The Free Thinker

Bush: The Great Keynesian Test Case

Thought I'd take a moment to summarize my views on the economic crisis, which I think have undergone a good deal of evolution in the past few months, but also have some continuity.

Causes.  Milton Friedman, in his 1963 classic (with Anna Schwartz) A Monetary History of the United States, turned the discipline of economics upside-down by arguing compellingly that the Great Depression had nothing to do with Keynes' "animal spirits" and aggregate-demand multipliers but, instead, was a result of inept monetary policy by the Fed, which shrunk the money supply and drove down prices during a recession.  My analysis of the current crisis is similar.  The Fed-- Greenspan in particular-- wasn't so much incompetent this time, as he had the wrong mandate.  He was supposed to stabilize consumer prices, while maintaining high employment, and by that standard, he did fine.  It wasn't Greenspan's job to prevent a stockmarket bubble or a housing bubble.  What I think this recession is making clear is that the harms done to the economy by falling asset prices, especially falling house prices, are at least as bad as the harms from falling consumer prices.  Interest rates should have been higher for much of the past ten years to prevent these bubbles from inflating, and maybe we should have accepted a bit of consumer price deflation.  Now, on the other hand, we should try to push house prices at least partway back to their previous level, even at the expense of pushing up consumer prices.

Model updating.  For some reason, Keynesianism is suddenly fashionable.  It makes sense to revise one's model of how the world work when new, unanticipated facts appear.  Call this "model updating."  Keynesianism has lost a lot of ground in the past 40 years; now maybe some people think what they're seeing is causing them to revise their models back in the direction of Keynesianism.  I can't tell whether there are actually many people doing this.  Some economists, Eugene Fama for instance, seem inclined to disregard Keynes entirely, and few seem to be getting on board whole-heartedly with plans for Keynesian stimulus except the usual leftie suspects like Krugman and DeLong.  Is there someone who's been a skeptic of Keynesianism, on theoretical and/or empirical grounds, who has been persuaded to favor it by recent developments?  What are those grounds?

In the past few years-- before the crisis-- I had been "updating my model" in favor of Keynesianism somewhat, because of Bush.  The 2001 recession looked, in some ways, a lot like the 1929 recession: a huge stockmarket boom, driven by lots of new technology, in an era of relatively small and conservative government, led to a sudden crash.  In the 1930s there was a lot of intervention but overall the record of Hoover and FDR was not Keynesian.  One move in particular-- sharp rises in taxes-- was anti-Keynesian, tending to suppress aggregate demand just when, according to Keynesian theory, it was most needed.  The Bush administration, by contrast, spent a lot and cut taxes during a recession-- the Keynesian formula.  And the Fed kept interest rates low.  The result looked pretty spectacular, not so much for the US, which did fine but no better than usual and a bit worse than the late 1990s, but for the world, which enjoyed a spectacular boom for about four years.  So, while I still resisted it at the theoretical level and was far from convinced empirically, I was starting to think, "Maybe Keynesianism works after all."

Now I'm revising my model in the opposite direction.  Bush's deficit tax-cutting and spending pulled the US and world economies along for a few years, and may have prevented (in any case it didn't happen) the 2000-01 stockmarket correction from leading to a depression like that after the crash of 1929.  But this seems to have come at the expense of increasing economic distortions, such as a housing bubble, and growing private and public debt.  Perhaps there's some link between this and the labor force participation rate.  The revised view towards which I'm gravitating is that Keynesianism can work, at least sometimes and if it's pursued quite aggressively, in the short run, but that the long-run price paid in economic and institutional distortions is too high. 

The international dimension of the crisis is very important and that's the part I understand least well. 

Congratulations to Iraqis on their second democratic elections.  The quixotic project of not only regime changing Saddam, which was worthwhile in itself, but also of bringing democracy to Iraq, is looking more and more like a success.  A very crude summary of what Bush did is: 1) Keynesian economics at home; and 2) liberation in foreign policy.  (Social Security and immigration reform were part of his domestic-policy vision but, sadly, not his legacy.)  Now (1) is looking like a bad mistake, and (2) is looking shrewd and far-sighted.  Lesson: Abandon (1), do more of (2).  Unfortunately, Obama looks like he'll do just the opposite.

One more thing.  I've tended to be a little disdainful of popular pessimism about the economy in recent years.  To me, the pretty low unemployment and strong productivity growth of the Bush years (plus strong growth in developing countries) constituted an objectively good economy, and people's economic pessimism showed they were either ignorant or spoiled.  Now, though, I'm thinking that maybe people felt something I wasn't picking up, that they had shrewd premonitions of impending trouble.  Was growing debt, public and private, the signal of turbulence ahead?  If so, might people welcome a sudden embrace of austerity?

UPDATE: It occurs to me that maybe the great politician of our generation is really... Newt Gingrich.  Think about it.  The late 1990s have become the new golden age.  What did we do right that brought us that?  Welfare reform and balancing the budget.  Clinton deserves some credit for that, but he was sort of along for the ride.  Gingrich was the revolutionary, the one who put together a popular platform, ran on it, implemented it, the one who rolled back government enough to give the economy room to grow.  Are there any Newt Gingriches waiting in the wings to grab the steering wheel in 2010?

How Do You Disseminate New Money?

Nobel laureate Robert Lucas likes Ben Bernanke's monetary policy: ("Ben Bernanke is the Best Stimulus Right Now", Wall Street Journal) (hat tip: Tyler)

The Federal Reserve's lowering of interest rates last Tuesday was welcome, but it was also received with skepticism. Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused. Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.

There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount -- lend against -- a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)...

The Fed can satisfy the demand for quality by using reserves -- or "printing money" -- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector...

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.

Now, I'm not criticizing Bernanke here, because I'm sure he's constrained in what he can do by the statutory authority of the Fed, and he's trying to expand the money supply within those limits.  But, legal issues aside, is buying private securities, without looking too carefully at their quality, the best way to get liquidity into the private sector?  To the extent that the Fed is buying private securities for more than the market values them at, those who are in a position to sell/issue such securities are getting, in effect, a subsidy from the Fed, as a side-effect of the way the Fed conducts monetary policy.  That may be a price worth paying to increase the money supply to the level the economy needs, but do we have to pay it?  And what incentives does it create for private-sector actors going forward?  Might it not be better to just issue the money directly to the people?

Is There a Dollar Bubble?

I didn't understand what could justify the run-up of housing prices, but I was hesitant to call bubble.  I didn't have faith that markets knew what they were doing, but I was reluctant to trust my own judgment that they were out of line.

Maybe economists should be more willing to second-guess markets.  Here's what I'll say now.  The recent run-up in the dollar, as shown in these two charts...

   

... doesn't make sense.  The first chart shows the dollar against the euro over the past year, the second, over the past five years.  Since last summer and especially since last October, the dollar has risen strongly.  It briefly lost about half its gains this month but is now recovering them.  Why?  The 5-year chart shows that the dollar has been sliding since the beginning of 2006.  This made sense: the US has long been running a current-account deficit and strong growth elsewhere in the world made their currencies look better.  As the dollar weakened, US exports became more competitive and surged.  That made sense.

That the dollar rose amidst the crisis is a comforting reminder of the confidence foreigners still have in the US.  They're not wrong: the US is stable, and the dollar will retain much of its value in any case.  But I think the 2005-08 trend was more reflective of fundamentals.  The dollar rally in the past few months is, I suspect, driven by speculation and capital flight, and that's not a stable motive.  Particularly because the Fed is printing so many.  So, my tentative guess is that the dollar may be in a bubble, and we might see it pop soon.  That wouldn't be a bad thing for the US, which could use the exports.

We Didn't Take the Car to the Repair Shop, Now It's Breaking Down

It's a good thing we didn't pass Social Security reform three years ago, isn't it!  If we had, all those seniors on the brink of retirement would have lost half their savings in the big stockmarket slide of 2007-08.  That just goes to show that we can't make people risk a dignified retirement on the Wall Street Casino.

Wrong.

First, in the later stages of the Social Security reform debate, Senator Jim DeMint proposed a plan by which Social Security private accounts would be created which would consist only of Treasury bonds.  I supported this plan, because the move to semi-privatized Social Security accounts holding private stocks and bonds, though it is the correct way to handle publicly-mandated retirement finance, involves fiscal and institutional complexities which I thought should be handled gradually.  DeMint's plan was a step towards a fuller reform that channeled mandatory retirement savings into private assets.  If private accounts consisted solely of Treasury bonds, no one would have taken any losses on them during the past year and a half.

However, even if a more ambitious version of Social Security reform had been adopted, there was never any question (a) of forcing people who are near retirement to move to the new plan (Bush set the limit at 55), or (b) of putting older people's money all in stocks.  A sensible private investor will invest mainly in stocks and riskier assets when young, then shift towards bonds and safer assets as she grows older.  Social Security private accounts would do this automatically, erring on the side of caution.  Young people might indeed have lots a good deal of money in their private Social Security accounts, but they have time to recover, and older people would have lost little.  Also, with Social Security private accounts in place, the stockmarket slide might not have occurred, or not have been as deep.  However, that's so complex that I can't certainly rule out the possibility that it might have been deeper.  It is simpler to think what would have happened now if we had adopted the DeMint plan in 2005, and started creating accounts with only Treasury bonds in them.

If the government sets up private Social Security accounts which consist only of Treasury bonds, the fiscal effect is, to a first approximation, nothing.  The government is still taking your money and making promises in return.  None of the money is going to private assets, and the government doesn't have to borrow any other money to make up for revenue flows that have been diverted into private assets.  The only difference is that the promise takes a different, more definite, legal form, and you possess a highly restricted form of ownership over assets (Treasury bonds) attached to a definite income stream.  That income stream is still reinvested into your account, so you don't see it, but it is, in some sense, legally yours.

Now, suppose the crisis of 2008 hits.  All of a sudden, there is massive demand for Treasury bonds from all over the world as investors "flee to safety."  Meanwhile, stocks and housing prices are plunging, to a level which, though it's hard to know what they'll do in the immediate future, it's a pretty good bet that stocks at least (and homes too if immigration reform passes) are a good long-run bargain.

By now, people would have accumulated significant quantities of Treasury bonds in their Social Security personal accounts.  So, the government could enact a simple reform.  First, let people opt to transfer the management of their Social Security private accounts to licensed financial managers.  Second, allow them, through these managers, to sell some of the T-bonds in their accounts and buy stocks instead.  Of course, some people would be too spooked to invest anything in the stockmarket right now, but clever young people would know that, since the volatility shouldn't matter to them, it's worth the risk.  Older people who have other retirement assets and aren't heavily reliant on Social Security, or who for whatever reason simply have high risk tolerance, would also make the switch.

Social Security private accountholders who took this option still wouldn't see any of the money.  People could control how their money was reinvested, but it would all be reinvested.  These are still mandatory retirement savings.  But as they bought stocks, the money would go into private hands.  Stock values would rise, encouraging business investment and/or, through wealth effects, private consumption.  Note that the total stock of government liabilities would not increase in this scenario.  They'd just change hands, from Social Security private accountholders willing to take on risk at a time when long-term returns look especially good, to other investors "fleeing to quality."  Yet the effect would be "stimulus," that is, the use of the government's slack borrowing capacity to offset a sudden wave of financial disintermediation.

Why can't we do that now?  Because although all those entitled to future Social Security checks are implicitly owners of government obligations, and although some of us might be happy to sell those government obligations and take on the risky assets whose falling prices are causing so many problems, the types of government obligations we implicitly own are of a such a poorly-defined and dysfunctional form that it's impossible to render them liquid.  Therefore, the government can use its slack borrowing capacity to stimulate the economy only through tax cuts, which are distortionary, or through government spending, which is even more distortionary.  These distortionary policies, in turn, tend to dampen confidence still more.  Meanwhile, the government has to issue still more obligations, making more promises, because it cannot put its present stock of promises outstanding to work.  Thanks to soulless Congressional Democrats who, not content with the politics of personal destruction, resorted to the politics of destruction of democratic deliberation, and refused even to talk with Bush and the Republicans (who had a powerful electoral mandate for Bush's agenda) about Social Security reform.  As a result, we are still burdened with dysfunctional institutions of public finance, and handicapped in our ability to cope with the crisis.

UPDATE: It occurs to me that even as the Democrats were introducing an artificial panic about the not-really-very-risky-at-all prospects of putting Social Security money of people not near retirement into accounts partly of private stocks and bonds, Fannie Mae, Freddie Mac, the mortgage-interest tax deduction, and federal homeownership promotion policies generally, were actively encouraging the much riskier practice of highly leveraged homebuying.  If people are so risk-averse that they can't tolerate the limited long-term risks involved in long-term investment of retirement savings in diverse portfolios of high-quality financial assets, then they shouldn't be buying homes on credit and exposing themselves to large undiversified risks in local real estate markets.  If homebuying on credit does make sense then Social Security private accounts should be a piece of cake.

Of course, Social Security private accounts would probably be, not more, but less risky than the current Social Security program, only it involves a different kind of risk.  Today's Social Security involves political risk: twenty, thirty, or forty years from now, the nonretired majority might decide they're sick of paying ever-higher taxes to subsidize seniors, and pull the plug.  Market risk has several advantages over political risk.  One is that market risk motivates people to engage in activities such as scrutinizing firms and gathering information about investment opportunities, which have positive social value since they encourage the allocation of capital to its best uses.  Political risk, by contrast, motivates rent-seeking by organizations like the AARP, as different groups of society scramble to get politicians on their side.  Another advantage of market risk is that you can opt for different degrees of it by the way you structure your portfolio, putting more in growth stocks if you don't mind some risk, or moving into blue-chip stocks, AAA-rated bonds, or Treasuries if you want to reduce or minimize risk.  Political markets can offer no such menu of risk/return choices.  Finally, financial markets generate vast amounts of data from which you can derive at least some estimate, albeit subject to a good deal of revision and error, of the mathematical expectation distribution of the income streams you'll get from your assets.  With political risk, no such data is available.

"Watch out world, Americans are saving again"

In one of the biggest and most misunderstood changes in modern economic history, citizens of the largest economy in the world are suddenly doing something they haven't done in years: They're saving money. It is having myriad consequences, including a tsunami of money in one part of the world, and an air pocket in demand in other parts of the world, especially China.

Americans are suddenly spending less than they earn. While that might not sound heretical or surprising - how long can you go on spending more money than you earn? - it is an epochal moment for the free-spending United States. After saving an average of more than 7 per cent of disposable income until almost 1990, the United States went into a savings tailspin. Savings rates fell, in fits and starts, from 8 per cent, through 6 per cent in the early 1990s, to 2 per cent around 2000, to the ignominy of a negative savings rate by mid-2005.

Now, however, that is changing rapidly. November economic data showed U.S. savings spiked to 2.8 per cent of disposable income, up from zero at the beginning of 2008. Is it that Americans have suddenly figured out that saving is a good thing, or are they taking some sort of moral stand against profligate spending?

Be serious. Americans remain the wild-eyed spenders of the world, and that was never likely to change without external pressure. They have, however, been forced into this, with their equity investments and real estate investments all sliding into nothingness, and with the economy in a deep recession. They must repair their broken personal balance sheets, and so, as painful as it might be, they are saving money.

Great. Good for Americans, right? Savings über alles! Well yes, but there is much more to it than that. For starters, the U.S. savings rate won't stop at 2.8 per cent. My guess is it will rapidly rise to 4 per cent by the end of the year, and will likely hit 7 per cent by late 2010.

But in the end, fixating on those numbers misses everything that matters because that money has to come from somewhere. Your savings, in some sense, represent my lost income.

Not if my savings go into a bank, which lends them out to an entrepreneur, who starts a new business and hires you.  But will that happen?

It should be said that the supposed low savings rate was always a little bit misleading.  Why save when your net worth is rising anyway because of rising home and/or stock prices?  Low official savings rates were the flip side of the asset bubble.  People want their net worth to rise over time.  Now that rising asset prices aren't raising their net worth for them, they're saving instead. 

It's too bad, though, that we piled up so much debt to the Chinese to build houses we didn't need.  Don't forget that a lot of the blame for that belongs to Freddie Mac and Fannie Mae, and the mortgage-interest tax deduction, and the misguided policies that tried to drive homeownership rates artificially high.

Them's Fightin' Words

Arnold Kling writes:

Actor	The Promise	The Reality
Financial Executives	Brilliant Risk Management	Catastrophic Losses
Eliot Spitzer	Mr. Clean, Financial Reformer	Celebrity Prosecutions, Real Abuses Untouched, and Not So Clean
Sarbanes-Oxley	Financial Responsibility	Large Costs, No Apparent Benefits
Basel Capital Standards	International Coordination, Sound Banks	Worldwide Banking Collapse
Fannie, Freddie	Stable Mortgage Credit	Fed the Boom, Stuck Taxpayers with the Bust
TARP	Unclog the Financial System	Zombie Banks
Big Fiscal Stimulus	Put the Economy on a Better Path	Wait and See

The pattern is big egos, big money, and big power offering big promises, getting big media play, and making big mistakes (Spitzer's mistakes were relatively small, to be honest). To me, the fiscal stimulus represents yet another redistribution of power away from ordinary people and toward the elite, when already the imbalance is too high. I am more worried about rot at the top of society than at the bottom.

Wow!  Angry, cranky... and probably right on.  I see the seeds of a new Reaganism in Kilng's attitude, a new anti-Big Government, anti-arrogant elites, anti-Big Business if and only if it begs/gets government money.  The GOP should distill this, spread it, sloganize it, run with it, and it could bring them to power in 2010 and beyond, and with the kind of mandate they like.  People are mad at the bailouts.  That anger is a political resource.

GOP types might be put off because it comes from a "libertarian."  Libertarians have a lot of right ideas, but unfortunately they hold them in an unhealthy way: they're adherents of a gnostic political theology, and sneer at ordinary people who just want to protect the good life from government messing things up.  In recent years, they've actively supported government expansion, by voting Democrat and reducing Bush's margin and hence weakening his mandate, then by helping elect Obama.  McCain was actually taking a principled and risky stand against "spreading the wealth," but it was no use: libertarians are too in love with their own bitter posing even to think of being team players and giving credit where it's due.  Libertarians are a bit like people who complain loudly about litter while throwing their Coke bottles and plastic bags on the ground.  I guess I'd still consider myself both Republican and libertarian, but I'm proud of the first label, and sort of ashamed of the second.

But Kling is different.  He's ideological-- that term is in need of rehabilitation-- but not a gnostic.  No paranoid Lenin-style anti-imperialism in foreign policy.  He's hard-headed and smart.  And now he's angry.

Messing Around, Mucking Things Up

"Bernanke: Obama stimulus would lift the economy" (1/13/2009):

A mammoth stimulus package being crafted by President-elect Barack Obama could give the economy a much-needed lift, but other steps must be taken to bolster the wobbly financial system and for any recovery to stick, Federal Reserve Chairman Ben Bernanke said Tuesday.
Specifically, Bernanke suggested the government inject more money into banks. He also offered options to deal with rotten mortgages and other bad assets held by financial institutions, a problem that has contributed to a lockup in lending. Bernanke also again called for the government to do more to curb home foreclosures.

The Fed chief's extensive remarks, in a speech at the London School of Economics, come at a critical time as the U.S. gets ready to change its political and economic guard from President George W. Bush to Obama next week.

Bernanke said the roughly $800 billion recovery plan — a blend of tax cuts and increased government spending — now being worked on by Obama and the Democrat-controlled Congress could provide a "significant boost" to the crippled economy. But he made clear that such a plan must be part of a broader, multi-pronged government response to fight the worst financial crisis the hit the U.S. and the global economy since the 1930s.

"Fiscal policy can stimulate economic activity, but a sustained recovery will also require a comprehensive plan to stabilize the financial system and restore normal flows of credit," Bernanke said. "History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively."

To help on that front, the Fed is lending billions to financial companies and buying mounds of companies' debt to help bust through the debilitating credit clog. And the Treasury Department is overseeing a $700 financial bailout program that has pledged to inject $250 billion into banks in return for partial government ownership. Some government money also is being used to guarantee against possible losses from risky assets held by Citigroup Inc.

Bernanke said "more capital injections and guarantees may become necessary" to stabilize financial markets and spur more lending.

Question: Would it be any more subversive of America's economic constitution if the government just mailed $5000 worth of new money to every American?  To "inject capital" into banks is to partially nationalize them, and, more generally, it is to do unknown things to the incentives of all concerned.  What incentives does a bank that is partly government-owned and is getting regularly cash infusions and asset guarantees from the government to prevent its breakdown have to seek creditworthy borrowers and productive investments?  The point is not that the answer is "none."  The point is: Does anybody know?

A general giveaway of $5000 per head would be a lot more transparent.  But might it not also be a better way to shore up the banks, too?  Given the climate of fear prevailing today, people would probably save a lot of that money.  Where would they save it?  Surely the banks!  So that would also be, in effect, a capital injection into the banks.  The difference is that the banks would get lots of small depositors-- whose behavior is relatively predictable by the law of large numbers-- as opposed to getting one enormous depositor, and having to read the political tea leaves.

Bernanke is trying hard.  But I wonder whether the regime uncertainty he's creating with all his weird new approaches is doing more damage than whatever liquidity he manages to create does good.  Hoover and FDR, too, were big experimenters and activists.  That's likely a major reason why the 1930s were the worst decade in US economic history.

MORE: "We're All Keynesians Again" (George Melloan)

With a federal-funds interest-rate target near zero, the Fed has pumped tons of newly created dollars into the economy over the last four months. This has doubled the monetary base (bank reserves and currency), a phenomenal increase that has shocked market watchers and raised fears of inflation. But all economic indicators are flashing recession.

Last week brought the dispiriting news that the U.S. suffered a net loss of 2.6 million jobs in 2008, the most since 1945. Now 7.2% of the work force is idle. New factory orders, housing construction and retail sales have shriveled. Mortgage foreclosures are rising...

[T]he Fed is again in the position of "pushing on a string" and finding that nothing happens. Some economists describe this as a "liquidity trap." Money creation loses its stimulative power -- vastly overrated even in ordinary times -- because public demand for loans is weak. Americans are too strapped financially, too short on investment opportunities, or too concerned about the future to borrow. They prefer to save instead.

Some economists argue that "trap" is an inappropriate description. The new money the Fed has pumped into the economy to replace the financial-sector liquidity wiped out by the collapse of the bubble has to go somewhere, they point out. It has to end up in someone's bank account and banks have to quickly convert deposits (liabilities) into investments or go broke even faster than some have by loading up on polluted, mortgage-backed securities. Maybe "liquidity malfunction" is a better term than "trap."

With 30-year mortgage rates now hovering near 5%, banks are spending a lot more of their time and resources responding to householder demands for refinancing at the lower rates. That doesn't do much for bank profits, but it does improve household balance sheets, cushioning to some degree the impact of the recession.

But what the Fed has mainly been doing since Black September has been transferring economic resources to government from the private sector on a massive scale. There is one thing the banks can do with their deposits if they can't find willing and qualified borrowers -- the word "qualified" was rather neglected when Fannie and Freddie stood ready to buy any cats and dogs offered. They can put those deposits into U.S. Treasury securities.

Banks and investors around the world fleeing for safety have been doing just that, holding down federal borrowing costs, at least temporarily. The global flight for the presumed safety of Treasurys has also shored up the U.S. dollar in foreign-exchange markets, sending crude oil prices plunging. Because of the Treasury mania, 30-year Treasury bonds were yielding only 3.06% and the popular 10-year bond 2.39%.

So the Treasury has a good deal. The Fed pumps money into the economy by buying Treasurys with checks written on thin air. The Treasury quickly spends those dollars on the huge ongoing expenses of a government running a trillion-dollar deficit. Recipients of its spending put the money into bank accounts and, presto, the money comes right back to the Treasury to finance yet more government spending.

The government is thus the main beneficiary of the phenomenal rise in the monetary base. The base remained relatively stable through the ups and downs of Fed interest-rate policies in this decade, until it went on its fourth-quarter skyrocket trip.

Fascinating.  One thing I should mention.  I keep advocating variations of "print money" on this blog.  I should acknowledge that that is what Bernanke is trying to do.  Bernanke has, of course, no authority to just mail checks to the populace.  Congress does.  The collapse of credit has, in effect, given the US government a license to print money without-- for now-- sparking inflation.  Of course, they could refuse to do so, letting final intermediation unravel and the money supply and prices fall until the economy bottomed out.  But price stability is a good thing because prices are written into all manner of contracts: sudden price changes involve arbitrary redistribution, undermining the social contract and causing many economic plans in the economy to miscarry for reasons unrelated to their merit.  It should be avoided if possible.

Given that the government enjoys this windfall, however, what should it do with it?  My priors are that the government should spend the seigniorage windfall in the same way it should spend an oil windfall: distribute it equally to the populace.  The technical implementation of that simple formula is, of course, more complicated, but that's the idea.

Also -- if anything, I think the government's comparative advantage in spending is less in times of economic distress than at other times.  Entrepreneurs are quick-witted and adaptable, but perhaps selfish.  Government bureaucracies probably are more attentive to the public good, ultimately, but they are slow.  When the state or trend of the economy is stable for a long time, a government bureaucracy may have time to analyze and develop the structures and traditions to deal with some kind of market failure in a way that creates net value.  When the nature of the economy seems to be transforming itself before our eyes, private entrepreneurs are far more likely to figure out how to create value and thrive in the new circumstances quickly, than government bureaucrats are.

As Melloan notes:

Keynesians were banished in the 1980s by Reaganomics but made a comeback years ago and again control U.S. levers of power. They argue that massive deficit spending by the federal government is the right policy for these times. Paul Krugman of the New York Times has asserted that the Great Depression lasted 10 years because the New Deal didn't spend enough.Japan tried to spend its way out of its postbubble malaise in the 1990s but ended up with a mountain of debt and a "lost decade" of little or no economic growth.

By contrast, when the Asian crisis of 1997-8 hit, the IMF imposed austerity policies on countries like Thailand and South Korea, requiring them to cut spending in the midst of a recession.  As a result, they were vilified and burned in effigy, but they did exactly the right thing and Asia was booming again within a couple of years.  Asian countries were in a different situation than we are because, on the one hand, they could devalue and ride an export boom to recovery-- with the whole world weak right now, there's no one for us to export to-- and, on the other hand, they didn't own the world's reserve currency and so didn't have a seigniorage windfall, rather the opposite.  (We have to deal with the seigniorage windfall somehow, that's why I'm recommending currency giveaways.)  Still, the Japan/rest of Asia contrast is a useful display of the comparative merits of Keynesianism and austerity.

"Why Banks Still Won't Lend: Despite $1 Trillion in Largesse, Banks Still Don't Have the Capital Cushion to Make Fresh Loans" (BusinessWeek)

American Apparel (APP) executives should have been focused on the sales of their leggings and T-shirts this holiday season. Instead, management spent most of the critical shopping period worrying about $125 million of debt due on Dec. 19. After weeks of intense meetings with major banks, the trendy retailer landed a last-minute extension on a loan. The onerous strings: a $2.3 million fee and limits on capital spending. "The credit markets are still frozen," says Chief Financial Officer Adrian Kowalewski. "Even companies that are performing well can't get loans at reasonable terms."

The financial challenges facing Kowalewski and other corporate executives pose a major quandary for the incoming Obama Administration and Washington policymakers, who are trying to kick-start the economy. Despite all the government's best efforts in recent months, big banks still aren't lending money freely. One sign of the crunch: New loans to large companies slumped 37% in the three months ending Nov. 30 from the preceding three months. "Banks are being extremely cautious," says Edward Wedbush, chairman of the Los Angeles brokerage Wedbush Morgan Securities.

Diagnosis: Banks' lending practices have proven so dysfunctional lately that they no longer have a comparative advantage in allocating capital.  Give the money to the people.

Induction and Bubbles

In good times the public is probably insufficiently attentive to economists' advice when they think about policy.  All sorts of wise policies are thwarted by largely irrational resistance on the part of the public.  This is not to deny that there might be some biases built into economic theory.  Still, many policies widely advocated by economists, from free trade to privatization of the postal service to abolition of minimum wages to higher gas taxes to more liberal immigration policies to regulation of pollution based on fees rather than standards, would probably be beneficial.  Non-economists often regard economists' proposals with bemusement, and seem indifferent to losing arguments, assuming that economists are engaging in some sort of sophistry.  Then, when crises, recessions, depressions come, the public turns desperately to economists with lots of questions, and they don't like to hear economists repeat the standard answers that they are accustomed to dismiss as sophistry.  Those answers may, nonetheless, be true.

In particular, I have in mind the widespread belief among the public-- of course, some economists share and encourage it-- that the bursting of the housing and stockmarket bubbles is something scandalous and irregular.  People want a new explanation.  Yet bubbles have been a recurring phenomenon for hundreds of years.  There are some formal models of why they occur.  I think a general explanation is that people apply induction in understanding the world.  If the sun has risen every morning of your life, you predict that it will rise tomorrow.  Likewise, if some price p is rising, some people will form expectations that it will continue to rise.  If it is falling, people will expect it to continue to fall.  Of course, these expectations can be self-fulfilling, for a while: price p for good g may keep rising because people-- performatively, these people are "speculators," but it could be anybody, your next door neighbor or your colleague or you-name-it, they are not necessarily a specialized class-- buy good g to benefit from the rising price.  At some point, some factor like a reversal of sentiment or solvency effects reverses the trend, expectations turn, and the bubble "pops."

Economists make a distinction between "rational" and "adaptive" expectations.  "Rational" expectations are based on a knowledge of all available information; "adaptive" expectations extrapolate from past trends.  The distinction can make sense in some economic models.  Whether the distinction makes sense in the real world is not clear.  For one thing, in the real world there is always "model uncertainty": unlike the inhabitants of models, nobody in the real world knows everything about how the economy works.  Anyway, as long as people keep using induction to understand the world, we're likely to continue to see bubbles in the economy.  Get used to it.

A Bubble in Bearishness

Nouriel Roubini:

Last year’s worst-case scenarios came true. The global financial pandemic that I and others had warned about is now upon us. But we are still only in the early stages of this crisis. My predictions for the coming year, unfortunately, are even more dire: The bubbles, and there were many, have only begun to burst.
The prevailing conventional wisdom holds that prices of many risky financial assets have fallen so much that we are at the bottom. Although it’s true that these assets have fallen sharply from their peaks of late 2007, they will likely fall further still. In the next few months, the macroeconomic news in the United States and around the world will be much worse than most expect. Corporate earnings reports will shock any equity analysts who are still deluding themselves that the economic contraction will be mild and short.
Severe vulnerabilities remain in financial markets: a credit crunch that will get worse before it gets any better; deleveraging that continues as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus leading to cascading falls in asset prices, margin calls, and further deleveraging; other financial institutions going bust; a few emerging-market economies entering a full-blown financial crisis, and some at risk of defaulting on their sovereign debt.
Certainly, the United States will experience its worst recession in decades. The formerly mainstream notion that the U.S. contraction would be short and shallow—a V-shaped recession with a quick recovery like the ones in 1990–91 and 2001—is out the window. Instead, the U.S. contraction will be U-shaped: long, deep, and lasting about 24 months. It could end up being even longer, an L-shaped, multiyear stagnation, like the one Japan suffered in the 1990s.
As the U.S. economy shrinks, the entire global economy will go into recession. In Europe, Canada, Japan, and the other advanced economies, it will be severe. Nor will emerging-market economies—linked to the developed world by trade in goods, finance, and currency—escape real pain...
Thanks to the radical actions of the G-7 and others, the risk of a total systemic financial meltdown has been reduced. But unfortunately, the worst is not behind us. This will be a painful year. Only very aggressive, coordinated, and effective action by policymakers will ensure that 2010 will not be even worse than 2009 is likely to be.

Nouriel Roubini has become famous lately for being the one guy who predicted the financial crisis.  (Stiglitz fans claim he did, too, but I've never seen any evidence for that, and Stiglitz is most emphatically the kind of guy who would claim undeserved credit for it.)  But a stopped clock is right twice a day.  I wouldn't put too much credence in this.

Recessions in America have always passed quickly, except one.  "There's a first time for everything," so the saying goes (a married bachelor?) but I think as long as we don't have any Reconstruction Finance Corporations, Hawley-Smoot Tariffs, or New Deals in the next year or so, the US will be growing again by 2010.  No special insights here; just induction.

Russia could fall apart, like Indonesia in 1998.  There could be a revolution in China.  There could be a permanent upward shift in US savings rates-- probably a good thing.  Interesting times!