of Washington’s top mortgage regulator to pick through the wreckage of the housing bust looking for bargains.

And the world’s largest bond fund, Pimco, which has traditionally assessed the risk of any new investment according to five financial criteria, recently added one more: the impact of any change in federal policy.

“In the old days, Washington was refereeing from the sideline,” said Mohamed A. el-Erian, chief executive officer of Pimco. “In the new world we’re going toward, not only is Washington refereeing from the field, but it is also in some respects a player as well. . . . And that changes the dynamics significantly.”

The Ross example doesn’t tell us much — the financial world has always recruited government officials. The J.P. Morgan and Pimco examples, however, highlight how much the playing field has changed over the past two years. Washington is not just a more aggressive regulator. Given the stresses on the system, it has become a serial intervener — stepping in to prop up specific firms or credit channels that appear too important to fail. And it is now a major investor, with a burgeoning portfolio of investments in financial firms, auto companies, and mortgage backed securities.

As we commemorate the first anniversary of the fall of Lehman, it appears that the worst of the financial and economic crisis is behind us. And the policy conversation should increasingly focus on exit strategies. Not just the narrow question of how the Federal Reserve eventually unwinds the extraordinary expansion of its programs. But also how the Treasury eventually unwinds it TARP investments. How the FDIC walks back from offering guarantees on bank debt. How the government restructures Fannie Mae and Freddie Mac.

And, perhaps most importantly, how policymakers recalibrate their relationship with financial markets. To paraphrase Mohamed A. el-Arian: can Washington return to being a referee on the sidelines or will it continue to be a player?

Why Economists Messed Up

The biggest thing in economics today is Paul Krugman’s “How Did Economists Get It So Wrong?” in the New York Times Magazine. If you have any interest in macroeconomic policy, you should read it.

For one thing, the illustrations by Jason Lutes are quite entertaining:

06economic.8-190

More important, though, is Paul’s evaluation of how we economists missed the 800-pound gorilla in the room. He fingers three suspects:

  • Mistaking beauty for truth. I.e., too much reliance on elegant, solvable, mathematical models in which economic players are rational and markets adjust to shocks easily. These models are a joy to play with — and provide important insights — but they miss messy truths about the actual economy.
  • Excess confidence in financial markets. He argues that widespread acceptance of the efficient markets hypothesis (the idea that asset prices incorporate all information and thus get prices “right”) left us blind to the risks of asset bubbles.
  • The limits of mainstream macroeconomics. This critique is harder to summarize, but in a nutshell he argues that (a) some economists have (incorrectly) embraced the classical view that the government can’t and shouldn’t try to moderate the business cycle and (b) the larger body of mainstream of economists have (correctly) embraced the Keynesian view that the government can try to moderate the business cycle but have (incorrectly) concluded that the Federal Reserve is the only appropriate tool to do so.

I think each of these charges has merit, with one caveat. Back in graduate school, I was indeed taught that monetary policy was the preferred tool for addressing economic weakness (e.g., because of policy lags and concerns about the political economy of what passes as fiscal stimulus from the Congress). In my years in Washington, however, I have met many economists, of the left, right, and center, who believe in fiscal policy as well. Indeed, in policy circles, the idea of fiscal stimulus was active in 2001, 2003, 2008, and 2009, each of which witnessed tax cuts (and, in the most recent case, spending increases) that were partly or wholly passed in the name of stimulus. One can debate the merits of those acts, but the concept of fiscal stimulus has been alive and kicking.

Paul’s recommendations for the way forward for economists:

First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

On his final point, I should note that one of the leading thinkers on the links between finance and macro is none other than Ben Bernanke, current (and, one hopes, future) chairman of the Federal Reserve. That’s one of the reasons he’s the right person for the job.

Related commentary: EconomistMom, Barry Ritholz, Paul Kedrosky, Brad DeLong, and Paul Krugman himself.

Positive, Normative, and … ?

Am I the only one who feels unfulfilled by the standard distinction between positive and normative economics?

I am gearing up to return to the classroom next week, to teach microeconomics to incoming masters students at the Georgetown Public Policy Institute. Anyone who’s experienced the first day of micro class knows what’s coming. After introducing myself and talking about the wonders of economics (which is, indeed, fun, useful, and enlightening), I will launch into the great positive vs. normative distinction.

In brief:

  • Positive is the science side of economics: understanding and predicting the behavior of individuals, firms, markets, economies, etc. In short, the part of economics in which we try to be physicists (or, sometimes, biologists).
  • Normative is the side of economics where we make value judgments, identifying policies as good or bad. In short, the part of economics in which we try to be philosopher-kings.

Both styles of economics are important, particularly in a public policy program. And drawing a careful distinction is vital, not least because of the many people in Washington (both economists and non-economists) who try to dress up their value judgments as science.

I have one problem with this distinction, however: it overlooks a great deal of what economists actually do.

Continue reading “Positive, Normative, and … ?”