Posts from — February 2009

I just finished Superclass and while it initially sounded like exactly the kind of book I don’t like to read, after hearing Rothkopf in person and seeing Chris Blattman recommend it (in a hilarious post titled ‘Midway Down the Intellectual Food Chain) I decided to get the audio book. It was definitely entertaining and pretty interesting at times but definitely not a must-read. I was, however, struck by a conversation Rothkopf  had with Timothy Geithner (remember him?) on how he helped resolve a crisis in the derivatives market (the book doesn’t give any further information) that I think really captures the way many complicated (and extremely urgent) problems are addressed in our increasingly complex world:

What we did is, we got the fourteen major firms in a room down the hall here with their primary supervisors [..] and we said to them “You guys have got to fix this problem, tell us how you are going to fix it and we will work out some basic regime to work out there are no free riders to give you comfort so you know that if you move individually, everybody else will move with you” and there is nothing written, no guidance, no regulation, no formal process, [...]

These fourteen firms he continued, accounted for something like 90% of the all the activity in this market. The Fed, the SEC, the FSA, the Swiss and the Germans were there, and hose were the principals, each firm brought three people, they had an executive committee of four firms that had almost weekly a conference call among the four firms. And the best thing about the process was that it was efficient, there was nothing written except letters from the firm laying out their commitments, there’s no formal mechanism we could have used to force this on anybody so we had to invent it.

You have to have a borderless collaborative process, it does not mean it has to be universal every jurisdiction or every institution it just needs a critical mass of the right players it is a much more concentrated world, if you focus on the limited number of the ten to twenty large institutions that have some global reach, then you can do a lot.

Geithner is right, the world is becoming increasingly international but there are very few effective (and quick acting) international governing bodies and these adhoc meetings work very well. You don’t need to be a believer in World Government to realize that closer international coordination on finance and the economy (if nothing else) will be important in the future. The problem with doing things on an adhoc basis by getting the most powerful people and organizations in one room is that the concerns of the wider populace will be underrepresented (or not represented at all). The hurried actions of the US Treasury and Federal Reserve during the failure/bailout of Bear Stearns, AIG, and Lehman Brothers showed that personal contacts and informal meetings can help ensure quick action in an unforeseen crisis but they also show the dangers and resulting unfairness of the outcomes reached in such meetings. In the years ahead we will have to figure out how to build more effective coordinating (and potentially regulating) bodies on both the national and international scale. That should be a fun challenge.

From the Economist:

In Germany December’s machine-tool orders were 40% lower than a year earlier. Half of China’s 9,000 or so toy exporters have gone bust. Taiwan’s shipments of notebook computers fell by a third in the month of January. The number of cars being assembled in America was 60% below January 2008.

Yes these numbers are among the extremes and other industries aren’t faring quite as badly but the core point is that this is an international crisis and it will have serious impact everywhere – goodbye to fantasies of decoupling. A Fistful of Euros has had excellent coverage of how the crisis is affecting European and other countries, things are looking bad in Russia, Ukraine, Japan, Ireland, Latvia, and pretty much everywhere else.

While I personally find the complexities of the financial system fascinating it is important to remember (especially with lots of people currently questioning it’s usefulness) what the purpose of the financial system is. Brad DeLong (who uses Apture on his blog) sums up an old Robert Shiller paper on the purpose of financial systems and the problems, distortions, and inefficiencies they face:

Financial markets are supposed to tell the real economy the value of providing for the future–of taking resources today and using them nor just for consumption or current enjoyment but in building up technologies, factories, buildings, and companies that will produce value for the future. And Shiller has more than anyone else argued economists into admitting that financial markets do a really lousy job. The prices that financial markets feed the real economy value safety too much, are also much too frightened of risk, on average are too low–that is, greatly undervalue the worth of providing for the future, and are also grossly excessively volatile. Depending on the date, the same flow of rationally-expected future profits and values can vary in its price by a factor of three depending on what Akerlof and Shiller call “animal spirits”

Both group think and excess volatility are topics that everyone is very aware of right now but I few people would cite excessive risk aversion as a problem after the subprime mortage debacle. I do, however, agree that when it comes to investing in the future investors are very risk averse, at least when it comes to industries that they don’t fully understand. The problem was not that people knew that subprime mortgages were extremely risky but took the risk anyway, they understood subprime loans quite well but made the (fatal) assumption that house prices would continue to rise forever.

When it comes to the kind of risks that innovative startups face (“is this technically possible?”, “will people really find it valuable?”, “can we figure out how to monetize it?”) I do believe that most investors, even most (not all!) venture capitalists tend to be too risk averse. Paul Graham recently wrote an excellent essay on the topic and I believe that creating the next generation of successful companies will require investment in big and bold ideas – even if some of them (especially in biotech) will take significant time until they make money. The eventual payoffs will be worth it.

In yesterday’s post on why I am seriously starting to worry about the US economy and our plans for fixing it I said that monetary policy had with some exceptions run out of power. I want to elaborate a little bit on what I meant by this after stumbling upon two succinct paragraphs that give an overview of the problem in this post by Edward Hugh. First,  the problem:

Keynes argued that monetary policy ran the risk of becoming impotent in stimulating demand and raising spending since interest rates were already at their lowest possible level. Essentially he argued that increasing the monetary base by buying short-term government bonds is irrelevant at zero interest rates since money and short-term government bonds become effectively perfect substitutes.

As I said in my last post, however, there are still some things that can be done and while the Fed cannot lower short term interest rates any further it can still influence long term interest rates:

This (monetary policy impotence) argument has been challenged to some extent of late, most notably by Ben Bernanke, who argues that while the central bank may lose policy leverage over short term interest rates, by buying longer term instruments (10 or 30 year bonds) the bank may influence rates further up the yield curve.

This basically means that while short term interest rates have effectively reached zero the Federal Reserve can buy longer term bonds and thereby lower the interest rates on those, and incentivizing banks to shift their money to loan on which they can earn higher yields. This is extremely similar to what is generally known as Quantitive Easing (and unneccessarily complicated sounding term for a relatively simple concept).

Unfortunately even this won’t help too much in the situation that we are currently faced with since it does not address the underlying problem but it is something that other central banks such as the ECB should keep in mind. Some other possible actions a central bank could take are explained in this paper by Gauti Eggertson of the IMF that I have just started reading.

I believe that fiscal stimulus is both fundamentally sound and very important in the current economic situation that we are in. Monetary policy has largely run out of power, yes, there are certain things that the Federal Reserve can still do but they would most likely be too little too late. I understand why some people are skeptical about borrowing more money when that is a big part of what got us  into this mess in the first place but over the long run a prolonged recession or absence of growth would lead to greater losses in tax revenue then a large and effective stimulus.

Without getting into the details and starting to argue about different multipliers I also believe that the current stimulus is far from perfect (my perfect stimulus would pretty much look like the one described by Alice Rivlin) and that we have significant work to do on how to improve our chances for long term economic success. As I said recently the centerpiece of such a long term stimulus should be things that make America and all Americans smarter, something I will write more about in the future.

What really has me worried right now though is that Tim Geithner’s proposal for saving and restructuring the banking system is too timid and too unclear at a time when everyone is looking for the government to come up with a clear plan. The reason I am so worried about this is that the rest of the economy will be severely hampered until the banks recover as well. I’ve been worried about this for a while but a recent New York Times article on Japan’s crisis focused this worry even more:

A further lesson from Japan is that the bank rescue will determine the fate of the wider economy. While President Obama has prioritized his stimulus plan, no stimulus is likely to succeed unless the banking sector is repaired.

We have to come up with an effective solution for the banking problem before we can hope to get the rest of the economy going again, and we should think hard about what we need to do and what it will take, even if the solutions might sound politically difficult.

So far, the Obama administration’s plan avoids the hardest decisions, like nationalizing banks, wiping out shareholders or allowing banks to collapse under the weight of their own bad debts. In the end, Japan had to do all those things.

More to come…

One of the main issues with one time tax rebates as economic stimulus in tough economic times is that people will often save a large share of the additional money (in preparation of even worse times that my lie ahead ahead) instead of spending it. This was again seen with last year’s tax rebate and is one of the reasons this year’s stimulus has been structured the way it is (focusing more on infrastructure spending and money to producers).

One way is to give more money to poor who tend to spend a larger share of their income but given the current level of economic uncertainty even these might be less willing to spend. What if there were a way to force or at least strongly incentivize people to spend money they get from particular sources. One method for doing this is through Alternative Currencies, which have recently become more popular for a variety of reasons.

A recent Economist article talked about a number of Alternative Currencies that forced people to spend their money quickly so as not to have to pay special fees, such as the Chiemgauer (which is currently in circulation):

Spent it must be, because it loses value every quarter. The notes have an expiry date after which they need to be renewed with a sticker costing 2% of their value. The quicker money is spent, the faster, in macroeconomic terms, its velocity. Gesell argued that a higher velocity of money helps combat deflation.

Ignoring the bit about velocity of money, this scheme should force people to spend their newly gotten tax rebates if it is received in this kind of currency. It’s definitely unorthodox but I think it definitely sounds like an interesting solution and I’d be very interested to hear what some of the downsides might be.

Update: I’ve long wanted to have an actual reference that I can cite for the claim that people will only spend a small share of a temporary stimulus in uncertain times and I think the following Romer, Bernstein evaluation works pretty well though they don’t actually have any firm numbers but it will do for now:

It is important to note that the jobs effects of temporary broad-based tax cuts would probably be considerably smaller. Large proportions of temporary tax cuts are saved, blunting their stimulatory impact on output and employment.

I’m no expert on education but this post is about a great example of an unorthodox solution to a big and timely problem. Public discourse, especially in education, can be very hostile to unorthodox ideas and while I strongly agree that new solutions should be carefully analyzed and discussed before being implemented I think that our unwillingness and fear to discuss contrary or unpopular ideas hurts as a society and nation. In brainstorming there are no bad ideas. If you think the following is terrible or brilliant please leave a comment explaining why – either here or on the original post.

Victor Harbison has a very thought provoking (and certain to be controversial) guest post about Magnet schools at Nicholas Kristof’s New York Times blog. Harbison, a teacher, talks about how he sees average students excel when surrounded by smart peers and stagnate when they are surrounded by other average or less motivated students. Since magnet schools pull out top students from a large number of schools they rid many students of their smartest peers:

When educational leaders decided to create magnet schools, they didn’t just get it wrong, they got it backwards. They pulled out the best and brightest from our communities and sent them away. The students who are part of the “great middle” now find themselves in an environment where the peers who have the greatest influence in their school are the least positive role models.

So far so good, most people who have been through a Magnet school will tell you about how much they enjoyed the experience and the idea that taking the top performing students out of average schools might hurt their environment is relatively intuitive. Now for the controversial alternative:

What should have been done was to pull out the bottom ten percent.Educational leaders could have greatly expanded the alternative school model and sent struggling students to a place that had been designed to meet their educational needs. [...] Imagine if pulling out the “bottom ten” had been the policy for the past 30 years. Neighborhood schools could have purred along like the go-go 90’s under Clinton and the students with the greatest needs, facing the greatest challenges, would have had millions of dollars in resources devoted to their education in brand new state-of-the-art buildings (with Ivy League-educated, amazing teachers, no doubt). Just imagine.

Would this work? I think that tailoring curriculum to help get underachievers up to speed and to provide them with additional and specialized resources would definitely be a good idea. Furthermore, taking the worst performers out of most schools might free up additional teacher time for the remaining students and also stop distractions from such students.

On the other hand, would lots of underperforming students make these schools exceptionally hard to manage? Would it be difficult to get teachers to work in these more difficult schools (Teach for America is a good indicator that some teachers would like the challenge if given the support)?

Furthermore, what about the top performers – aren’t they a big part of creating the kind of innovative research and companies that help move a country forward? Would they be worse off if they have to continue to study with more average peers? Or would interaction with more average students give them a better understanding of the wider populace and allow them to create things more targeted and useful to more people? Harbison ends with the following:

I look forward to the arguments defending magnet schools. They are legion and many are spot on. That is, if you can live with the idea of condemning the vast majority of students in your community to sub-standard schools. No one can rationally argue that they are a good long term solution to what ails schools in this country.

The comments on the article are also very worth reading.

I generally tend to be pretty skeptical of Tom Friedman’s writing, hoping that he would think about some of the things he says a bit more critically before putting them out to the public as fact, and I don’t agree with much of the (admittedly partially satirical) tone of his last column, but he is 100% right on the core conclusion:

We live in a technological age where every study shows that the more knowledge you have as a worker and the more knowledge workers you have as an economy, the faster your incomes will rise. Therefore, the centerpiece of our stimulus, the core driving principle, should be to stimulate everything that makes us smarter and attracts more smart people to our shores. That is the best way to create good jobs. 

A government-funded venture capital fund might not be the right solution (that’s a longer question I don’t want to get into now) but he’s right – this is also the time to get smarter, more agile, and more productive.

We don’t want to come out of this crisis with just inflation, a mountain of debt and more shovel-ready jobs. We want to — we have to — come out of it with a new Intel, Google, Microsoft and Apple. I would have loved to have seen the stimulus package include a government-funded venture capital bank to help finance all the start-ups that are clearly not starting up today — in the clean-energy space they’re dying like flies — because of a lack of liquidity from traditional lending sources. 

Newsweek had an essay this week that began: “Could Silicon Valley become another Detroit?” Well, yes, it could. When the best brains in the world are on sale, you don’t shut them out. You open your doors wider.