...the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages.

Do we really need to worry so much in the short term?

Six years ago, Jeff Frankel and I examined the implications of the borrow-and-spend policies of the Bush Administration [PDF]. We estimated the following relationship:

(1) i_t ^long = 0.001 + 1 × π_t + 0.077 E(d_t+2) + 0.280 (y_t-y_t^FE) + 0.005 i_t^* - 0.574 int_t

Adj.-R² = 0.51, N=17, Smpl 1988-2004. i is the long term interest rate on ten year bonds, π is the y/y inflation rate, E(d_t+2) is the two-year ahead expected debt-to-GDP ratio and (y_t-y_t^FE) is the output gap (both according to OECD), and i^* is the foreign interest rate, and int is foreign purchases of US Treasury debt. (This specification was also discussed in this March 2007 post.)

We can use these estimates to do a back of the envelope calculation of what happens in a year, going from end FY2009 to end FY2010, by taking the total differential of equation (1). The change will be given by:

(2) Δ i = Δ π + 0.077 Δ E(d_t+2) + 0.280 Δ (y_t-y_t^FE) - 0.574 Δ int

According to the August CBO Economic and Budget Outlook, public debt held by the public two years ahead will rise from 65.2 to 65.9 ppts of GDP (that is, end FY 2011 to end FY2012, in Summary Table 1). The OECD November Economic Outlook reports that the output gap in 2009 was -4.92 ppts of GDP, and is projected to be -5.36 in 2010. If East Asian bank purchases of Treasuries remain constant, then one finds that the inflation adjusted interest rate will rise by:

(0.659-0.652)×0.077 + (-0.0536+0.0492)×0.280 = 0.0005-0.0012 = -0.0007

That is, the interest rate would fall by 7 bps (holding expected inflation constant). In other words, real interest rates would stay roughly constant, ceteris paribus.

Now, what about foreign purchases of US treasury bills and notes? These ran about $333 billion through September [1], or about 2.3% of nominal GDP. Suppose this went to zero (!). Then real rates would rise 1.3%. Of course, one needs net foreign purchases to drop to zero, which seems to me unlikely.

Some caveats: These estimates were obtained using data that spanned a period without extraordinary Federal Reserve credit easing, and in the face of an unprecedented financial collapse. And, the relationship is not precisely estimated. But they're the estimates we -- or at least I -- have.

By the way, CBO predicts only a 0.8 ppts increase in the ten year rate going from 2009 to 2010, and an additional 0.3 ppts by 2011 (Summary Table 2).

I'll further observe that the article gives the impression that the jump in Federal debt was due to the stimulus bill. But in fact, as shown in this post, most of the debt accumulation has been accounted for by the decline in tax revenues associated with the recession.

No doubt, trouble on the fiscal front is real, and has long been brewing -- from the tax cuts of 2001 (if extended) to Medicare Part D. And, indeed, I argued for a lot more fiscal restraint when we were near full employment. [2] But, in my view, apocalypse not quite yet.

Kwak goes on to endorse Chinn's ideological rant that the Bush tax cuts caused the financial crisis. Yes, I know that Chinn is speaking in the tone of economic analysis rather than a rant, but only a left-wing ideologue would take the thesis seriously. I bet Kwak cannot find a blog post of Chinn's where he made a policy point against Democrats/liberals or for Republicans/conservatives.

Where Kling is responding to James Kwak's assertion: "[Menzie] Chinn is not given to ideological ranting." (Thanks, James).

I don't find it very profitable to characterize anybody's posts as "rants", but I thought it useful to see what the definition is:

A rant or harangue is a speech or text that does not present a well-researched and calm argument; rather, it is typically an attack on an idea, a person or an institution, and very often lacks proven claims. Such attacks are usually personal attacks.

For those interested in reading my purported "rant", please see this article by myself me and Harvard professor Jeffry Frieden.

In his post, Dr. Kling lays down an explicit challenge. Well, I'm ready to take up the challenge. But before going down that route, let me pose philosophical question whether being an ideologue is the same as taking only one side of an argument. Suppose it's 1861, and you can only find fault with the desire by certain States to impose a certain peculiar institution. Does that make one an ideologue?

Well, on to Dr. Kling's challenge to identify cases where I supported positions adopted by Republicans or conservatives. I think these fall into cases referring to trade policy (specifically Doha round); gas tax vs. CAFE standards; TARP (that was a Bush Administration initiative, yes?); renminbi policy; fiscal restraint (well, that used to be something Republicans believed in). That's already five issue-areas. And just to set the record straight, I did work for half a year in the G.W. Bush Administration (at the staff, not policy, level).

Let me conclude that in my view it is a supreme irony that Dr. Kling feels qualified to label me an ideologue. For my part, I will eschew such labeling.

Update, 8/29 10:50pm: Arnold Kling apologizes, and I am happy to accept. As for myself, I will not use the term "ideological rant" in my characterizations.

For certain, there is little pressure apparent in short term forecasts like the WSJ and Survey of Professional Forecasters. This makes sense (at least if one believes in the Keynesian conception of an output gap [1]) given the amount of slack displayed in Figure 1.

I also plot the median expectation of ten-year inflation. Note that this measure has not budged much at all.

This data, of course, will not convince those skeptical of survey-based measures. What about market based measures? The standard approach is to subtract the TIPS yield from the Treasury yield. We know for a variety of reasons, this calculation can lead to misleading results. However, the Cleveland Fed has stopped publishing its adjusted series:

October 31, 2008

We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.

With that caveat in mind, Figure 2 displays the implied ten year expected inflation rate.

Some people are looking to commodity prices as indicators of expected inflation. I'd say that making inferences this way is fraught with difficulties, because changes in such commodity prices will incorporate both relative price and price level effects.

So, there's little evidence now of inflationary pressures. That being said, there's plenty to worry about as time goes on (as Jim recounts). And even if inflationary expectations remain well anchored, we do have to keep an eye on possible crowding out due to higher interest rates (all of us, except Dick Cheney, who didn't ever worry about deficits as the Bush Administration ran up trillions in debt [3]).

CALLER: Thank you for taking my call. I just wanted to point out something to you about your comments on taxing, and Obama's own economic advisors agree with you, and it's in a report that I found online. It's the Economic Report of the President. It's issued by the Council of Economic Advisors, which were appointed by Obama, and there's an entire section in that report that says lowering tax rates stimulates economic growth.

RUSH: That was then. They have removed that from the website. What's the woman's name that wrote that? I'm having a mental block. Romer. Christina Romer. She wrote that. She put it on their website and once Obama won: Bam! It came off, and now in its place is: "Spending a dollar generates a dollar and a half." It used to be, "Reducing taxes every dollar generates a dollar and a half," or a half a dollar. They've totally reworked it. She's been neutered, as it were.

There is are several errors in this exchange, but let me just identify a few of the most glaring.

• The Economic Report of the President, 2009 that is being referred to (and which I just got in the mail the other day, and is discussed in part in this post) is the last Economic Report of the President issued by the Bush Administration.
• While it is true that the White House website that had that particular CEA document online came down on January 20th, so did all the old WH websites (to my knowledge). That is standard operating procedure when the new administration comes in (I remember the 2000-01 switchover as I was there).
• Regarding "What's the woman's name...", Professor Romer still has the paper I think Mr. Limbaugh means to refer to (although I admit it is hard to tell since he mangled the descriptions so badly) on her website. It is also still on the NBER website.

I thought these assertions needed correction, especially as I suspect that these conspiracy-oriented interpretations will creep into more popular discourse over time. In any case, not such a "teachable moment" I think.

The vertical axes in Figures 1 and 2 have been made conformable. What is clear is that in the Senate compromise version, (1) the green portion (tax provisions, approximately) of the bars is bigger, and (2) a larger proportion of spending takes place in the next 20 months. Is that a good thing? In combination, no. What will happen is that there will be more tax cuts that expand the already increasing deficit but will have minimal impact on aggregate demand; and less spending on things that will have a maximal impact on aggregate demand. (By the way, throwing in big tax cuts that have minimal effect on aggregate demand makes it more likely that one gets fiscal policy ineffectiveness, as shown in Case 3 in this post.) Figure 3 shows the relative costs of each bill normalized by GDP.

I want to point out that I have been consistent in arguing for getting the maximal impact on aggregate demand per dollar stimulus. [1], [2] It is even more important because of the incredible profligacy of the Bush Administration which as I have repeatedly noted constrained our options should times like the ones we are now experience arrive. [3] [4] I would observe that those who argued "no problems" with borrowing driven by massive tax cuts, and borrowing from China, have little credibility. Readers of Econbrowser will know of whom I speak (there's a pretty big overlap with those who are arguing against this stimulus package).

One observation is that it looks like the stimulus is more concentrated early on. But such an interpretation is misguided. Take a look at the components. The amounts in Div B "direct spending" provisions are very similar in the two bills. (Note: change of scale in axes.)

The big differences come in terms of discretionary spending (Division A) and tax revenue provisions (Division B - revenues).

Most pernicious in the "compromise" was the stripping out of transfers to the state. For this, there is no reason in terms of stimulating aggregate demand to limit this component. The propensity to spend would have been the highest out of these funds. And the spending would have occured fairly quickly. Indeed, in so many of the cuts to the original Senate bill, the wrong things were cut. And the wrong things were expanded, including most importantly tax provisions. That expansion in tax provisions is seen in Figure 6.

The tragedy is that so many of these tax provisions are clearly going to have little "stimulus" effect (e.g. homebuyer credit [5] [6]). But where is the Republican outrage on this count?

So, summing up, I can't see a reason to dissent with Krugman's assessment of what the "moderates" have given us.

The original plan also included badly needed spending on school construction; $16 billion of that spending was cut. It included aid to the unemployed, especially help in maintaining health care -- cut. Food stamps -- cut. All in all, more than $80 billion was cut from the plan, with the great bulk of those cuts falling on precisely the measures that would do the most to reduce the depth and pain of this slump.

Just to remind people, here are the ranges of estimates for multipliers for various types of measures, as provided by the nonpartisan Congressional Budget Office.

Just to remind us all of the stakes involved, take a look again at the vertical axis in Figure 3: it's the ratio to GDP. This "massive" stimulus bill is pretty small relative to GDP. And in the absence of a cost-effective stimulus bill, we are hurtling toward a negative output gap that -- in the post-War era -- is of unparallelled proportions, in terms of depth and duration.

Given what data has come out since January 7, I have no reason to believe the outlook is any better than what is provided in this picture.

While this has been a depressing weekend for those of us who believe that reason can triumph over sheer ignorance, at least it's provided plenty of examples of bad reasoning to dissect in macro class. (By the way, still looking for a reputable macroeconomist against a stimulus bill [7].)

It's such a promising concept, harnessing volatility as a hedge, but it may not be there when you need it.

Matt - first of all, let me say, I LOVE VIX.  It is such a telling pulse on the market, and it's got such a cool name.  Conceptually, it is genius, because it has GREAT correlation benefit in times of stress...SPOT VIX that is.  And THAT, again, is what many people don't get about futures markets and futures-based products based on many conversations I've had.

If you were to get into this hypothetical new VIX ETN when VIX was at 20 and overnight VIX shot up to 80, you would almost certainly NOT quadruple your money. In fact you might have the same 20 bucks (if that was your investment) that you started with.  Probably you're up, but nowhere near the move on vol. 

And that is a shame, because if you looked at VIX in the fall, it directly reflected distress in the markets, and if you're intuition tells you that extreme volatility is not a good indicator of upward-moving markets, you're right.  Things are STILL too volatile for my taste to convince me the market is headed anywhere by sideways or down. When 200 on the Dow - even if it's up - is still a ho hum day, you've got problems.

So again - you have this great concept of VIX as a perfect hedge (it was pretty much the only thing going up in October) but because of the smoothing-out effect of the futures markets, it's a really dulled tool for that purpose. And Srikant Dash at S&P is calling it a straight trading tool.  I guess they don't like to use that word "hedge" over there these days.

All that said, I STILL think VIX is cool, and I STILL think that the concept of a VIX ETN is extremely interesting.  But Murray was all over the issues in his piece from a couple days ago.

Speaking of the Dow being up 200, how about the Obama administration ramming that $800 plus billion (so easy to say nowadays...it's like nothing) stimulus plan through the House of Representatives WITHOUT A SINGLE REPUBLICAN VOTE (so much for the end of partisanship)? Big things, big money. Mostly I'm there on both what the late Bush administration did and what Obama is doing, but the scope and magnitude of all this intervention is just stunning.

But let me let the the Economic Report of the President [large pdf] (Chapter 2) speak for itself:

• The roots of the current global financial crisis began in the late 1990s. A rapid increase in saving by developing countries (sometimes called the "global saving glut") resulted in a large influx of capital to the United States and other industrialized countries, driving down the return on safe assets. The relatively low yield on safe assets likely encouraged investors to look for higher yields from riskier assets, whose yields also went down. What turned out to be an underpricing of risk across a number of markets (housing, commercial real estate, and leveraged buyouts, among others) in the United States and abroad, and an uncertainty about how this risk was distributed throughout the global financial system, set the stage for subsequent financial distress.
• The influx of inexpensive capital helped finance a housing boom. House prices appreciated rapidly earlier in this decade, and building increased to well-above historic levels. Eventually, house prices began to decline with this glut in housing supply.
• Considerable innovations in housing finance—the growth of subprime mortgages and the expansion of the market for assets backed by mortgages—helped fuel the housing boom. Those innovations were often beneficial, helping to make home ownership more affordable and accessible, but excesses set the stage for later losses.
• The declining value of mortgage-related assets has had a disproportionate effect on the financial sector because a large fraction of mortgage-related assets are held by banks, investment banks, and other highly levered financial institutions. The combination of leverage (the use of borrowed funds) and, in particular, a reliance on short-term funding made these institutions (both in the United States and abroad) vulnerable to large mortgage losses.
• Vulnerable institutions failed, and others nearly failed. The remaining institutions pulled back from extending credit to each other, and interbank lending rates increased to unprecedented levels. The effects of the crisis were most visible in the financial sector, but the impact and consequences of the crisis are being felt by households, businesses, and governments throughout the world.
• ...

There is greater detail in the section titled: "Origins of the Crisis", subheading "The Global Saving Glut":

...

As this influx of capital became available to fund investments, interest rates fell broadly. The return on safe assets was notably low: the 10-year Treasury rate ranged from only 3.1 percent to 5.3 percent from 2003 to 2007, whereas the average rate over the preceding 40 years was 7.5 percent. While to some extent the low rates reflected relatively benign inflation risk, the rate on risky assets was even lower relative to its historical average: the rate on a 10-year BAA investment-grade (medium-quality) bond ranged from only 5.6 percent to 7.5 percent from 2003 to 2007, whereas the average over the preceding 40 years was 9.3 percent. The net effect was a dramatic narrowing of credit spreads. A credit spread measures the difference between the yield on a risky asset, such as a corporate bond, and the yield on a riskless asset, such as a Treasury bond, with a similar maturity. Risky assets pay a premium for a number of reasons, including liquidity risk (the risk that it will be difficult to sell at an expected price in a timely manner) and default risk (the risk that a borrower will be unable to make timely principal and interest payments).

Thinking in terms of systems of supply and demand is a very useful disciplining device. And here I think resorting to this framework, even allowing for distortions in the markets, can be useful, for it reminds one that the outcome (current account balances or the mirror image, financial account balances, and interest rates) are the equilibrium outcome of supply and demand for saving. (A related, but distinct, perspective is Brad Setser's creditors/debtors story.)

I'll admit that it's plausible to think of an exogenous shift in excess saving (decrease in investment demand in East Asia, increase in corporate and household saving in China, etc.) as resulting in increased US borrowing from abroad. This is indeed a variant of the Bernanke "saving glut" thesis. The Bernanke focus is on the "depth and sophistication" of the US capital markets.

Well, I think this last point leads us to my critique. Was it really sophisticated capital markets in the US, or a mania in which either agents made implausible assessments of future risk/return tradeoffs, or were engaged in "looting" the system by exploiting implicit guarantees and building up contingent liabilities for the taxpayers, that sucked in capital from the rest of the world.

Three years ago, I'd surely have a difficult time convincing people that US capital markets weren't completely self-regulating and self-correcting. Maybe it's time to revisit the "saving glut" hypothesis, and say that perhaps capital "sucked" into America, rather than "pushed" into America.

Even if one were to say that the excess saving from East Asia -- and the oil exporters as we enter 2005-08 -- drove the bubble (and I'm willing to admit that there is something to the argument that global imbalances exacerbated domestic imbalances, especially related to the housing sector), I have two big caveats.

The argument that the saving glut led to low interest rates is not unambiguously accepted. [2], [3], [4], [5] [6] [7]. Consider Wright's work [pdf] on how the conundrum can be explained without resort to a central role for international factors (although he allows for some; see also this post). Also consider the correlation between low interest rates and the US current account. Below is a graph from a post two years ago.

But, thinking again about exogeneity, why were funds flowing to the US. Some of it was low national saving. And why was that saving low? Because we were piling tax cuts upon tax cuts (admittedly I'm sounding like a broken record here: [8] [9]). But then add to this question why did the oil exporters start building up current account surpluses of enormous magnitudes? Because demand for oil rose in China, and the US (some observers conveniently ignore the US and focus on China, but it was adding substantial amounts of incremental demand up to 2005 or so). But some of that Chinese demand for oil was "derived demand", driven by US consumption of Chinese made goods.

So, while I won't say that the idea of saving flows coming from East Asia had some role in the financial crisis we're now undergoing, I'd say one has to think about how those flows came about, as much as how big they are. We don't usually think of the rest-of-the-world driving macroeconomic events in the US (here's my take: [10]), and I still don't think it's time to start.

By the way, I am disagreeing slightly with Brad Setser's take on this subject, although I think it is more a point of emphasis than substance. My reading of his post is that excess saving from East Asia and oil exporters enabled (my phrase, not his) the US housing boom, and the search for yield. I think that's somewhat different from the ERP thesis.

The Administration's forecast calls for real GDP to continue to fall in the first half of 2009, with the major declines projected to be concentrated in the fourth quarter of 2008 and the first quarter of 2009. An active monetary policy and Treasury's injection of assets into financial institutions are expected to ease financial stress and to lead to a rebound in the interest-sensitive sectors of the economy in the second half of 2009.

Part of the Bush CEA's optimism (relative to other forecasts [1], [2]) is based upon this correlation:

The regression suggests that if the decline in output is severe, then the rebound will be strong. If, on the other hand as indicated in some forecasts, [3], the peak-to-trough decline in output is 2%, then the rebound will be right about on mean value of 4.6% for two years (in other words, we're right on the dashed lines in the chart).

My one observation is that the last two recession observations ('90-'91; '01) are substantially below the regression line. One aspect of the 1990-91 recession that seems particularly relevant is the fact that it was accompanied by a capital crunch -- that is a crisis that required injections of capital into the banks. In that sense, that recession was conjoined with a financial crisis and a housing crash (see IMF analysis discussed here). So, while I'm hopeful, I'm not too sanguine [4].

Candidate Explanations

In particular, when one examines the mixture of policies and events that have led us to the brink of possibly the deepest and most persistent downturn since the Great Depression, one can see several suspects listed.

• Fannie and Freddie
• Community Reinvestment Act
• CDO's and CDS's
• Global saving glut
• Monetary policy
• Deregulation
• Criminal activity and regulatory disarmament
• Tax cuts and fiscal profligacy
• Tax policy

Red Herrings

I've already dealt with the first two "betes noire" -- favorite villains in the fevered commentary of certain noneconomists -- in this post, so we can dispense with these as key drivers (Jim attributes some blame, here, although I don't think he attributes central blame here either). I don't think CDO's and CDS's in and of themselves caused the crisis, although they certainly obscured the primary problem of overleveraging (CDO's) and lack of transparency (CDS's). And the saving glut -- well, the saving glut was a worldwide phenomenon, but I think it safe to say the countries that did and didn't borrow from the Chinese have suffered in the current crisis (here is my critique from 2005; CFR report [pdf]).

Synergy

So what I want to think about is the toxic mixture of the last five items, which interacted in a synergistic manner to place us in the situation we are now in.

First, monetary policy. While there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not -- according to a Taylor rule framework -- overly lax.

Second, deregulation. On this front, I think it's important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS's does not). I outline some empirical research on what factors were important in this crisis in this post.

Third, regulatory disarmament/nonenforcement and "criminal activity". I would have discounted this item in the absence of clear evidence, but now that we know about how the OTS "helped out" IndyMac [2] [3], I think we can be reasonably confident that we'll hear a lot more about how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.

Fourth, fiscal profligacy via tax cuts. I think it's important to focus on profligacy (because it pushed the economy more into a boom exactly at a time when not needed) and on tax cuts (because it made people feel like they had more discretionary income than reasonable), thereby pushing the asset boom.

Fifth, tax policy. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (I've been thinking about this in part because mortgage deductibility on a second home never made sense to me, let alone on a first home). Capital Games and Gains has pointed out this provision, citing a NYT article. But even this last article doesn't locate primary blame here; rather it's cited as a contributing factor. I suspect that on its own, this provision wouldn't had a big impact, but in combination, it might have. My caveat here is that I haven't found much empirical work backing a big role for this factor.

Typically, in my academic work, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But (departing from a model, and with no econometric work to back up the hypothesis interactive effects), I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) we've witnessed, the deflation of which has been associated with the ongoing financial crisis.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [7]; with regulatory oversight absent, and low interest rates, well the stage was set.

Prescient, or Not

To sum up, I won't claim to have foreseen the full enormity of the crisis we're now undergoing. As I indicated when I posted my first blogpost some three years ago, I thought the sheer irresponsibility of the fiscal policy being pursued, against a backdrop of overconfidence in largely nontraded derivatives, would lead to grief in the form of a "sudden stop" of net capital flows to the US. In this respect, I was wrong -- what we've achieved instead is a sort of "global sudden stop" where the process of deleveraging proceeded in a discrete (and "disorderly") fashion. So, unlike some, I was only partially -- not completely -- blindsided. (And, I'm sure Akerlof and Romer were completely aware of what was coming...)

I believe history will look critically on the Bush Administration's economic stewardship, in particular how the policies propelled an unsustainable bubble, and tied our hands in the use of fiscal policy tools. In sum, I think Kevin (Dow 36,000) Hassett's view "Bush's Legacy May End Up Better Than You Think" will not prove true.

Technorati Tags: financial crisis, recession, subprime, regulation, Bush Administration, Office of Thrift Supervision, Fannie Mae, and Freddie Mac.

Dec. 7 (Bloomberg) -- President-elect Barack Obama said the nation owes its military veterans "a sacred trust" and named retired four-star General Eric Shinseki to make the U.S. Department of Veterans Affairs "a 21st century" system.

"No one will ever doubt that this former Army chief of staff has the courage to stand up for our troops and our veterans," Obama said at a press conference in Chicago, held on the anniversary of the 1941 attack on Pearl Harbor. "No one will ever question whether he will fight hard enough to make sure that they have the support that they need."

Shortly before the 2003 U.S. invasion to oust Iraqi dictator Saddam Hussein, Shinseki told Congress it would take several hundred thousand troops to stabilize postwar Iraq, more than then-Secretary of Defense Donald Rumsfeld had estimated.

Rumsfeld roundly rejected Shinseki's assessment, insisting the effort could be accomplished with a U.S. commitment of no more than 150,000 troops. He also cut short Shinseki's tenure as chief of staff, which critics of the Bush administration said was punishment for Shinseki's testimony.

Rumsfeld himself later resigned his post, his reputation damaged by the failure of U.S. planning for the invasion's aftermath and the subsequent violence. As of Dec. 4, a total of 3,395 U.S. troops had been killed in action in Iraq and 30,852 had been wounded.

While this is not an economics issue in and of itself, it does relate to economic policymaking. Many of the critics of Obama's choices for his economics team have centered on the fact that some of the choices were in the Clinton Administration, or have been associated with the centrist wing of the Democratic party, and hence could not represent "change" (e.g., [0]). But I think this all misses the point. The "change" we need is not so much ideological in nature, but the return to policy authority of people who have expertise, and are willing to look to past experience and (most importantly to me) analysis to make their judgments about how best to proceed -- in economics as well as in issues of war and peace. So I'm happy with the developments thus far (on my previous posts on Shinseki vs. Rumsfeld and the Iraq debacle, see: [1], [2], [3]).

In other words, just like it probably takes more than a hundred thousand troops to stabilize a country the size of Iraq, it probably is true that the elasticity of labor supply and capital is insufficient to yield a tax revenue increase that yields a net tax receipts gain, in response to a permanent tax rate cut holding all else constant (in other words, extreme supply side nostrums [4] belong in the trashbin along with the Rumsfeld doctrine).

...basically, it seems to me, we're all flying blind. The markets are spiraling down, and our leading experts don't have much of a clue as to what to do.

Given that, one has to welcome the expected appointment to senior positions in the Obama administration of economists like Lawrence Summers, Timothy Geithner, Jason Furman, Peter Orszag, and Goolsbee himself. They're sober and competent people who know we face a real crisis -- and who, importantly, may be more willing than many of their colleagues to adjust their thinking early and often.

Indeed, one hopes they're not too invested in the findings of the economics profession of which they're such distinguished products -- because one suspects many of the conventional answers of that profession aren’t much applicable to the current situation. After all, wasn't it excessive confidence in complex economic models and sophisticated financial instruments on the part of people well educated in modern economics that helped get us into the current mess?

So I hope the best and the brightest who will be joining the new president will at least entertain the possibility that a lot of what they think they know is wrong. I trust they'll remember that successful economic policies in the past have pulled together elements from unlikely sources, and that they're as likely to find wisdom from reading political economists like Friedrich Hayek or Joseph Schumpeter, or Keynes himself, as from poring over the latest academic paper in a peer-refereed economics journal.

My puzzlement is driven by several assertions.

• Are our economic leaders flying blind?
• Were the economists overly enamored of complex economic models?
• Were the economists overly confident in sophisticated financial instruments?
• Is it as likely to find wisdom from Hayek or Schumpeter as in the latest academic paper?

On the first point, I think Kristol is on the most solid ground. So much of what has happened has been unprecedent in terms of institutions, although as Markus Brunnermeier has pointed out, the general outlines are remarkably similar to banking crises of the past. So, here I think reasonable people can certainly disagree whether it's ignorance, or failure to agree between Fed and the Bush Administration and components thereof.

What about complex models? First ask what exactly constitutes a complex model? Is Kristol alluding to models involving algebra? Or calculus? Or lots of equations? I think one could make the argument that the models weren't complex enough to capture important effects (asymmetric information, agency costs, etc.) despite the complexity along other dimensions.

Were economists overly confident in sophisticated financial instruments? Here I think it might be useful to discriminate between economists that work in the financial world, and those that work in academia. From the former group, I always heard a lot about "risk management" and sophisticated statistical models to price derivatives. From the latter, I heard a lot more skepticism, perhaps borne of ignorance. So, Kristol might be right, but I suspect his views are deeply influenced by the sample of economists he talked to.

By the way, I won't say I saw the full enormity of the leveraging problem, but at least I can truthfully say I was suspicious of the free lunch aspects of the net borrowing binge of the past decade. From my August 2005 Council on Foreign Relations report:

Although the likelihood of a "disorderly adjustment," is small,37 the potential consequences are so troubling that the possibility of economic disruption cannot be ignored. In addition to the threat of rising unemployment and declining income, sharp movements in asset prices and interest rates could also threaten the stability of the financial system. In the past, policymakers have been able to contain the threats of systemic crises, such as the crisis of Long Term Capital Management in 1998. That event was at least partly attributable to bets on interest rates movements that did not meet expectations. Markets for making bets are much larger and diverse than they were seven years ago. Some are very new and remain untested. The question is whether they are up to the task of distributing risks when low probability events occur.38 This open question should in itself give some additional weight to the case for action now, to avoid putting the world economy in the position of finding out the answer.

I'm confident it's quite easy to dig up plenty of quotes from other economists who were nervous.

Finally, the assertion that really caught my attention: That the likelihood of finding useful nuggets of economic wisdom in Schumpeter and Hayek is equal to that of finding it in the latest article in peer reviewed journals (I get the feeling he's making a perjorative remark about peer reviewed journals, but I'll let that slide).

Why do I think this is odd? Well, because the statement identifies modern economics as distinct from the great thinkers of the past. But in fact many of the works in the "peer reviewed journals" are not orthogonal to the works of the past, but like many other intellectual endeavors, based upon them. Open up the JPE or the QJE (or better yet, the NBER Working Paper series, and there are plenty allusions to "the greats", and ideas like "creative destruction". That being said, just like there has been plenty of thinking in political science since Machiavelli and The Prince (you'll get the allusion if you've read Dani Rodrik's take on Kristol's economics acumen), there's been a lot of insight developed in economics over the past hundred years. In this respect, the admonition to look backward sound good, but is less profound that it appears at first glance.

- Of course a depression is what they used to call a recession. Then came the Great Depression. After that, economists and politicians stopped using the word for fear of jinxing the economy. Now, a depression means a severe and protracted recession.

- Bush may be right about the chances of the US slumping into a depression. Part of the problem is that it’s not only the US that’s…

- But W. didn’t stop there. Apart from wanting governments to be “smarter” (who doesn’t?), he called for called for leaders to recognize that “government intervention is not a cure-all” for economic problems. So what was Fannie and Freddie all about? Or Hank Paulson’s Troubled Assets Relief Program. Or the bailout of AIG? If government is not a cure-all,…

- But W. didn’t stop there. Apart from wanting governments to be “smarter” (who doesn’t?), he called for called for leaders to recognize that “government intervention is not a cure-all” for economic problems. So what was Fannie and Freddie all about? Or Hank Paulson’s Troubled Assets Relief Program. Or the bailout of AIG? If government is not a cure-all,…

- Here’s the breakdown, from CreditSights, a research firm in New York and London, as reported in Forbes magazine.

The Fed

• $1 trillion in overnight or short-term loans since March to primary dealers through its emergency discount window*
• $1.8 trillion in loans to primary dealers through the Fed’s term auction facility since in January*
• $29 billion in Bear Stearns debt
• $60 billion of credit available to American International Group
• $22.5 billion to set up…