The Free Thinker

Drawing the Battle Lines

"Obama Gets Strong Support in Poll" (Wall Street Journal)

President Barack Obama enjoys widespread backing from a frightened American public for his ambitious, front-loaded agenda, a new poll indicates.

He is more popular than ever, Americans are hopeful about his leadership, and opposition Republicans are getting drubbed in public opinion, the new Wall Street Journal/NBC News poll suggests.

The poll found a sharp jump in the proportion of Americans who say the nation is "generally headed in the right direction" since Mr. Obama's January inauguration, a period when economic indicators and financial markets have suggested the opposite. The survey shows that 41% of Americans say the country is headed in the right direction, up dramatically from 26% in mid-January, before Mr. Obama took office, and up from 12% before the election.

The number who say the country is on the "wrong track" is still higher at 44%, but given the economic conditions, pollsters expected it to be much higher.

In the past, similarly sudden improvements in national mood were recorded only after national emergencies that prompted a rallying effect, such as the 2001 terrorist attacks. In this case, the boost is being driven by Democrats and other Obama voters who are pleased with the opening weeks of the administration. Overall, two-thirds of all Americans say they feel "hopeful" about Mr. Obama's leadership and plans, compared with 28% who say they feel "doubtful."

"US Stocks Drop 20% after Obama takes office" (Business Day):

One of the major measures of the health of US stocks, the Dow Jones Industrial Average, has fallen 20% since Barack Obama was inaugurated on January 20 - the fastest drop under a new president in almost a century.

Experts say investors may be worried Mr Obama’s stimulus measures won’t revive the economy anytime soon.

The 20.4% drop in the Dow is the steepest for a new administration in at least 90 years, according to data compiled by Bloomberg. The Dow tumbled 25% in 2009, its worst annual start, as unemployment climbed and bank losses increased.

Overnight, the Dow slid 4.1% to 6594.44, its 12th decline in 15 days, as the worst start to a year for US stocks deepened. The Standard & Poor’s 500 Index lost a further 4.3% to 682.55, extending its retreat to 19.7% since January 20.

"It’s the Obama bear market," said Dan Veru, who helps oversee $2.8 billion at Palisade Capital Management in Fort Lee, New Jersey. “We don’t know what the rules are in so many different areas the government is touching.”

These articles describe the two sides in the class war: it's those who answer poll questions against those who own 401(k)s and stocks.  Of course the groups overlap somewhat, but the point is that the median voter-- or answerer of poll questions-- owns a lot less stocks than the median shareholder (particularly if the median is wealth-weighted), so it's possible for Obama's popularity to rise even as he is probably chiefly responsible for the destruction of trillions of dollars of wealth since his election, or even in the briefer time since he took office.

In the short run, Obama's shrewd application of the Median Voter Theorem may pay political dividends, and it's even possible that his tax cuts and education and other benefits targeted to the middle class (not the poor) may yield net benefits to some of them.  In the long run, everybody loses from class war, because the class that is most vulnerable to class war-- investors, entrepreneurs-- is the one that drives most of the long-term increases in society's well-being.

America's Dark Ages

"How Government Prolonged the Depression" (Wall Street Journal)

The New Deal is widely perceived to have ended the Great Depression, and this has led many to support a "new" New Deal to address the current crisis. But the facts do not support the perception that FDR's policies shortened the Depression, or that similar policies will pull our nation out of its current economic downturn.

The goal of the New Deal was to get Americans back to work. But the New Deal didn't restore employment. In fact, there was even less work on average during the New Deal than before FDR took office. Total hours worked per adult, including government employees, were 18% below their 1929 level between 1930-32, but were 23% lower on average during the New Deal (1933-39). Private hours worked were even lower after FDR took office, averaging 27% below their 1929 level, compared to 18% lower between in 1930-32.

Even comparing hours worked at the end of 1930s to those at the beginning of FDR's presidency doesn't paint a picture of recovery. Total hours worked per adult in 1939 remained about 21% below their 1929 level, compared to a decline of 27% in 1933. And it wasn't just work that remained scarce during the New Deal. Per capita consumption did not recover at all, remaining 25% below its trend level throughout the New Deal, and per-capita nonresidential investment averaged about 60% below trend. The Great Depression clearly continued long after FDR took office.

Why wasn't the Depression followed by a vigorous recovery, like every other cycle? It should have been. The economic fundamentals that drive all expansions were very favorable during the New Deal. Productivity grew very rapidly after 1933, the price level was stable, real interest rates were low, and liquidity was plentiful. We have calculated on the basis of just productivity growth that employment and investment should have been back to normal levels by 1936. Similarly, Nobel Laureate Robert Lucas and Leonard Rapping calculated on the basis of just expansionary Federal Reserve policy that the economy should have been back to normal by 1935.

So what stopped a blockbuster recovery from ever starting? The New Deal. Some New Deal policies certainly benefited the economy by establishing a basic social safety net through Social Security and unemployment benefits, and by stabilizing the financial system through deposit insurance and the Securities Exchange Commission. But others violated the most basic economic principles by suppressing competition, and setting prices and wages in many sectors well above their normal levels. All told, these antimarket policies choked off powerful recovery forces that would have plausibly returned the economy back to trend by the mid-1930s.

The most damaging policies were those at the heart of the recovery plan, including The National Industrial Recovery Act (NIRA), which tossed aside the nation's antitrust acts and permitted industries to collusively raise prices provided that they shared their newfound monopoly rents with workers by substantially raising wages well above underlying productivity growth. The NIRA covered over 500 industries, ranging from autos and steel, to ladies hosiery and poultry production. Each industry created a code of "fair competition" which spelled out what producers could and could not do, and which were designed to eliminate "excessive competition" that FDR believed to be the source of the Depression.

These codes distorted the economy by artificially raising wages and prices, restricting output, and reducing productive capacity by placing quotas on industry investment in new plants and equipment. Following government approval of each industry code, industry prices and wages increased substantially, while prices and wages in sectors that weren't covered by the NIRA, such as agriculture, did not. We have calculated that manufacturing wages were as much as 25% above the level that would have prevailed without the New Deal. And while the artificially high wages created by the NIRA benefited the few that were fortunate to have a job in those industries, they significantly depressed production and employment, as the growth in wage costs far exceeded productivity growth.

These policies continued even after the NIRA was declared unconstitutional in 1935. There was no antitrust activity after the NIRA, despite overwhelming FTC evidence of price-fixing and production limits in many industries, and the National Labor Relations Act of 1935 gave unions substantial collective-bargaining power. While not permitted under federal law, the sit-down strike, in which workers were occupied factories and shut down production, was tolerated by governors in a number of states and was used with great success against major employers, including General Motors in 1937.

The downturn of 1937-38 was preceded by large wage hikes that pushed wages well above their NIRA levels, following the Supreme Court's 1937 decision that upheld the constitutionality of the National Labor Relations Act. These wage hikes led to further job loss, particularly in manufacturing. The "recession in a depression" thus was not the result of a reversal of New Deal policies, as argued by some, but rather a deepening of New Deal polices that raised wages even further above their competitive levels, and which further prevented the normal forces of supply and demand from restoring full employment. Our research indicates that New Deal labor and industrial policies prolonged the Depression by seven years.

By the late 1930s, New Deal policies did begin to reverse, which coincided with the beginning of the recovery. In a 1938 speech, FDR acknowledged that the American economy had become a "concealed cartel system like Europe," which led the Justice Department to reinitiate antitrust prosecution. And union bargaining power was significantly reduced, first by the Supreme Court's ruling that the sit-down strike was illegal, and further reduced during World War II by the National War Labor Board (NWLB), in which large union wage settlements were limited by the NWLB to cost-of-living increases. The wartime economic boom reflected not only the enormous resource drain of military spending, but also the erosion of New Deal labor and industrial policies.

The real explanation of the Great Depression rather pulls the raison d'etre out from under Keynesian theory.

The Late, Great Clinton-Bush Economy

Nato, in a comment, quotes a bunch of statistics and draws the conclusion that "Bush II beats Bush I, but both his terms have been worse than the next worst results in the last half century (Nixon/Ford)."  He doesn't say where he got the data, and given that there are a lot of ways to muddle numbers, color me skeptical.  It may be true, though, for the simple reason that Bush took office at the height of a probably unsustainable bubble-boom that was already bursting.  When the economy has grown as much as it did in the 1990s, just to sustain the new levels would be something to be grateful for; to make further progress is an achievement.

Anyway, because GDP growth statistics are affected by business cycles, they're not a good measure of the core growth of the economy.  The best indicator of long-run growth is the productivity trend.  Behold:

Source: BLS.

Fast productivity growth started under Clinton, not Bush.  It's often attributed to computers, but that doesn't explain why (a) computers were pervasive ten years before the productivity acceleration started (this used to be called the "Solow paradox"), and (b) the productivity acceleration didn't show up in most of Europe or Japan.  A McKinsey study, The Power of Productivity, attributed about half the productivity acceleration to Wal-Mart.  My pet theory, which I'd like to explore empirically sometime, is that welfare reform was the cause: it gave people more of a reason to work, and also created a ratchet effect as welfare-leavers created competition for low-end jobs and made the people who had previously worked those jobs work harder to compete.

If productivity is growing so fast, why haven't incomes been rising?  We've all heard the muttering on the left about how incomes have been stagnant for a generation.  I was always puzzled by this claim since it contradicts just about all the personal experience of the economy of myself and anybody I know.  This Minneapolis Fed study seems to say the claim is just wrong: "Middle Americans' incomes rise substantially even while income inequality increases."  (That increase in income inequality may be in the process of reversing itself now, the way the financial sector-- a source of huge salaries and an important driver of income inequality-- is getting hammered.  Not that this is a good thing, but we might as well look at one of the bright sides of the recent chaos.)

While productivity is most important for long-run growth, unemployment seems to be the most important feel-good factor, at least until pretending the economy was bad (and blaming "Kansas" for not noticing) became a pastime of prosperous Bush-haters.  There's a reason for this: Americans don't like welfare, but we do believe in a social safety net of sorts, and that is jobs.  When everyone can get a job, we feel like a just society; when there aren't enough jobs to go around, we don't.  The chart below shows unemployment in the years 1970-2007, also from the BLS.  

Economists do not typically regard 0% unemployment as possible: someone is always "between jobs."  Near-zero unemployment rates are thought to be unsustainable.  The "non-accelerating inflation rate of unemployment" is generally thought to be around 5%, give or take.  From 1975 to 1987, the unemployment rate was always over 6%.  It fell below 6% after 1995 and has been below that ever since (except briefly touching it in 2003).  

These two indicators, productivity growth and unemployment, show the continuity of the Clinton-Bush economy, and how it differs from what came before.  Nato writes that "if the economy under Obama is worse than it has been under Bush, it will be fairly amazing and very disappointing."  I'm afraid I must disagree.  What is amazing, or at least striking, is the strong performance of the economy in 1995-2007.  Not that I think it's a fluke: I think prosperity is normal as long as wise policies are in place.  Wise policy, however, is rare.  The experience of the 1930s and 1970s show that full employment and ongoing improvement in productivity are not inevitable.  I'm afraid I don't see Obama as having the inclination or capacity to run a full-employment economy.  He has things on his website like this:

Raise the Minimum Wage: Barack Obama and Joe Biden will raise the minimum wage, index it to inflation and increase the Earned Income Tax Credit to make sure that full-time workers earn a living wage that allows them to raise their families and pay for basic needs.

Some people-- including teenagers and other non-primary earners-- work even though what they earn is less than what they need to live on.  Unless the government, in the spirit of paternalistic benevolence, tells them they can't.  That's where long-term unemployment comes from.

UPDATE: I forgot to mention the biggest single point in favor of the Bush economy: the world economy was booming in 2004-07, growing at maybe the fastest pace in history.  Now, that may or may not have much to do with President Bush.  I can think of a couple of reasons why it might.  (1) The Bush administration's deficit spending served as a Keynesian stimulus for the world economy as a whole.  (2) The Iraq War may have served as a good stiff shock to dictators and nasty rulers that they'd better govern well or they might get overthrown.  Both of these possibilities are just speculation.  Also, the current financial crisis is making it look like this worldwide boom might have been an unsustainable bubble (which, if so, may or may not have been, to some greater or lesser degree, the Bush administration's fault).  But it will take a steep drop and a period of slow growth or stagnation to erase the world economy's gains in 2004-07.

Historical Analogies Run Amok

"From Plan A to Plan F" (Brad DeLong, The Guardian, 10/16/2008)

The Bush administration, having entered office as social conservatives, leaves office as conservative socialists, proprietors of the most sudden large expansion of the state's role in the US economy since mobilisation for the second world war. Why did they decide to partially and quasi-nationalise America's banks - to invest $250bn in preferred stock plus warrants and tell the banks that it wanted them to use the capital to expand their loan base rather than contract it via deleveraging? It is certainly not what Henry Paulson signed up as Treasury secretary to do.

I am an economic historian. An occupational disease of being an economic historian is to insist that the answers to all questions lie in the Great Depression that started in 1929. When the financial crisis hit in a sudden squall in August 2007, in the back of the Federal Reserve's mind was that it should not repeat any of the mistakes that led to the Depression. Hence Ben Bernanke and his Fed loaned extraordinarily freely to banks and near-banks and non-banks in order to avoid what Milton Friedman said was the key mistake that made the Depression Great: that the Fed had triggered or allowed a liquidity squeeze that made cash hard to get. Call this Plan A.

In a couple of months it became clear that Plan A was not working. The economy was weakening. And the Fed remembered the theory - put forward by, among others, Lawrence Summers and myself - that what made the Depression Great was that businesses began to expect deflation. The expectation of falling prices made every business postpone its investment spending - better to wait a year and build your plant and equipment then when prices were cheaper - and so private investment collapsed. So Bernanke and his Fed lowered interest rates to what they thought were levels that might trigger inflation, as a way of making sure that no business anywhere would even begin to suspect that a deflationary spiral was in the making. That was Plan B.

But the economy fell toward (if not into) recession, and interest rates had already been pushed down so low that the Fed's monetary policy had lost its virtue and vigour. So it was time for Plan C: mail out a bunch of extra tax-rebate cheques, hoping that they would stimulate consumer spending and that once consumers began spending more the economy would recover with at worst a small recession.

Meanwhile, the investment bank Bear Stearns collapsed. The Federal Reserve and the Treasury concluded that they could not stand by and wait to see if Plan C was working. They had to move to Plan D: case-by-case forced mergers, liquidations and nationalisations of banks and other financial institutions in order to prevent the course of events that the third theory of the Depression said had made it Great.

This theory was Bernanke's: that the downfall of 1929-1933 was largely the result of bank failures that collapsed businesses' ability to borrow to expand or even fund ongoing operations. So we had the forced merger of Bear Stearns into JPMorgan Chase; a lull to see if Plan C would work (it didn't); the renationalisation or deprivatisation of the mortgage lenders Fannie Mae and Freddie Mac; that strange weekend when the Fed bought the insurance company AIG; and the bankruptcy of Lehman Brothers, as Bernanke and Paulson decided that they could not rescue the creditors of every firm on Wall Street.

They were wrong. The failure of Lehman Brothers triggered or uncovered or brought on financial catastrophe - not just in America but in Europe too, where hitherto policymakers had been watching with concern and some alarm. It was time for Plan E: the Paulson plan, a $700bn programme by which the Treasury would buy up troubled mortgages, mortgage-backed securities and derivatives thereof with an eye toward making sure that the banking system recovered so that it could do its job of transferring the savings of Americans to businesses that wanted to hire workers, and so keep the recession a small one and avoid the mistakes that the Bernanke theory said had made the Depression Great.

The hope behind the Paulson plan was supply and demand. Banks and investors want yield, and so are willing to buy risky assets. If the Treasury were to buy $700bn of risky financial assets and put them on the shelf, this would diminish the supply. When supply falls, prices rise. As the prices of financial assets rose, banks would profit immensely - and people would no longer fear that the bank they were dealing with might dry up and blow away in the next week.

The financial markets swallowed the passage of Plan E without a burp and continued on their downward spiral toward universal financial-sector bankruptcy.

It was time for Plan F. If the prospect of buying up mortgage-backed securities did not boost asset prices and bring banks enough investment profits to create confidence that they were not all going bankrupt next month, governments could invest public money in the banks whether they liked it or not, thus making them so well-capitalised that their failure would be inconceivable.

What I find most scary about this is that policymakers (and Brad DeLong, but that's not so important) seem to be thinking so much about the Great Depression.  The world economy today is dozens of times bigger, and far more integrated.  There have been tremendous technological changes, big changes in the socioeconomic structure of most societies, big changes in policy.  Both Wall Street and Washington-- or, more generally (or rather, less metonymously) both finance and government-- have been transformed.  Even without any specific story about how 2008 is different from 1929, is it plausible that making the right policy choices now consists of nothing but implementing our best guess about what would have been the right thing to do eighty years ago.

If you look in the rear-view mirror all the time, you crash.

Financial and Legal/Regulatory Co-Evolution

For economic commentary on the current financial crisis, I am not the equal of Dani Rodrik, or Tyler Cowen, but I might as well comment on the topic du jour, since I'm supposed to be an expert a specialist of sorts.  Latest news:

• With Goldman Sachs and Morgan Stanley turning into bank holding companies to escape the fates of Lehman Brothers, Merrill Lynch, Bear Stearns etc., the once-mighty investment bank is no more.  (I remember hearing Harvard undergrads chattering to one another with starry-eyed greed about "i-banking" jobs.  The recollection now has the flavor of one of those historical anecdotes with a built-in moral, like the Titanic.) 
• The Bush administration/Hank Paulson is pushing for fast action on what is being called a $700 billion bailout of Wall Street.

Lest I violate my personal taboo on political blogging, I'll leave the news and retreat into arcana. 

Suppose I promise to do A in return for your promise to do B.  We have a contract, maybe we even write it down with the help of fancy lawyers.  But am I willing/able to do A, and you to do B?  If not, will a court enforce the contract, and how?

As the economy gets bigger and more complex, the types of contracts that it is advantageous for people to sign keeps increasing, as a means to incentivize effort or innovation, or to spread risk.

Suppose that at time t, the economy is sufficiently developed that three types of contracts would be advantageous for private agents to sign; we'll call them Contracts X, Y, and Z.  Contract X is well-understood by regulators and courts.  Contract Y is not dealt with in any extant legislation or case law, but the private sector is aware of it.  Contract Z, no one has thought of yet.

Some agents will choose not to engage in contracts of type Y, but some will, hoping that either (a) counter-parties will keep their end of the bargain voluntarily, from honor or for repeat business or their reputations, or (b) courts and/or regulators will find out about, approve, and enforce Contract Y if forced to do so by a breakdown of some instance of it.  If Contract Y is more advantageous in some circumstances than Contract X, market forces will cause it to spread, and eventually some breakdown will force courts/regulators to catch up with the private-sector-driven evolution of contract law.  Once they do, the margins for Contract Y-type deals will be reduced by competition, and some clever entrepreneur may have an idea for Contract Z.

One interpretation of financial crises is that they reflect the painful learning curve as those to whom justice and property rights are entrusted learn to cope with the ever-growing sophistication of markets.

Russia's Suez Crisis Update

"Russia halts trading after 17% fall in share price" (FT, 9/16/2008):

Russian shares suffered their steepest one-day fall in more than a decade on Tuesday, losing up to 20 per cent, as a sharp slide in oil prices and difficult money market conditions triggered a rush to sell.

The heads of the Russian central bank, the finance ministry and the financial market regulator met on Tuesday night for an emergency discussion on ways to halt the crisis.

Earlier, trading had been suspended on both the Micex and RTS stock exchanges as investors ignored assurances by Russian officials and a cycle of distrust set in amid liquidity fears.

Margin calls forced domestic traders to liquidate positions and brokers pulled credit lines. At least one Moscow bank failed to meet payments.

The rouble-denominated Micex Index closed 17.75 per cent down, the sharpest one-day drop since the August 1998 financial crisis, while the dollar-denominated RTS index closed down 11.47 per cent, its lowest lvel since January 2006.

Interbank money market rates climbed to 11 per cent, their highest since a mini-banking crisis in summer 2004.

Chris Weafer, chief strategist at Uralsib investment bank: “We’re in completely uncharted territory where the prevailing emotion is of fear and numbnes. No one knows where this could stop”.

Alexei Kudrin, finance minister, insisted that the financial system was not in a systemic crisis but the central bank injected a record $14.16bn in one-day funds into the money market.

The finance ministry also placed an additional R150bn ($5.8bn) in one-month deposits into the banking system. Konstantin Korishchenko, central bank deputy, told Russian news agencies that the bank and the finance ministry could provide a total of $117.6bn in liquidity to the banking sector.

But market players said banks were ceasing to lend to second and third-tier companies and brokers were pulling credit lines. KIT Finance, big Moscow investment house confirmed rumours that it had been unable to make payment on a series of short-term loans.

It said: “In connection with the fact that a series of our clients did not meet their obligations to our bank, we have not met our obligations to our counterparties.

“We recognise our responsibility to our counter-parties and to the market and we are working intensively to resolve the situation.”

Andrei Sharonov, managing director of Troika Dialog, a Moscow investment bank, and a former deputy economic minister, said: “This is a vicious circle,” said , .

“It is a situation of total mistrust. The liquidity crisis is being caused by a crisis of confidence in which people are frightened to borrow and frightened to lend.”

Shares in Russia’s biggest state-controlled banks led the slide with Sberbank, the state-controlled savings bank, closing 21.72 per cent down and VTB losing 29.26 per cent. The bank was suffered on investor fears about its securities portfolio, which makes up about 10 per cent of its assets.

It's been ten years since Russia's last financial crisis, in 1998.  The war in Georgia is probably not the main cause of this-- turmoil on Wall Street, and falling oil prices, were surely the trigger-- but it undoubtedly made matters worse.

It's up to Putin, as prime minister, to do something about it.  For Russia's sake, I hope he gets them through it all right.  But if he doesn't, he ought to be vulnerable, and maybe he really is.

Meanwhile, let's hope Russians learn the lesson: Aggression doesn't pay.  Thanks to Tyler for the pointer.

"The Greatest Financial Crisis in America Since the Great Depression"

The title of this post is probably an accurate description of what's happened on Wall Street in the last year or so and especially the last 72 hours.  And yet, the funny thing is that it's far from certain the US economy-- "Main Street"-- will be hurt, or hurt much.

What is the difference between a financial crisis and a crisis for the economy?  In 1929 there was a financial crisis that led to an economic depression.  In 1987 there was a financial crisis that basically had no effect on the economy.  In 2001 a stockmarket bubble popped, without it ever being quite a crisis, and the economy slowed down a bit: it's generally regarded as a recession though I'm not sure it's clear that it meets the technical definition of two quarters of consecutive decline.  So far, the US seems to have weathered financial crisis for a year without anything that can be legitimately called a recession, although Phil Gramm's accurate characterization of it as a "mental recession" has proven unpopular.  What's the pattern?  Is there a pattern?

Look at it another way: Why care about the financial sector more than other sectors?  Suppose there were a crisis in the toilet-paper sector.  Cheap toilet paper from Mexico, or a standards war, or mismanagement in toilet-paper giants lead to a collapse in domestic production, bankruptcies, lay-offs.  No one would think the US economy as a whole was endangered by this development.  Why is finance more important than toilet paper?  It's bigger, but there seems to be a widespread impression that finance is important out of all proportion to most measures of its industry size.

There are good theoretical reasons to think finance is especially important.  But it's difficult to establish how much the theory fits the reality.  Or, if finance is important generally, what parts of finance matter, and how much, and why.

As an "economist"-- still in training, second-year PhD student with an earlier Masters involving PhD-level economics, and four years' work experience in econ-related positions-- I feel like I'm supposed to care about dramatic developments in Wall Street and have special insights about their significance.  I'm not sure I do.  Except maybe one thing.  The biggest cause of the turmoil seems to be the decline in housing prices.  The decline in housing prices is especially damaging because of the way it affects the functionality of the standard mortgage contract: when the price of a house falls, it no longer serves as effective collateral for the associated loans, giving people an incentive to walk away from their houses.  For even a little bit of that to occur can have devastating ramifications.  It seems to me that as long as America's unusual homeownership-cum-mortgage model is in place-- and although it's a bad model artificially created by distorting subsidies, don't expect it to go away soon (not that homeownership is bad, but America has way way way over-promoted it)-- the Fed cannot allow house prices to fall without crippling the financial system.  And if it can't allow house prices to fall, it shouldn't allow them to rise, either, otherwise policy has an inflationary bias.  So we need to re-define inflation to include home prices-- not rental prices, which are already included in the relevant indices, but home purchase prices-- and maybe other asset prices as well.  It should be part of the Fed's mandate to prevent home prices from rising too fast.  That means we should have had tighter money over the past decade or so, back to the Greenspan years.

Right now, I think we should tolerate just a bit more inflation temporarily so that housing prices can recover a bit, or anyway stop sliding, in order to shore up the financial system.  At the same time, we should probably also explicitly think about the dollar's attractiveness as a world currency, since that's also been called into question somewhat over the past year and a half.  But those goals conflict a bit.  Hmm.

No Recession

Economy rebounds in second quarter, spurred by exports (Washington Post, 8/28/2008):

U.S. economic growth accelerated from April to June as taxpayers spent their federal rebate checks and a weakened dollar boosted exports, the government reported today.

According to new data from the Department of Commerce, gross domestic product grew at an annualized rate of 3.3 percent in the second quarter of the year, the fastest rate since mid-2007. The department had initially estimated growth for the period to be 1.9 percent, but more complete data -- particularly on exports by U.S. companies -- showed the economy to be growing faster.

The new data offer a respite from a period of sluggish growth. GDP shrank in the last three months of 2007 and grew at an annual rate of less than 1 percent from January to March of this year.

Whether that pace of growth continues, however, is another issue.

Taxpayers in May and June, for example, received more than $100 billion in rebates from the federal government. That money helped boost consumer spending compared to the prior quarter -- but won't be available to sustain it going forward.

A recent recovery in the value of the dollar, meanwhile, and slowing growth abroad could temper what has been a rapid rise in exports. Exports have been a key support for a U.S. economy buffeted by a falling real estate market and a financial crises that has spread from brokerage firms to include banks and mainstay companies such as mortgage giant Fannie Mae.

Yes, but now gas prices are falling.  It looks like amidst all the doom-and-gloom, we may not even hit a recession.

Issue #1

McCain Talks Straight on Fan-Fred Reform (Larry Kudlow, 7/30/2008)

There will be no more business as usual for housing lenders Fannie Mae and Freddie Mac if John McCain is elected president. That's McCain's clear message in a recent hard-hitting op-ed in the St. Petersburg Times and in various straight-talk media interviews.

Politically powerful Fannie and Freddie may be popping champagne corks in Washington, where a congressional bailout package provides full government backing for their outsized management pay packages, massive political-contribution and lobbying practices, and private portfolio hedge-fund activities. These government-sponsored enterprises (GSEs) got just what they wanted, and they now have the power to pay more dividends to their shareholders without any caps on compensation.

But Big Mac is gonna put an end to this if he's elected come November.

"Americans should be outraged at the latest sweetheart deal in Washington," writes McCain. "Congress will put U.S. taxpayers on the hook for potentially hundreds of billions of dollars to bail out Fannie Mae and Freddie Mac. It's a tribute to what these two institutions -- which most Americans have never heard of -- have bought with more than $170-million worth of lobbyists in the past decade."...

John McCain has taken a strong reform position here, and he's totally right. This is McCain at his very best. He argues that Fannie and Freddie employees manipulated financial reports to line the pockets of senior executives. He calls the GSEs a danger to financial markets. And he says if one dime of taxpayer money ends up in those institutions "the management and the board should immediately be replaced, multimillion dollar salaries should be cut, and bonuses and other compensation should be eliminated. They should cease all lobbying activities and drop all payments to outside lobbyists."

He also argues for strong regulation of Fan and Fred "that limits their ability to borrow, shrinks their size until they are no longer a threat to our economy, and privatizes and eliminates their links to the government."

McCain economic advisor Steve Forbes wants to breakup Fannie and Freddie into 10 or 12 companies, completely severing their ties to the government. With these private companies competing in the mortgage market, Forbes says the entire housing sector will be revived, with taxpayers off the hook for a change.

 

Hear hear!  This is the most important issue in America right now.  And it's the perfect McCain issue.  A lot of McCain's complaining about pork, though correct, has been low-stakes.  This goes to the heart of the American economy.  This is where McCain's campaign finance reform credentials meet McCain's porkbuster credentials meet McCain's Reaganite origins meets McCain's Teddy Roosevelt reformist patriotism.  I was hoping McCain would filibuster the housing bill, but maybe that would have been quixotic.  Anyway, McCain can undo the damage from the White House.  If McCain can just articulate how important this is, this is the issue where he can show that he's the man to fix the economy. 

With all due respect to Greg Mankiw, it looks dumb to have spilled so much ink on small beans like the gas tax holiday when Fannie and Freddie are in the scales.  Particularly when the spike in oil prices turns out to have been a bubble, and the gas tax holiday would just have smoothed prices for a couple of months before the bubble burst.

UPDATE: The Homeownership Obsession, Robert Samuelson:

The real lessons of the housing crisis have gotten lost. It's routinely portrayed as the financial system run amok; the housing market became a casino. The remedy, we're told, is to enact rules that prevent a repetition. All this is partly true. But it ignores a larger truth: Our infatuation with homeownership, embedded in dozens of government policies, has turned housing -- once a justifiable symbol of the American dream -- into something of a national nightmare.

As a society, we're overinvesting in real estate. We build too many McMansions. They use too much energy, and their carrying costs, including mortgage payments, absorb too much of Americans' incomes. We think everyone should become a homeowner, when many families can't or shouldn't. The result is to encourage lending to weak borrowers who are likely to default. The avid pursuit of a few more percentage points on the homeownership rate (it rose from 64 percent of households in 1994 to 69 percent in 2005) has condoned enormously damaging policies.

Does every house need a "home entertainment center"? Well, no. But when you subsidize something, you get more of it than you otherwise would. That's our housing policy. Let's count the conspicuous subsidies...

We might curtail housing subsidies without exposing the economy to the disruption of outright elimination. The mortgage interest deduction could be converted to a less generous credit; Fannie and Freddie's expanded powers could be made temporary; the FHA's minimum down payment could be set at a more sensible 5 percent. But even these modest steps would require recognizing that the homeownership obsession has gone too far. It would require a willingness to confront the huge constituency of homeowners, builders, real estate agents and mortgage bankers. There is no sign of either. When tomorrow's housing crisis occurs, we will probably find its seeds in the "solution" to today's.

That's why McCain's ability to demagogue a bit, focusing his attacks on the seven-digit salaries of Freddie's and Fannie's executives, rather than on a national homeownership obsession-- as I would put it, a propensity to subsidize sprawl, a social-engineering scheme to turn everyone into a suburbanite bourgeoisie-- whose harms it might be hard for McCain, or for ordinary voters, to understand.  McCain's sense of honor serves as a remarkably good substitute for economic analysis.

The Bush Economy

Some revealing charts at RealClearMarkets.  First, "Getting Richer, Paying More."

Particularly noteworthy is that the share of income earned by the top 1% of households did not increase during the Bush administration; rather, it jumped during the Clinton administration.  It rose steeply, from 10.3% to 15.5%, between 1995 and 2000.  By contrast, under the Bush administration it stayed almost exactly the same, going from 15.5% to 15.6%.  Yet while the rich haven't gotten (relatively) richer under Bush, they have started paying more taxes: the share of taxes paid by the top 1% has risen from 25.5% to 27.6%.  The facts don't support the idea that the Bush administration has been a president for plutocrats.

How this can have occurred even as Bush cut taxes on the rich I don't pretend to know.  I'll hazard a guess that could be completely wrong.  In the 1990s, the rich got big capital gains.  Since 2000 they've got less capital gains and more wage and salary income.  And I think wage and salary income is taxed at a higher rate than capital gains.  Maybe this has nothing to do with the administration-- there was a stockmarket bubble in the 1990s, it burst, all quite independently of the political process.  However, it's worth noting that among Bush's tax cuts was a tax cut on dividends.  Now, when dividends are heavily taxed-- "double taxation of dividends," as it is sometimes called, not because of high rates but because taxes hit the same cash flows twice, as corporate taxes and then as taxes on dividends, before they get to the shareholder's pockets-- companies may be inclined not to pay dividends, but to re-invest profits and drive up the value of the stock.  Capital gains become a substitute for dividends, and possibly an inefficient one if the company's internal investment opportunities aren't all that great, and it would be better to recycle the cash to other firms with better prospects.  So, after the tax cut, firms started making big profits and paying big dividends.  Again, I'm not at all sure that this is the explanation of the puzzling increase in the share of taxes paid by the top 1%, or even that it's part of the explanation.  I'm just guessing here.  Still, it's a fascinating case study in tax incidence.  Whose income is actually reduced by a tax is not necessarily or even typically the same as the person who pays the tax.  A capital tax cut would seem, prima facie, to benefit the owners of capital, stereotypically the rich.  In fact, it may result in the top 1% paying a larger share of the total tax bill.

Second, "Manufacturing Productivity":

RealClearMarkets' caption, "Outpacing the rest of the economy," is a reminder that manufacturing productivity has been growing faster than nonmanufacturing productivity since the 1970s.  Indeed, it is interesting that a large gap opened between manufacturing and nonmanufacturing productivity growth just then.  But that's old news.  What I find interesting is that (a) productivity in both sectors has been growing faster than at any time since the 1960s, and (b) nonmanufacturing productivity has been closing the gap, a little bit in the 1990s, and much more quickly since 2000.

Again, I'm guessing here... but I would attribute the growth in manufacturing productivity mostly to technology and international factors-- US manufacturers have to compete with emerging Asia-- while I think the growth in service-sector productivity may have a good deal to do with the good policy environment created by the Bush and Clinton administrations.  I'd give top credit to Clinton (and Gingrich and the Contract with America Congress) for passing welfare reform, which taxes away the safety net and increases the incentive for the less-skilled workers in retail, restaurants, etc., to work.  Immigrants, legal and especially illegal, also deserve kudos. 

#2 credit goes to the Bush administration for benign neglect of the regulatory environment and for not passing new welfare measures that affect working-age people.  (His education reforms may also raise productivity in the long run but presumably not yet.)  Also, I wonder if the slightly-higher unemployment in the Bush years has helped productivity growth.  Unemployment was so low in the 1990s that no one needed have much fear of joblessness.  In this decade, people may be just a little worried, and work harder to avoid it.

Paul Krugman, in The Conscience of a Liberal, explains the weird unpopularity of the objectively-robust Bush economy by saying that, although there has been economic growth on average, it has been of a Bill-Gates-walking-into-a-bar character, with gains only at the top, while ordinary people feel left behind.  These charts utterly demolish that interpretation (which seems pretty clearly to be a function of Krugman's liberal ideology and partisanship, rather than of sober, disinterested analysis).  It was precisely in the late 1990s, when the rich grew their share of the pie by 50%, that the economy was uber-popular; in the Bush years, when the rich were standing still, and productivity was growing still faster, everybody was depressed about the economy. 

No doubt unemployment is a big reason.  For some reason, even though for decades swings in unemployment have only changed the employment status of a few percent of the workforce at the very most, perceptions of economic performance seem ultra-sensitive to the behavior of this variable.  So , the 1%-or-so rise in unemployment since the 1990s has caused tens of millions to see the economy as on the wrong track.

I wonder, whether people don't measure the performance of the economy as much as anything by the frequency of get-rich-quick headlines in the media.  The Bush economy has been good for the typical person, but it hasn't generated enough Horatio Alger stories to give us that proud-to-be-American feeling.

UPDATE: Hmm... According to the charts above, this claim:

One fundamental fact cited by Douthat and Salam is this: "Over the last 25 years, most of America's economic gains have been concentrated in the hands of those with four-year college degrees -- and, over the past five years, in the hands of the top one percent, even the top 0.1 percent, of the income distribution."

... is just false.