The Free Thinker

Interest, Usury, and Mortgages

I believe the prohibition of interest has been a common feature of the moral rules of several civilizations. Interest was condemned by Aristotle and generally by the ethical systems of the ancient world. It was treated as a sin by the medieval Catholic Church and subject to bans and punishments. And Islam also forbids interest today, a rule that Muslims, unlike modern Christians, still regard as binding, which has driven the emergence of "Islamic banking."

Contemporary economists, by contrast, habitually regard both legal prohibitions and moral strictures against interest as pure superstition. They regard interest, on the contrary, as both necessary to the functioning of the economy, and as morally innocuous. All the prohibitions of interest by philosophers and ecclesiastics for so many centuries they regard as based on the simple fallacy that regards it as "unfair" to get more money tomorrow for money lent today because of the inequality of the sums of money involved. But of course, money-today is not the same commodity as money-tomorrow: for one thing, prices may have changed; but even if they haven't, there is a set of opportunities between today and tomorrow to which money-today gives you access and money-tomorrow doesn't. For people to exchange money-today for money-tomorrow is perfectly sensible and rational on both sides, like trading haircuts for nails or bread for cars or any other ordinary, voluntary, mutually beneficial exchange, and there's no reason that the price should be $1:$1.

Who is right? Mostly the economists. Interest is certainly necessary; it is often innocuous and useful; prohibiting loan interest is a very bad idea; and the motive for past prohibitions has usually been simple fallacies combined with the aristocratic class prejudice and philosopherly impracticality. However, there is one valid argument on the other side. Laboratory experiments have shown that people often exhibit hyperbolic discounting behavior, a fancy term meaning that they place a higher relative value on present enjoyment than is consistent with their desires when they are taking the long view. It seems to be human nature to be somewhat impulsive and to behave in ways prejudicial to one's long-run well-being, to the extent that people sometimes invest in costly self-control mechanisms. (Example: If I remember right, it has been shown statistically that people buy gym memberships even though it would be cheaper to pay per visit; the argument is that they foresee this, but are trying to bind themselves to exercise regimens by lowering the marginal cost of visiting the gym.)

If (some) people are impulsive, other people can exploit this weakness, giving them money now for prices in future money that their long-run selves would not agree to. How to do welfare analysis when people have time-inconsistent preferences presents difficulties, but plausible intertemporal utility functions would support the folk economics idea that loan sharks harm their customers. It might be useful to define usury as lending at interest that exploits people's impulsive short-sightedness, and interest as lending at interest to rational borrowers who have good reasons to place especially high value on money-today. Of course, an external observer couldn't always tell, and you might never be completely certain, whether any given transaction was a case of usury or interest. Even the lender and the borrower might not know. Indeed they might know least of all: they would have the best information, but maybe also incentives for self-deceit.

I think the Christian attitude should favor interest, thus defined, and oppose usury. It should be regarded as a sin to lend money at interest if the lender has strong reasons to think that the borrower is being impulsively short-sighted and will regret the loan later. It might also be good for the law to prohibit usury. This is paternalistic, but perhaps not coercively so, The law could (maybe it does, I'm not sure) simply say, "We define such-and-such contracts as usurious and therefore invalid, and we will not enforce them. If a usurious lender wants to simply trust his borrowers to repay, we won't interfere, other than to make it clear to borrowers that they are entirely at liberty to walk away from such illegal debts; of course, a lender who tries to recover his money by any but purely social and moral pressure will be treated as any other extortionist."

But of course, the problem is how to prohibit usury without prohibiting interest. That can't be done perfectly. The moral usury/interest distinction will not correlate perfectly with any particular interest rate or form of contract. A loan at 0% interest might be motivated by instant gratification, while a prudent entrepreneur may occasionally have sound business reasons to borrow even at very high interest. Some entrepreneurial ventures might be recklessly self-indulgent, while other loans purely for present consumption (think of a payday loan to provide a wedding reception for one's daughter) might be quite consistent with making the best use of one's resources in the long run. The ideal might be a combination of law and moral suasion. Usury laws should prohibit the most abusive forms of lending, even at the expense of occasionally curtailing entrepreneurship; but they should allow a wide range of lending practices and rates, even though this will leave the door open to a good deal of substantive usury and exploitation. Meanwhile, churches and civil society organizations should use exhortation and stigma to shape norms so that moneyed persons will use moral discernment to try to lend only in a manner that benefits their borrowers.

A system of "morally sound" financial practices as described above would likely have prevented much of the crisis. Of course, we have some of it already: usury laws are on the books. Yet all in all our society is the opposite of the medieval Catholics: the state not only does not prohibit lending at interest, but subsidizes it. Student loans are one instance of this, and perhaps the policy of putting young people in so much debt gets less criticism than it deserves. But the most egregious example is the mortgage-interest tax deduction, which creates strong incentives for much of the population to become deeply indebted. It's clear now, in the wage of the largely mortgage-driven crisis of 2008, that much of the home mortgage industry was usurious in the sense described above, yet this industry was, and still is, being subsidized by the tax code. Surely this is perverse and should be abolished. We shouldn't go back to medieval prohibitions of usury, but perhaps something in between?

"It's Still the Economy, Stupid" (Daniel Henninger):

It's been a long time since James Carville said the most famous thing he ever said: It's the economy, stupid. That famous phrase was in fact part of a sign hung in the Clinton campaign headquarters in 1992. There was a sense among the electorate in the fall of 1992, not entirely accurate, that the economy was foundering under George H.W. Bush. Bush lost control of the public's perception of the economy, and then he lost the presidency.

Why with unemployment heading above 10% was Barack Obama on TV last night draining a dwindling reservoir of presidential capital on health care? Redesigning the 17% of the economy that is health care appears to be the siren song of Democratic presidencies. Mr. Obama's crew has famously said it wouldn't make the mistakes the Clintons made on health care. How calling forth both houses of Congress in prime time to join him in betting the ranch on health care qualifies as smarter politics than the Clintons is a mystery.

Even more so now than way back in 1992: It's still the economy, stupid.

To save himself and his party from enduring another health-care debacle, Barack Obama should put his agenda on the back burner, bend his efforts to raising the economy, and rebuild his political capital by taking credit for the inevitable rebound. That just might minimize the impending loss of House seats and allow him to revisit his wish list in 2011. The alternative is promising big, accomplishing little and getting credit for nothing. This could be America's greatest failed presidency.

The economy is Barack Obama's 9/11. If you're Mr. Obama, it must seem a little unfair. One year ago at the Labor Day turn toward the stretch, Mr. Obama and his team were on the cusp of one of the most thrilling wins in American presidential history. No matter that many Obama voters were looking past all the state-based initiatives in his politics; the air was filled with possibility.

Except that Obama wouldn't even have won the election without the financial crisis.  McCain was just overtaking Obama in the polls when the financial meltdown hit and spooked the sheeple into numbly doing what the MSM told them.  But I think Henninger's right: Obama should be trying to solve the country's problems, not creating more.  To deal with health care now is self-indulgent.  The bizarre timing of the health care drive is a function of the fact that the voters aren't likely again to make the mistake they did in 2008, so the Democrats want to (ab)use their power while they still have it.

Publicity for "Economic Contractions in the United States: A Failure of Government"

From my co-author Charles Rowley, in the Daily Telegraph: "Adam Smith would not be optimistic in today's economic world: Adam Smith once commented that "there is a great deal of ruin in a nation". He meant that bungling governments imposed only a limited check on the economic performance of a Great Nation."  This article accompanies the launch of Economic Contractions in the United States.  For regular readers of this blog I'll stop to point out my... differences of emphasis... as appropriate:

As Nathanael Smith and I show in our study of US economic contractions, Adam Smith would be much less sanguine were he confronted by today's financial crisis and the US government's response. Indeed, it is not impossible that the US will experience the kind of economic collapse from first- to third-world status experienced by Argentina under the national socialist governance of Juan Peron.

"Not impossible" is so weak that it makes the claim innocuous, I suppose, but this seems like an exaggeration, and it seems to conflict with the 7th chapter of Economic Contractions, where we predict that "profligate deficit-spending and interventionism" will produce disillusionment and a conservative revival (p. 97)-- a prediction that events seem to be bearing out.

The US economy suffers from a growing culture of indebtedness that has increasingly contaminated the federal government since 2001 and has spilled over dramatically into private household behaviour. The combination of the ill-conceived fiscal-furnace fired by President Bush and the US Congress and the reckless monetary-furnace fired by Alan Greenspan and Ben Bernanke throughout the period 2001-2007, created unsustainable housing market and stock market bubbles whose collapse brought on the financial crisis and economic contraction of 2008-2009.

I would put the charge in more measured terms.  Fiscal policy under George W. Bush was less expansionary (smaller deficits as a share of GDP) than under Ronald Reagan, even though the US was at war in the Bush years and not in the Reagan years.  (At a time when Obama and the Democratic Congress are redefining "reckless" in the upward direction at a rate of $100 billion a month or so, it seems strange to use the term for the Bush administration, though the Bush administration should certainly have known better.)   And while interest rates stayed low in 2003-04 for too long after recovery had begun, they then rose steeply, so "throughout the period 2001-2007" seems to make the charge too broad.  Even the low interest rates of 2003-04 seem more like a serious technical mistake combined with having the wrong Fed policy rules-- housing should have been included in the CPI-- than "reckless."  And dating the problems to 2003-04 would seem to absolve Bernanke and concentrate responsibility on Greenspan. 

What led to the bubble was that (a) fiscal and monetary policy were expansionary at the same time for the first time since the 1970s, and (b) house prices were-- we argue, mistakenly-- excluded from the price index, causing the Fed to see "low" inflation at a time when house prices were rising at well over 5% per year.  What I find ironic is that, in a sense, the crisis is Osama bin Laden's revenge.  Bin Laden wanted to deal a devastating blow to the US economy.  Determined to deprive him of this victory, Bush and Greenspan adopted expansionary fiscal and monetary policies that lifted the economy out of what could, and maybe should, have been a deep recession in 2001.  As a result, they inflated a debt bubble and made the next crisis sooner and deeper.  Fortunately, al Qaeda was ruined by the war in Iraq, so bin Laden's victory is Pyrrhic.  But if the government had let the 2001 recession play itself out naturally, there might not have been any 2008 crisis.

The policy responses to the debt bubble demonstrate crude political consideration rather than economic understanding. If excessive government indebtedness is a major source of the problem, why increase the government debt? Why encourage households to go yet further into debt?

The prognosis is catastrophic if projected government policies are not cut back. According to the White House's own estimates, the federal budget deficit in 2009 will be $1.6 trillion, approximately 11.2pc of the overall economy, the highest on record since the end of the Second World War. In 2019, the national debt will represent 76.5pc of the US national economy, the highest proportion since just after the Second World War. In such circumstances, the international reserve status of the US dollar will not survive. As it fades, so interest rates on government securities will rise and the real burden of servicing the debt will increase. In such circumstances, the US economy will teeter on the edge of a black hole.

Hmm... why bring in "the international reserve status of the US dollar?"  I don't remember anything about that in the monograph.  Do we have-- does anyone have-- a theory relating government debt to the viability of a reserve currency?  Personally, if there were some way to transition out of a dollar regime without global chaos, I think it might be nice not to own the world's reserve currency: I think being able to print the world's reserve currency causes a form of "Dutch disease," undermining the competitiveness of our industries and fueling excessive growth of government.  Also, why would more debt cause the US economy to "teeter on the edge of a black hole," rather than, say, acting as a drag on growth and depressing living standards for decades-- as it has arguably done in Japan?  Government debt in Japan and Italy is way above 76.5% of GDP; both countries have suffered malaise rather than crisis.

Prosperity and full employment in the US will only be restored by a return to laissez-faire capitalism. Our study outlines a radical, but politically feasible, approach. Monetary policy should be expansionary. But, on the micro-economic side, tariffs and other trade barriers should be repealed unilaterally; a "Right-to-Work" Act should reduce the minimum wage and curtail the powers of unions; and business regulation should be reduced. Individual banks and their counterparties should not be bailed out, although the system should be protected by ensuring that failing banks are wound up in an orderly fashion – this is the only way to restore market discipline.

A little late not to bail out individual banks, no?  Rather say that laws and policies should be rewritten so as to prevent future bailouts (except of insured deposits through the FDIC).  And is it really "politically feasible" for "tariffs and other trade barriers [to] be repealed unilaterally?"  Maybe!  I wouldn't rule out the possibility that bold, visionary political leadership can make the politically impossible possible -- after all, Obama seems to have made people dislike unions and appreciate the health care status quo! -- but that is as much as to say that the range of the "politically feasible" is very broad.

Rowley and I found enough to agree on to put a book together, but he might have a tendency to overclaim. 

MORE: "Barack Obama accused of making 'Depression' mistakes: Barack Obama is committing the same mistakes made by policymakers during the Great Depression, according to a new study endorsed by Nobel laureate James Buchanan." (Daily Telegraph):

"Endorsed by Nobel laureate James Buchanan."  That's brilliant marketing.  But it's not false advertising, for here is Buchanan's Frontispiece:

A comprehensive and coherent assessment of the current economic contraction, one that largely rebuts attribution of failure to capitalism or the market. The targets become practicing politicians of all parties, whose cumulative mistakes have now hurt us all. We have learned some things to reduce the severity of the current contraction. But we have made no progress toward putting limits on political leaders, who act out their natural proclivities without any basic understand of what makes capitalism work.

Anyway, here's what Edmund Conway of the Telegraph has to say:

His policies even have the potential to consign the US to a similar fate as Argentina, which suffered a painful and humiliating slide from first to Third World status last century, the paper says.

There are "troubling similarities" between the US President's actions since taking office and those which in the 1930s sent the US and much of the world spiralling into the worst economic collapse in recorded history, says the new pamphlet, published by the Institute of Economic Affairs.

In particular, the authors, economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute, claim that the White House's plans to pour hundreds of billions of dollars of cash into the economy will undermine it in the long run. They say that by employing deficit spending and increased state intervention President Obama will ultimately hamper the long-term growth potential of the US economy and may risk delaying full economic recovery by several years.

Excellent.  The title of the Telegraph piece may slightly overplay the 'Depression' analogy -- while we do identify some similarities with policies from the Depression era, monetary policy is (no thanks to Obama) just the opposite, and we haven't seen anything like the crazy tax hikes of Hoover and FDR yet though there are some ominous signs -- but this last paragraph nicely captures a central argument of the book.  Conway continues:

The study represents a challenge to the widely held view that Keynesian fiscal policies helped the US recover from the Depression which started in the early 1930s. The authors say: "[Franklin D Roosevelt's] interventionist policies and draconian tax increases delayed full economic recovery by several years by exacerbating a climate of pessimistic expectations that drove down private capital formation and household consumption to unprecedented lows."

Heh.  If Rowley and I get credit for debunking the myth that FDR's Keynesian New Deal got us out of the Great Depression, that would be as unfair as Columbus getting credit for debunking the myth that the world is flat.  To our cost, this myth remains potent at the popular level, but among economists I don't think even Paul Krugman would defend it.  Rather, Keynesians claim that WWII got us out of the Great Depression.  This is also debatable -- "GDP" grew, but should bombs and guns and tanks count as GDP, when they don't contribute to human happiness; or if they do count as GDP, don't we need some more appropriate way of measuring the economy's contribution to human well-being, which would likely put paid to the odd notion that WWII was an economic golden age? -- but it has no bearing on the episode Rowley and I deal with, namely the 1930s.  It's rather odd that at this late date anyone can make headlines with what ought to be a truism, namely that the New Deal exacerbated, rather than "got us out of," the Great Depression, but if that's still news to a lot of people, then those headlines need to be made.  Conway continues:

Although the authors support the Federal Reserve's moves to slash interest rates to just above zero and embark on quantitative easing, pumping cash directly into the system, they warn that greater intervention could set the US back further...

And then proceeds with quotes from Rowley and Buchanan, already quoted above in this post.  I'm glad that the message is clear that we support quantitative easing.  On that point we're basically Milton Friedman-type monetarists.  Too bad our advocacy of immigration reform and Social Security reform doesn't seem to be making it into the reviews so far!

"Warning: The deficits are coming!" (John Fund, WSJ):

David Walker sounds like a modern-day Paul Revere as he warns about the country's perilous future. "We suffer from a fiscal cancer," he tells a meeting of the National Taxpayers Union, the nation's oldest anti-tax lobby. "Our off balance sheet obligations associated with Social Security and Medicare put us in a $56 trillion financial hole—and that's before the recession was officially declared last year. America now owes more than Americans are worth—and the gap is growing!"

His audience sits in rapt attention. A few years ago these antitax activists would have been polite but a tad restless listening to the former head of the Government Accountability Office, the nation's auditor-in-chief. Higher taxes is what hikes their blood pressure the most, but the profligate spending of the Bush and Obama administrations has put them in a mood to listen to this green-eyeshade Cassandra. "He's so unlike most politicians," says Sharron Angle, a former state legislator from Nevada, "his message is clear, detailed and with no varnish."

This historical analogy is crazy in most ways, but in two respects America today bears a weird resemblance to France before the 1789 Revolution: (a) it is being paralyzed by an unmanageable debt burden, and (b) status-seeking. In pre-Revolutionary France, the status symbol du jour was public office, and I've read that people would buy offices for more than the value of the bribes they would recover, just for the prestige. Today, the status symbol du jour is education. My hunch is that what the country really needs is for less people to go to lots of school and for more people to start businesses. (I realize the irony of my saying this.) And I actually suspect people might even learn more (more about life, more building of character) that way.

UPDATE: It occurs to me that the deficit and the status-seeking problems may be related. Why start a business if a mind-bogglingly indebted government seems likely, sooner or later, to confiscate whatever wealth you create if you succeed? Even if an education is worth less than the money and foregone income you spend to get it, at least the government can't take it away!

Subprime Uncle Sam

Megan McArdle on "The Risk of Debt":

So why should we worry about the ability of the government to borrow?  For the past decade, at least, the American government has been able to borrow pretty much all the money it wanted without seeming to pay much of a price in terms of higher interest rates.  Bush's deficits were worrying in a number of ways, but they certainly didn't crowd out private investments, and we got a good deal on the money.

Bush's deficits didn't crowd out private investments?  I'm not so sure.  Investment was down in 2001-2008 relative to the 1990s.  And what investment there was was concentrated in housing, a sector that (a) is politically favored, and (b) where the investors are ordinary people who might be less savvy to the changing future than businessmen are.  I'd bet that Bush's deficits did crowd out private spending.  Not that we'll ever exactly know.  McArdle continues:

But Obama's spending plans are extraordinarily ambitious.  His projected deficits for the rest of his possibly presidency are higher than the "runaway" deficits that plagued most of the Bush administration--and after the first few years, that's not stimulus, that's ordinary spending outstripping revenue.  For a while now, I've been asking people at conferences, on and off the record, what America's sovereign debt risk is?  That is, how long until people stop treating treasuries as the "risk free" securities, and start demanding a premium for the risk that we might default.

The answer from the right has been a nervous (perhaps hopeful) 2-3 years.  The answer from the left, and professional Democratic wonks, is some unspecified time in the future.  Probably, there will be a Republican in charge.  Markets hate Republicans.

But last Thursday, the Treasury auction was . . . well, descriptions vary from "weak" to "horrible".  This raises the unpleasant possibility that markets are, as my business school professors insisted, "forward looking".  Voters may believe that getting a bunch of special interests to agree in principal that costs should be cut is the same thing as actually cutting costs.  Bond markets don't.  That's why James Carville famously wanted to be reincarnated as the bond markets so he could "intimidate everyone".

In hindsight, it seesm obvious that subprime borrowers were taking out loans they couldn't afford and were headed for disaster.  What will Obama's spending plans look like in hindsight?

Debt-Deflation

Ed Glaeser:

In the stock market, crashes can happen in hours or even minutes.  In the housing market, crashes take months and years.  Homeowners with their houses on the market, don’t just get up one morning, smell the coffee and decide to reduce their asking prices by forty percent.  It takes time for people to recognize that a bubble has burst, and plenty of sellers never do.  They just sit on their homes for years until the market turns around. 

As we are in the midst of the slowly unfolding collapse of the greatest housing price bubble in the short history of well recorded housing prices, each month’s data brings little change.  Instead, month after month, we got the slow wheeze of a bubble bursting.  The January 2009 Case-Shiller house price data, released this morning, by Standard and Poor’s, looked a lot like last month’s data. The decline between November and December for the composite 20 index was 2.6 percent; the decline between December and January was 2.8 percent.    Don’t get excited by the fact that last drop was a little higher: those numbers are essentially indistinguishable. 

The cities on sand—Phoenix and Las Vegas—continued to have some of the biggest price declines.  Phoenix prices dropped by 5.5 percent between December and January; they fell by more than five percent between November and December.  Las Vegas’ price declines have been trending at 4.5 percent down per month.  If the trend continues, by February, Phoenix prices will have dropped by more than 50 percent since the peak. 

I am somewhat surprised that these markets aren’t starting to settle down.  The defining characteristic of these two areas, and many other affordable, growing places like Dallas and Houston, is that their ability to supply housing is essentially unlimited.  Since builders can produce housing in practically enormous quantities at reasonable prices, and land is essentially infinite, it was always a little absurd for people to pay so much more than construction costs for housing in these areas.  But now prices are converging back on construction costs, which is where I had thought that they would land.  However, the rate of decline isn’t slowing, and it now looks as if prices might dip below these costs.  If that happens, then building will essentially cease.  This would be a colossal change, since the Phoenix and Las Vegas areas together permitted more than 30,000 units last year.

After these two places, the most diminished housing markets are in California and Florida. San Francisco, Miami and Tampa all continued to have dismal months. Prices in Los Angeles and San Diego each did slightly better, dropping by about 2.7 percent, but that looks good only by comparison. Prices in these five areas have declined by about 40 percent relative to the peak. These areas had some of the biggest price booms and now they are experiencing some of the biggest price busts. Reversion to the mean is a regular feature of housing markets and they are experiencing that now...

The housing news continues to be bleak for the financial actors who are holding mortgages, the value of which is tied to housing prices.  Continuing price declines probably mean that the banks will need even more bailout money. 

Yet, these declining prices aren’t all bad.  When prices fall, buyers get bargains.  One of the glories of America is that people are able to buy high quality houses at affordable prices.  We had lost some of that advantage during the unfortunate bubble, now we are getting it back. 

Yes, there's a bright side to falling real housing prices.  But falling nominal housing prices cause major institutional problems.  This is the phenomenon Irving Fisher called "debt-deflation" in the 1930s and identified as a major cause of the Great Depression: when the prices of assets that are used as collateral fall, the incentive-compatibility of loan contracts is destroyed.  That's why the Fed should not allow asset prices to rise so much.  The Fed should have choked off the housing bubble three or five or eight years ago with higher interest rates.  Now, however, it should do the opposite, and try to reflate housing prices-- nominal housing prices-- to something nearer their 2006 level, at the expense, if need be (and need probably will be) at the expense of fueling consumer price inflation. 

Fortunately this is sort of what the Fed is trying to do.  Monetary policy is by far the brightest spot in economic policy right now.  It's the one thing that definitely distinguishes the policy response today from that in 1929-33, when monetary policy was contractionary, and it's the main reason that this is not likely to be Great Depression II.  Most of the rest of what the government has done has been hapless at best and perverse at worst (the "stimulus," the Obama budget), and might just make this Great Depression II after all despite much better monetary policy.

Krugman doesn't like Geithner's bank plan:

Over the weekend The Times and other newspapers reported leaked details about the Obama administration’s bank rescue plan, which is to be officially released this week. If the reports are correct, Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy — specifically, the “cash for trash” plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.

This is more than disappointing. In fact, it fills me with a sense of despair.

After all, we’ve just been through the firestorm over the A.I.G. bonuses, during which administration officials claimed that they knew nothing, couldn’t do anything, and anyway it was someone else’s fault. Meanwhile, the administration has failed to quell the public’s doubts about what banks are doing with taxpayer money.

And now Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.

It’s as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street. And by the time Mr. Obama realizes that he needs to change course, his political capital may be gone.

But the stock market does:

Wall Street got the news it wanted on the economy's biggest problems -- banks and housing -- and celebrated by hurtling the Dow Jones industrials up nearly 500 points.

Investors added rocket fuel Monday to a two-week-old advance, cheering the government's plan to help banks remove bad assets from their books and also welcoming a report showing a surprising increase in home sales. Major stock indicators surged about 7 percent, including the Dow, which had its biggest percentage gain since October.

If Krugman is right about Geithner's plan basically being a recycled version of the Paulson Plan, the stock market's positive response is a sort of vindication for the Bush administration's bold crisis management in late 2008.  The problem with the Paulson Plan bears a certain resemblance to the Iraq War: it was a bold, unorthodox, big expensive radical move that actually got it right, but was not adequately explained to the public.

Dow Surges Back

"Stocks Post Best Rally of 2009 on Improved Citigroup Outlook" (Bloomberg)

March 10 (Bloomberg) -- Stocks around the world staged the biggest rally of the year after Citigroup Inc. said it was having its best quarter since 2007, spurring speculation the worst of the banking crisis is over. Treasuries and gold fell.

Citigroup jumped 38 percent as Chief Executive Officer Vikram Pandit wrote in an internal memorandum that the bank, which reported five straight quarterly losses, was profitable in the first two months of 2009. JPMorgan Chase & Co. climbed 23 percent and Bank of America Corp. surged 28 percent as Federal Reserve Chairman Ben S. Bernanke urged an overhaul of financial regulations. General Electric Co. rose 20 percent, its steepest advance since at least 1980.

“If we’re not at a bottom, we’re a pretty close,” said Michael Binger, Minneapolis-based fund manager at Thrivent Asset Management, which oversees about $60 billion. “It’s time to start putting money into stocks. Stocks are cheap and worldwide stimulus will eventually help lift earnings.”

The Standard & Poor’s 500 Index rebounded from a 12-year low, increasing 6.4 percent to 719.6 as all 10 industry groups rose more than 2.3 percent. The Dow Jones Industrial Average added 379.44 points, or 5.8 percent, to 6,926.49.

Wow.  That's great.  A stockmarket rebound encourages investment, by making capital more valuable, and investment is the key driver of the business cycle in normal times, though this one is very different in many ways.  That said, I suspect stock prices would have to rise quite a bit before firms would see a point in growing the capital stock.  Even with stocks pushing 14,000 investment was sluggish.  Meanwhile, here's a warning: "Ease Up on the Gas Pedal, Bernanke!"

Inflation is reigniting. The U.S. Bureau of Labor Statistics announced last week that consumer prices, which had declined from November and December, rose 0.4% between December and January, an inflation rate of 4.9% on an annualized basis. The bureau announced earlier that producer prices rose 0.8% in the same period, a 10% annual rate of inflation.

Why is this happening? The answer is painfully clear. From the end of January 2008 to the end of January 2009, the Federal Reserve's monetary liabilities, the sum of currency and bank reserves known as the "monetary base," more than doubled. This is a year-over-year expansion unprecedented in the Fed's history. During the last three months of that period alone, the base grew an incredible 50%. (At that pace, it would have quintupled in a year's time.) The base has thankfully receded a bit in February.

Broader measures of the money stock reflect the rapid growth in the base. The M1 measure (the sum of the public's currency and checking deposits) has grown at an annualized rate of 23% over the last six months, while the broader M2 measure has grown at 15%. As standard theory predicts, this rapid money growth has pushed short-term interest rates to historic lows. For the last 10 weeks 12-month Treasury bills have been trading at yields below 0.6%.

For perspective, flash back to the early years of the Great Depression. Between 1929 and 1932, runs on the banking system led to a sharp decline in the money stock, leading in turn to a general deflation. The best-known historians of the event, Milton Friedman and Anna J. Schwartz, faulted the Federal Reserve system for not using its money-creation powers to stop the decline.

In a 2002 speech at a conference honoring Milton Friedman on his 90th birthday, Ben Bernanke promised that the Fed would never again commit that error. Today, as chairman of the Fed, Bernanke is so eager to fulfill his promise that he is erring strongly on the side of monetary overexpansion.

Chairman Bernanke is quite right to want to avoid a collapse of the money stock, because when that happens, economic activity contracts needlessly. Certainly the Fed should not sit idly by while the money stock shrinks.

But today's money stock is not collapsing--not by a long shot. Moreover, while asset prices have fallen over the past year due to the bursting of real estate and stock market bubbles inflated by years of excessive money growth, the prices of consumer goods and services have not. The decline of asset prices thus does not represent a general deflation. Instead, it represents the correction of a relative price distortion. The reduction in asset prices is actually the beginning of recovery; thus, an effort to prop up asset prices delays recovery.

It's true that the decline of asset prices represents the correction of a price distortion.  But that correction could occur either by asset prices falling or by consumer prices rising.  If you have a $200,000 home that should be worth $100,000, the correction could occur through asset prices falling by half, or consumer prices doubling.  The latter is better.  Home-price deflation is disastrous because it creates a lot of deadbeat debtors, gives people an incentive to walk away from mortgages, and kills the banks.  Consumer price inflation is also bad, but probably less so.  A big inflation would be, in effect, a generalized partial debt amnesty, which is just what the country needs.  An inflationary five to ten years thereafter is a price worth paying.

If there is a recovery in the near term, the next question is whether Obama's stimulus worked, or whether it was a result of monetary policy by the Fed.  I'd bet on the latter.  I think-- very tentatively-- that Bernanke has been a bit too experimental in bailing out banks and buying private assets, but I've always thought his uber-easy money was the big bright spot in the US government's policy response to the crisis.

Responses to Nato:

If the rest of the world wasn't tanking right along with us, one might have more cause to believe that Obama has some amazing power over the economy, but it is. The PotUS has limited control over US economic performance - especially in the short run - and even more limited impact on the rest of the world.

I'm not at all sure that's true.  First, the fact that the rest of the world is tanking too does not at all prove that the unfolding crisis isn't driven by events in the United States.  I'm not sure anyone understands, exactly why, today as well as in 2000-01, global economic business-cycle movements are so coordinated, and certainly I don't pretend to.  Yet it seems to be the case.  In fact the coordinated drop in stockmarkets worldwide almost inexorably suggests that there is some powerful web of interdependency emanating from the United States.  As for the PotUS's small impact on the US economy, two points: 1) that may have been true in the past, but it's less plausible today because government intervention in the economy has grown so much, and 2) presidents probably have always had much more power to hurt the economy than to help it.

Most economic events are far more easily explained by factors other than the details of Obama's plans.

Explaining stock market movements is hardly ever "easy."  Politics is often the easiest explanation, but may not be the truest.  The 4.2% stockmarket drop on March 2, 2009, is an exception.  Obama revealed a budget that jeopardizes the long-run solvency of the United States in a way that has perhaps never been done before; markets digested the news; and got spooked.  That's why I was able to predict it, which I've never tried to do before and may never do again.

For what it's worth, I think that those details are, on balance, a net negative for the economy, but at a level that would fall well below the noise floor.

How would projected deficits of trillions of dollars, deficits that will never fall below 3% of GDP under the rosiest scenarios, and then explode, be so unimportant as to "fall well below the noise floor?"  I don't get it.  The markets are big, but not so big that fiscal events on this scale are irrelevant.  I have no idea how Obama's fiscal time bombs will play out.  Maybe Congress will strip the Fed of its independence and monetize the debt through inflation.  Maybe there will be a desperate class war as the government fleeces the productive classes to pay its rentiers.  Maybe there will be an outright default.  I think we're kidding ourselves not to admit that Obama's deficits are highly dangerous.  I think they put the whole social fabric of America in jeopardy.  Investors would be idiots not to foresee big trouble, and to commit to projects now is begging to be at the losing end of it.

If this is not true, then it would seem one would have to make some special pleading to avoid Bush 43 being equally responsible for the results during his tenure:

DOW
Oct1 2000:10273
Oct1 2008:10831
0.66% annual growth

Nov3 2000:10817
Nov3 2008:9320
1.84% annual loss

I would hold Bush 43 responsible for these results.  I've defended Bush on Iraq and tried to rein in excessive criticism on the deficit.  Also I was naturally more favorable to the Bush domestic policy record in, say, 2006, than now-- "when the facts change, I change my mind," as the saying goes.  At this point I'm more than ever convinced that the low spending and fiscal conservatism of the late 1990s were great for the economy, that's the bliss point we need to get back to. Clinton and the Gingrich GOP were good; Bush, not-so-good; and Obama, much worse, precisely because he's going even further in the same direction as Bush, cutting taxes and growing the government with new deficit spending.

Neither makes for a very flattering result for Bush 43. Is it his fault? Not really, no, but it's strange that Nathan gives Bush credit for the boom in the developing world while the US economy stayed stagnant, then feels it makes the most sense to attribute the recent stumbles of the global financial markets to the guy who just showed up at the scene.

No, it's not strange. I might be wrong on both counts, but I'd be consistent in my mistakes, attributing too much influence on the world economy to the US and the US president. Actually, recent events, precisely because of the striking degree of global coordination in the crisis, make me rather more convinced than I was that the global boom was driven by US fiscal policy (previously I was just putting it out there without attaching a high likelihood to it).  But it also makes me think the boom may have been of an unsustainable, even unhealthy nature and that it's far less credit to Bush (or anyone else) than it seemed to be in 2006 or 2007.

By all means criticize Obama's responses to the various crises, but reading into every swing of the market - in the presence of other obvious proximal causes of those swings - a verdict on Obama's latest statement is bizarre.

I certainly wouldn't attribute every swing in the market to Obama's statements.  The budget announcement is the most significant statement by Obama so far, because it is the strongest sign yet of what his presidency is likely to be like, and makes it look more left-liberal than it had previously seemed.  It now looks unlike that Obama will be a centrist or moderate in any significant way unless the GOP wins Congress in 2010 and he has to change like Clinton did.  So I do attribute the March 2, 2009 drop to Obama's statements.

More generally, I think the ongoing breakdown and transformation of the US economic constitution in the past six months, towards something far more national-socialist and corporatist, with the possibility of a level playing field for business and a stable public/private dichotomy retreating into a distant dream, is the dominant factor driving market movements in recent months.  This is by no means all Obama's fault.  If anything, until now, the biggest player was Henry Paulson.  The trouble is that Paulson in effect greatly expanded the discretionary, arbitrary role of the federal government in the economy, and this excess power fell into the hands of Obama.  Till now Obama has looked like rather hapless, but now he's asserting himself as an actor in history, and in effect he's waging class war.  He doesn't know he's waging class war.  Presidents usually only have a dim conception of the historical role they're playing-- Clinton had little, Bush only a bit more-- but Obama's grasp of current history is vacuous and childish to an extent that I suspect has few parallels in the history of the Republic.  Suffice it to say that he thinks that his campaign slogans of "hope" and "change" meant something rather than being empty escapism useful in suckering into a coalition an array of malcontents who had nothing substantive in common, which even his cannier supporters knew full well would be exposed as a travesty as soon as he came into office.  He thinks that the liberal counter-narrative of the Bush years was not only a coherent view-- as opposed to a collection of fashionable sneers of latte liberals insulated from responsibility-- but the obvious truth, to which indeed Obama lacks the curiosity to explore the alternatives.  So Obama thinks he's just doing the right thing, acting on the liberal pieties that all right-thinking people knew we ought to do all along and didn't because we were "irresponsible."  But what he's really doing is waging class war.

The deficit, in particular, is an instrument of class war.  It hangs the threat of future tax hikes over the heads of anyone, and investors in new capital particularly, who does anything that will lead to a high future income.  Of course, it might work out differently: maybe the rentiers, the holders of currency and government bonds, will be on the losing end of the class war, if we monetize the debt through inflation.  Obama's tax hikes on the rich I would not class war, if the rich would get something in return, such as a reduction of the deficit that would help raise the stockmarket and put some value into 401(k)s.  But now Obama wants to raise taxes on the well-off and exacerbate the deficits that only point to more tax hikes later.  And he's raising taxes, such as capital gains, that are especially destructive to incentives.  The Atlas class, the class that is at the heart of the nexus of making and doing in this country, is under siege.

The growth of deficits is certainly something Bush can be blamed for.  I think it's a big part of the cause of the present crisis.  But Obama's deficits are on a new order.  With Bush, you could argue, though only just, that the deficits were sustainable, and that we might be able to keep paying the bills without a radical fiscal reorientation.  I don't see how that's possible now.  If I were a representative of the US Treasury trying to explain why it was sensible to lend money to the US, how, given recent political trends, we're going to manage not to go broke in the long run, I don't think I could do it.

I don't think there's a better explanation that that for why the markets are running scared.  Or even close.

"Failed to Assuage"

Bloomberg:

The S&P 500 has fallen almost 17 percent in 2009, the worst start to a year on record, as President Barack Obama and Treasury Secretary Timothy Geithner failed to assuage investor concerns with an $787 billion economic stimulus plan comprised of tax breaks and government spending.

The euphemism deftly balances political correctness and financial reporting.  A verb that more accurately describes what Obama's banana-republic fiscal policy is doing to investor confidence would damage Bloomberg's aura of journalistic neutrality.

Historians may find it worthwhile to distinguish the "economic" and the "political" phases of the 2008-and-onward crisis.  The former might have been relatively brief.