Baseline Scenerio

Long but worth it:

The Baseline Scenario
The Crisis Is Over, And We Wasted It
Posted: 26 May 2009 06:22 AM PDT
Rahm Emanuel reportedly has a doctrine: Never let a serious crisis go to waste. His point is a good one - vested interests usually block change across a wide range of important issues in the US, and a major financial/economic crisis provides an opportunity to bypass or breakthrough those interests in order to introduce meaningful and substantial change. Emanuel listed (from the 1:40 minute mark) five priority areas for change: health care (cost control and expansion of coverage), energy (independence and alternatives), taxes (fairness and simplicity), education (fundamental changes to effectively train the workforce), and financial regulation (transparency and accountability).
The financial crisis is abating - although the economic costs continue to mount and new problems may still appear (ask California or Ukraine). At least among the people I talk with on Capitol Hill, there is a very real sense that business is returning to usual; certainly, the lobbyists are out in force, they want what they always want, and it’s hard to see many of them as seriously weakened. How much progress have we made on any of Emanuel’s priority areas or, for that matter, along any other public policy dimension that was previously stuck?
The charitable answer would be: this is still a work in progress and you cannot expect miracles overnight. True, but Rahm’s Doctrine (as Larry Summers apparently calls it) says that you should implement irreversible change while you still have the chance. Tell me if I missed something, but has there been any breakthrough of any kind? Was it wrapped up in the fiscal stimulus? Is the credit card bill a bigger blow to vested interests than we have so far recognized? Has there been some secret progress on healthcare (although than a vague and apparently deniable pledge drive)? Were the bank stress tests more subtle than meets the eye?
We discussed this issue on Bill Mayer’s Overtime segment from about the 2:20 minute mark on Friday. Jon Meacham just interviewed President Obama and came away with no clear sense of where the President is really pushing to make fundamental change – although Jon and Bill nicely summarize where he is compromising (from about the 4 minute mark of Overtime).
On financial sector issues, the lobbies look stronger than ever. “You can’t recover without us” appears to be a winning slogan for big banks and their appointees. Tough financial regulation may still appear later this year, but it looks like an uphill struggle – and there is no sense that the administration even wants to break vested interests in this sphere.
Perhaps Rahm’s Doctrine was overly optimistic as a broad aspiration, but at least on the financial front some tangible opportunities went to waste.
By Simon Johnson

What Good Is It, Anyway?
Posted: 25 May 2009 08:26 PM PDT
Behind the ephemeral debates over the financial crisis and the bailouts it has spawned, there is a broader debate about the financial sector as a whole: what good is it, how much of it do we need, and how do we know if it is working?
There are many descriptions of what the financial sector does, but most of them have something to do with moving capital (money) from someone who has more than he needs to someone who could use a bit more. And I think most people would agree that is a good thing, as long as the latter person has some productive use for it. Mike at Rortybomb, in “The Financial Sector We Want,” describes a doctor saving up $1,000 more than she needs for consumption and lending it to a factory, which returns her $1,100 after a year. In real life, we need some kind of a financial sector to get the money from the doctor to the factory, even if it’s just a single local bank. Everyone is happy.
When you start asking how big the financial sector should be, and whether or not it is working properly, things get more complicated. One of the Economist’s Free Exchange bloggers took the position that financial innovation is generally good in and of itself, although it has a high risk of creating “negative spillovers” – a higher risk than for non-financial innovation: “Most financial innovations are positive, and we don’t know ex ante which will be negative, so giving ourselves the power to block certain innovations because they might have negative spillovers is risky.” At first blush, this seems like a reasonable extension from real-world innovation to financial innovation.
However, Mike (Rortybomb) has an interesting counter-argument. Financial innovation, he says, is not like real-world innovation; the former only creates value if it solves an existing market imperfection. Figuring out which factories are worth investing in – so the doctor doesn’t have to worry about it – solves a market imperfection. But his point is that it’s the factory that’s creating the value; the financial sector is helping make that possible. So, he argues, if someone figures out a way to get a higher yield out of a risk-free investment (and that was the point of the CDO boom, where you could create a “super-senior, better-than-AAA” bond that paid a higher yield than Treasuries), then you either have to show what market imperfection it is solving, or it isn’t actually risk-free. In most cases, he suspects, innovation that generates a higher return does so simply by taking on more risk.
So what are we to make of the last quarter-century, when the financial sector got bigger and bigger and the people in it got richer and richer?
An instinctive free-market reaction might be to assume that the financial sector was doing great things, and that the people getting rich deserved to. But from Mike’s perspective, you have to ask: did people suddenly discover how to fix such massive market imperfections that they deserved to make that much money for so long? Ryan Avent put it this way:
Frankly, I have no idea what most of the recent growth in finance was for. . . . To get back to Mike’s original point, when you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.
And Felix Salmon, I think, pinpointed the crucial issue. If the financial sector was doing such a good job innovating, then it shouldn’t have continued making so much money.
[O]ne would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.
Ordinarily, if an industry innovates, a few people make a lot of money, and then most of the benefits flow to that industry’s customers. Let’s take one of the greatest examples of recent history: Microsoft and Intel together probably created a handful of billionaires and a few thousand multi-millionaires out of their employees; but for at least the last ten years, no one going there has gotten anything more than a decent salary and a good resume credential. As computers get smaller, cheaper, and faster, the benefits flow overwhelmingly to their customers – to us. And those are near-monopolies. The general pattern in the technology industry is that a few entrepreneurs make a lot of money, and the vast majority of people make a decent salary; even the highly-educated, highly-trained, hard-working software developers, most of whom could have been “financial” engineers, are making less than a banker one year out of business school.
That’s the way innovation is supposed to work. You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.
By contrast, the historical pattern of the financial sector – rising revenues, rising profits, and rising average individual compensation – is what you get if there is increasing demand for your services and, instead of competing to lower costs and prices, you limit supply. Sure, prices fell on some financial products, but financial institutions encouraged substitution away from them into new, more expensive products, with the net effect of increasing profitability (and compensation). Why this happened I won’t try to get into here, but it would be worth understanding if we want to reduce the chances of living through this crisis again in our lifetimes.
By James Kwak