In which Krugman borrows Martin Wolf's scalpel, possibly via Geithner

[n.b. see update in mid-post. I seem to have misread...]

In October 2010, Financial Times columnist Martin Wolf led off a column with a heroic simile to describe Obama's economic performance:

An ambulance stops by the roadside to help a man suffering from a heart attack. After desperate measures, the patient survives. Brought into hospital, he then makes a protracted and partial recovery. Then, two years later, far from feeling grateful, he sues the paramedics and doctors. If it were not for their interference, he insists, he would be as good as new. As for the heart attack, it was a minor event. He would have been far better off if he had been left alone.

That is the situation in which Dr Barack Obama finds himself...more stimulus was needed. After all, it was quite modest: fiscal stimulus was less than 6 per cent of GDP and so accounts for less than a fifth of the cumulative deficits of 2009, 2010 and 2011, while monetary policy is caught in a liquidity trap.

The truth is not that policy was foolhardy and failed, but that it was too timid and so could not succeed.

Lo, now cometh Paul Krugman to review Tim Geithner's memoir:

Münchau to EU: Signal now that Eurobonds are forthcoming

Today, an eponymous Wolf Munch Rock award (so named because the truth is hard to swallow) to Wolfgang Münchau, for an op-ed that's at once a primer on the dynamics of the European sovereign debt crisis  and a powerful brief (judged on its own terms) for issuing Eurobonds sooner and working out the political implications later.

First, for the uninitiated, Münchau spells out why it's so destabilizing for the solvency of member states to come in doubt -- and why the haircut for banks holding Greek debt may have exacerbated rather than relieved the markets' panic:

I am hearing from Berlin that the German government believes that the arrival of Mario Monti as Italian prime minister is all it will take to calm the markets. This unsurprisingly complacent view misjudges the underlying dynamic of the most recent events. The cause of the panic attack was the European Council’s decision on October 26 to renegotiate the private sector participation of Greek sovereign debt holders. With that decision European leaders destroyed what was left of a functioning eurozone government bond market. Investors interpreted it – correctly in my view – as a precedent. They then dumped their Portuguese, Spanish, Italian and even French government bonds. As of now, there is only one significant risk-free asset in the eurozone – German government bonds.
The German government bond market is large and liquid, but not large enough to sustain the world’s second largest economy. The presence of a risk-free asset can hardly be overstated in a modern financial system. Each insurance company, each pension fund needs to invest part of its income in such assets. Through a combination of short-sightedness and financial illiteracy, the European Council has now put itself in a position where it desperately needs Eurobonds, if only to assure the existence of a functioning financial sector.

Next, why the European Financial Stability Facility (EFSF) is inadequate:

Wrestling with hope for Egypt

It is interesting to watch sober minds grapple with their hopes in the wake of the Egyptian revolution. Nowhere more so than on the Comment page of the Financial Times, where columnists based on various continents address as a matter of course the current and likely future progress of democracy (and humanity), and Fukuyama haunts the space (and not infrequently, visits in the flesh, or rather ink). 

Up today is Martin Wolf, who explains the tidal pull toward democracy in basically Fukuyaman terms -- economic pressure to compete plus an Aristotelian understanding of human nature as essentially political, determined to self-govern. Unanswered in the short space of a column is the relationship between the two: as Wolf points out, usually it's only when a country has reached a certain level of economic development that its people are equipped to express "something deep within us" that demands self-governance.  If the will to self-governance is prior to the economic conditions that unleash it, that suggests that the "democracy drive" is either evolutionary or a product of intelligent design.

As an economist, Wolf places his bet on Egypt in mainly economic terms:

Scepticism is not unreasonable. As my colleague, Gideon Rachman notes, the stability of democracy goes hand in hand with economic advance. The richer the country, the more educated its people, except where wealth comes mainly from resource rents. Again, the higher the proportion of the desperately poor, the greater the likelihood of a successful electoral appeal by ultimately ruinous populists. Finally, the poorer the country, the smaller the resources at the disposal of any democratic government with which to protect itself against its foes...

True, Egypt is a relatively poor country with a sizeable proportion of the population illiterate. Yet its gross domestic product per head, at purchasing power parity, is almost double India’s and 50 per cent higher than Indonesia’s. This does not suggest that democracy is, in any sense, inconceivable. Egypt does have a well-organised Islamist movement. But does this have to be deeply anti-democratic? This must be put to the test. Remember that Catholicism, too, was once widely thought incompatible with successful democratic government.

What interests me is, with the ground thus prepared, Wolf grapples with "naivete anxiety" while giving way, mostly, to that "something deep within us" that yearns for democracy:

Roubini wishes Obama had done it all

Nouriel Roubini may have a keen macroeconomic insight into what the world economy needs and what the U.S. economy needs. But he has little appreciation for the realities of U.S. politics. Or rather, he suppresses his awareness of those realities while assessing the performance of President Obama.

In his contribution to the Financial Times' series of such assessments (Obama at Bay), Roubini credits Obama with preventing another Depression, via the stimulus and the bailouts, and with understanding the need for more stimulus now and a timed plan for deficit reduction later. He also gives him points for forming the deficit commission. He blames the President, though, for what has not happened and what will not happen:

In an ideal world Mr Obama would also have been able to move towards reforming and reducing entitlement spending, with commitments to measures that could be phased in over the next few years, therefore avoiding short-term fiscal pain. He would also have committed to increase, gradually over the next few years, less distortionary taxes such as a VAT and a carbon tax. This would have reduced the fiscal deficit, and created a climate in which no investor would worry about additional stimulus.

Sadly, this has not happened. In fact the opposite will now take place. The term stimulus is already a dirty word, even within the Obama administration. After the Republicans make significant electoral gains further stimulus is even less likely. Medium-term consolidation, meanwhile, will be all but impossible as the 2012 presidential election begins to loom large.

Martin Wolf recalls his cry of Feb. 2009, and bites Obama

Sometimes, consolidating conventional wisdom is clarifying -- when the weight of evidence pushes convention toward consensus. That's what Martin Wolf's column assessing the Obama administration's economic performance to date does, or purports to do.

Wolf's conclusion: the stimulus, coupled with the Fed's emergency measures, was effective but inadequate.  Notwithstanding Larry Summers' dictum, "when markets overshoot, policymakers must overshoot too," the stimulus undershot. Citing the well-circulated conclusions of the study by Alan Blinder and Mark Zandi, as well as CBO estimates, Wolf consolidates mainstream economists' consensus that the stimulus, bailouts and Fed measures averted catastrophe, boosted GDP, mitigated the plunge in employment  --  but, as Wolf himself judged in February 2009 (and happily highlights here), was "too small, too wasteful and too ill-focused." It therefore left the country with a sputtering recovery -- and left the Democrats holding the bag.

Can electorates walk and chew gum?

Martin Wolf presents a fact-dense, closely argued version of Paul Krugman's argument: that swings toward fiscal austerity in the EU and U.S. risk stopping the global recovery in its tracks and bringing on "cyclical fiscal deficits" - that is, depressed demand which slows growth and keeps tax revenues low.  He then asks:

The best policy is to put together measures that sustain strong growth in demand in the short run, while constraining the huge deficits in the long run. This is walking and chewing gum at the same time. Why should that be so hard?

Jonathan Chait has an answer for that. Citing a Wall Street Journal op-ed lambasting Obama for "hypocrisy" for advocacting precisely Martin Wolf's prescription, which Obama has done since taking office, Chait writes:

Moore and the Republicans think it's "hypocrisy" to be for high deficits during a liquidity crisis but against them during a recovery. Really. The whole Republican message is based on not understanding this distinction.

And why don't they understand?  Because drumming up fear of deficits and loathing of short-term stimulus is working:

Larry Summers takes a long and multilateral view of China and trade rebalancing

As China signals that it is ready to start letting yuan appreciate again, Larry Summers, in an interview with the FT's Martin Wolf, gives some important hints as to the Administration's long-term approach  toward China.

With regard to exchange rates and a more general rebalancing of trade, both between the U.S. and China and more generally between high-export and high-consumption economies, two of Summers' emphases in particular are noteworthy: 1) a global rebalancing of supply and demand should be pursued through multilateral channels and institutions -- the U.S. should seek allies and so diffuse the expectation (and possibility) of gladiatorial combat between the U.S. and China over exchange rates; and  2) it's going to take time -- rebalancing the world economy is a project of years and probably decades, and yuan appreciation is only one piece in a complex (re)balancing act.

On the first point, Summers is very careful to build the multilateral context:

MW Okay, just tell me about where you are on the exchange rate question vis-a-vis China and the adjustment process vis-a-vis China.

LS The G20 made a common commitment last year in London, reiterated in Pittsburgh, to seeking more stable and balanced global growth. And I think we’ve made more progress in laying a foundation for restored global growth than has yet been made in assuring more balanced global growth - to be sure that growth, the pattern of growth over the last year, has been more balanced, with trade deficits and trade surpluses both coming down. But as the global economy recovers, it will be very important not to see a major resumption and a major widening of imbalances.

Summers channels Krugman chanelling Uncle Sam(uelson)

Compare Larry Summers' message at Davos (relayed by Gideon Rachman) to Paul Krugman's shot across China's bow back on New Year's Day.

Summers:

Larry Summers, the chief economic adviser in the White House, was rather more subtle in his flirtation with protectionism. He told the Davos audience that one in five American men aged between their mid-20s and their mid-50s is now out of work. In the 1960s, he pointed out, 95 per cent of this age cohort had been employed. Mr Summers was careful to say that the US remains committed to open trade and can gain from globalisation. But he also pointed out that Paul Samuelson, a famous economist (and uncle of Mr Summers), had argued that the case for free trade might not apply when countries were trading with nations that were pursuing mercantilist policies. The reference to China did not need to be spelled out.

Krugman:

I usually hear two reasons for not confronting China over its [mercantilist] policies. Neither holds water....

...there’s the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson, who more or less created modern economics: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

The party of federal debt and the path to sustainability

Lest anyone forget that Republicans have for a generation been the party of federal debt, a timely reminder from Martin Wolf:

In the case of the US, 1.8 percentage points of a 6.5 percentage point deterioration will be due to such measures. Most of the change is structural: the levels of GDP and fiscal revenue will not return to the previous path....the rise in the debt ratio is comparable to that in big wars – smaller than the second world war, but larger than in the civil war and the first world war. But this is not the first time the US has had a huge increase in its debt ratio in peacetime. The first occasion was under the Republicans between 1981 and 1992. That was when they discovered supply-side economics.

Supply-side fervor went hand-in-glove with deregulatory fervor - which, to be fair, also infected Clintonian Democrats. Hence the need for a massive course correction by the party of relative fiscal responsibility -- the Democrats.

A Wolf whistle on bankers' pay

Almost two years ago, FT economics columnist Martin Wolf surprised himself (rhetorically, anyway) by seconding a proposal by Raghuram Rajan, former chief economist of the International Monetary Fund, that regulators force banks to tie bonus pay to long-term performance:

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

Today, Wolf further surprises himself by calling for a windfall tax on bankers' bonuses. Here's how his case begins:

Windfall taxes are a ghastly idea. They are a sop to prejudice, a burden on risk-taking and a form of arbitrary confiscation.

So Wolf once again casts his stance as a Nixon-to-China moment. But the logic seems incontrovertible:

“Windfall” support should be matched by windfall taxes.

And in a bit more detail:

Fourth, ordinary people can accept that risk takers receive huge rewards. But such rewards for those who have been rescued by the state and bear substantial responsibility for the crisis are surely intolerable. What makes them yet more so is that the crisis has devastated the prospects of tens, if not hundreds, of millions of innocents all over the globe. The public finances will be devastated for decades: taxes will be higher and public spending lower. Meanwhile, bankers are about to reap huge rewards. This damages the legitimacy of the market economy.

Fifth, it is hard to argue in favour of exceptional interventions to bail out the financial sector at times of crisis, and also against exceptional interventions to recoup costs when the crisis is past. “Windfall” support should be matched by windfall taxes.

If a nonideological free marketer like Wolf can make this case seem watertight, there ought to be ample cover for a large Democratic majority badly in need of landing a populist blow. But then, Wolf presumably doesn't take campaign contributions.

Human Rights Watch's true-blue conservative

Early this year, David Brooks put on his Big Think cap and counterpoised against our society's alleged individualist shibboleths a communitarian ethos put forward by political scientist Hugh Heclo in a book published last summer, On Thinking Institutionally. As relayed by Brooks:

In this way of living, to borrow an old phrase, we are not defined by what we ask of life. We are defined by what life asks of us. As we go through life, we travel through institutions — first family and school, then the institutions of a profession or a craft.

Each of these institutions comes with certain rules and obligations that tell us how to do what we’re supposed to do. Journalism imposes habits that help reporters keep a mental distance from those they cover. Scientists have obligations to the community of researchers. In the process of absorbing the rules of the institutions we inhabit, we become who we are.

New generations don’t invent institutional practices. These practices are passed down and evolve. So the institutionalist has a deep reverence for those who came before and built up the rules that he has temporarily taken delivery of. “In taking delivery,” Heclo writes, “institutionalists see themselves as debtors who owe something, not creditors to whom something is owed.”

While Brooks never used the word "conservatism" he was plainly holding up this "institutional" ethic as a kind of Platonic conservative ideal. Proud professionals devote their lives to "saving" the honorable essence of institutions that themselves conserve the distilled wisdom of generations.

From this standpoint, Tom Malinowski, Washington Advocacy Director for Human Rights Watch, is a true-blue conservative. Consider his call to trust in the accumulated wisdom of core U.S. institutions in his June 9 testimony before the Senate Judiciary Subcommittee on the Constitution:

Seven years after Guantanamo opened, a stable set of rules for determining who should be detained and with what degree of due process has still not emerged.

Some of these problems are due to the inherent flaws of the system. But many are the inevitable result of creating any new system from scratch, especially one that deviates so much from standards with which US courts are comfortable and American lawyers are familiar. America's civilian criminal justice system, on the other hand, has been around for more than 200 years. The Uniform Code of Military Justice has been around for almost 60. We've had all that time to get the kinks out of the system, to establish stable rules, to train a cadre of lawyers and judges who know those rules, and to develop special procedures for special kinds of cases, including those involving terrorism.

If we try again to create a new system from scratch, if we rely again on trial and error to work out the rules, the result will again likely be more error than trial. Eventually, stable rules may emerge, after all the legal challenges and legislative re-dos are exhausted. But how long should we be prepared to wait to get to that point? Five years? Ten years? Can the United States afford more years of controversy over how to detain suspected terrorists?

To Obama, who has signaled that he wants to revamp rather than scrap the improvisations of the Bush administration - military commissions and preventive detention -- Malinowski points out that there's a kind of infinite regress in trying to reproduce the due process protections of the criminal justice system in a new regime that grants the Federal government powers the whole purpose of which is to short-circuit those protections:

Theoretically, one could design a system of preventive detention that affords detainees such a high level of due process and judicial review that it would not look like Guantanamo, or even Guantanamo-lite. But if you allow protections similar to those already provided by federal courts and courts martial, why go to the trouble of creating a new system at all?

Commentators as diverse as Andrew Sullivan, Martin Wolf and Jack Goldsmith have pointed to a kind of conservatism in Obama -- a propensity to retool rather than radically remake existing institutions, a reform impulse that aims to restore institutions to working order. With regard to treatment of detainees, Obama promises to work within our political institutions, in concert with Congress and the courts, to revamp military commissions and create Constitutional rules for preventive detention. But reforming and "conserving" Bush's radical, ad hoc exercise of this power may simply serve to codify core violations of Constitutional principles as previously understood. As Diane Marie Amann, a law professor at UC Davis, warned in the wake of Obama's May 20, speech on national security:

He signaled a plan by which they — and perhaps other detainees yet to be arrested? — could remain in custody forever without charge. There is no precedent in the American legal tradition for this kind of preventive detention. That is not quite right: precedents do exist, among them the Alien and Sedition Acts of 1798 and the Japanese internment of the 1940s, but they are widely seen as low points in America’s history under the Constitution.

President Obama promised that his “new legal regime” — words identical to those Bush Administration official John Yoo used in 2002 –- will provide an array of “fair procedures.” That ought to be a given, for the Constitution requires due process before liberty may be deprived. But no amount of procedures can justify deprivations that, because of their very nature violate the Constitution’s core guarantee of liberty.

Time will tell how "institutionally" Obama thinks about the U.S. Constitution.

Martin Wolf and Paul Krugman share a worry: will Obama funk reform?

Martin Wolf's assessment today of Obama's handling of the banking crisis follows the same curve as Paul Krugman's last week. Both note Obama's essential conservatism, his wish to reform with as little upheaval as possible. Both allow (Krugman grudgingly) that the sequence of bailouts, stress tests and capital raisings, coupled with cheap money from the Fed, may have saved the 19 biggest banks, providing space for them to grow their way out of crisis. Both worry that preserving the status quo will lead to another blowup. Both wonder whether Obama has the chops to impose structural reforms.

The conservatism, in Krugman's eyes, is pusillamity; Obama has decided to "muddle through the financial crisis." Wolf has a more positive view:

“If we want things to stay as they are, things will have to change.” Thus wrote the Sicilian writer Giuseppe di Lampedusa, in The Leopard. This seems to me the guiding principle of the Obama presidency...In his own way, Mr. Obama is following the path trodden by Franklin Delano Roosevelt.

On the possiblity of short-term success, here's Krugman:

It’s a strategy that might work. After all, right now the banks are lending at high interest rates, while paying virtually no interest on their (government-insured) deposits. Given enough time, the banks could be flush again... maybe we can let the economy fix the banks instead of the other way around.

And Wolf:

The purpose of the exercise was indeed conservative: to make it credible, though not certain, that the existing banking system and assets can survive the likely battering. This has been done well enough to satisfy the markets. But these banks will also be unable to expand their balance sheet significantly in the near future.

Interestingly, both identify the chief long term danger as failure to reform. Krugman thinks that the banks see Obama as King Log, not King Stork:

...while the Federal Reserve and the Obama administration continue to insist that they’re committed to tighter financial regulation and greater oversight, Wall Street insiders are taking the mildness of bank policy so far as a sign that they’ll soon be able to go back to playing the same games as before.

Wolf cites more structural reasons to be skeptical that we'll get change we can believe in:

Ensuring the rescue of a financial system packed even more than before with complex and “too-big-to-fail” institutions may well be the cautious response to this crisis. But it leaves the government with the even more onerous task of imposing effective regulation in future. Unhappily, the record of regulation of generously insured financial systems is extremely poor. The mobilised self-interest of highly rewarded players easily overwhelms the constraints imposed by far less well-rewarded and almost certainly less able regulators.

The more the crisis unfolds, the more evident it is that incentives in the financial system were (and are) badly distorted. I sympathise with the conservative approach to crises, but not if it leaves in place the plethora of perverse incentives that created them. At the end of this, then, there will be one big test: will the number of institutions thought “too big to fail” be as large as now and, if so, how will they be controlled? If the answers are still not clear, there will need to be yet more change.

On the day this was published, the WSJ reported, "The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry," and Federal regulators outlined plans to regulate derivatives. First steps on a long road.

Wolf, crying; Obama, rebalancing

Can massive fiscal and monetary intervention slow and shorten a Depression?

Martin Wolf's answer: maybe, somewhat. But recovery will be slow, uncertain, fraught with danger.

Today he casts a cold eye on the present, a colder eye on the future, and walks us through four conclusions:

1) Measured by falling output and bank activity, the current crisis is worse than the great Depression.
2) Unprecedented intervention by governments and central banks is likely to break the fall to a degree.
3) Those interventions will create a whole new set of problems and dangers and will be difficult to unwind.
4) We have not begun to cope with the global trade imbalances that made the growth preceding the current crisis unsustainable.

Wolf's quick sketch of Great Depression II took my breath away. Perhaps these facts are well known to economists; they were a slap to me:

In the US, the rate of decline of manufactured output compares with that of the Great Depression. Japan’s output of manufactures has already fallen by almost as much as in the US during the 1930s (see chart). The disintegration of the financial system is, arguably, worse than it was then.

He then offers some apparent comfort in a similarly compressed overview of worldwide government response, which in the aggregate looks almost coordinated:

If the world experiences a “Great Recession”, rather than a Great Depression, the scale of policy support will be the explanation. Three of the world’s most important central banks – the Federal Reserve, the Bank of Japan and the Bank of England – have official rates close to zero and have adopted unconventional policies. The real OECD-wide fiscal deficit is forecast at 8.7 per cent of gross domestic product next year, with a structural deficit of 5.2 per cent. In the US, the corresponding figures are 11.9 and 8.2 per cent. Governments of wealthy countries have also put their healthy credit ratings at the disposal of their misbehaving financial systems in the most far-reaching socialisation of market risk in world history.

But what about the morning after?

What is most disturbing, moreover, is the scale of the policy action required to halt this downward spiral. This raises the big question: how and when might the world return to normality, with sustainable fiscal positions, strongly positive short-term official interest rates and solvent financial systems? That Japan has failed to achieve this over 20 years is surely frightening.

Not to mention the underlying problem, still to be addressed:

The danger is that a turnround, however shallow, will convince the world things are soon going to be the way they were before. They will not be. It will merely show that collapse does not last for ever once substantial stimulus is applied. The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started and, for all these reasons, a return to sustained, private-sector-led growth probably remains a long way in the future.

Wolf might have noted that Obama, for one, agrees with him about the core problem and has worked to focus the world's attention upon it. Perhaps the keynote of his G-20 appearance was this, from his April 1 press conference in London:

"In some ways, the world has become accustomed to the United States being a voracious consumer market and the engine that drives a lot of economic growth worldwide," Obama said, hinting that this position may not be sustainable. "We're going to have to take into account a whole host of factors that can increase our savings rate and start dealing with our long-term fiscal position as well as our current account deficits.

Reinforced by this, on April 3 in Baden-Baden, Germany:

...the whole point is to move from a borrow-and-spend economy to a save-and-invest economy.

Now, the U.S. will remain the largest consumer market, and we are going to make sure that it's open. One of the principles that we very clearly affirmed in London was that protectionism is not the answer. It's not the Germans' fault that they make good products that the United States wants to buy. And we want to make sure that we're making good products that Germans want to buy. But if you look overall, there is probably going to need to be a rebalancing of who's spending, who's saving, what are the overall trade patterns.

And it, by the way, it doesn't just include developed economies like Germany and the United States; it also means we want to encourage emerging markets to consume more. If you start seeing China and India improve the living standards of its people, now those are huge markets where we can sell. And that's why the last few days that I've spent talking about the international economy relates directly to the jobs that are being lost in the United States.

Talk not action, one might say. And yet, with the eyes of the world upon a new U.S. President, talk is action. When the time comes for tough negotiations about exchange rates and trade barriers, this overall strategic framework - cast as a shared framework for sustainable global growth -- will be in place.

Wielding power by mapping its limits

More wisdom from the FT's Philip Stephens today:

By contrast, the US president has grasped that if America is to hold on to its pre-eminent role in the world it will be within a system in which others have a stake. Mr Obama shows wisdom beyond his years in realising that to understand the extent of US power – and it is still unrivalled – a president must also map its limits.

and more:

The so-called Group of 20 – I counted 29 delegation heads round the dining table in 10 Downing Street – is a cumbersome grouping. Its reach gives it legitimacy, but at the price of operational efficiency. A smaller grouping – say, of 15 – might yet be a better answer.

Whatever the imperfections, the process promises to embed the habit of multilateralism in a multipolar world. History reminds us that big shifts in global power, such as we are witnessing, often end in war as rising states challenge the status quo. A few arguments about tax havens or bank regulation are a small price to pay for a peaceful transition.

The FT columnists, in their long collective struggle to take the measure of the economic meltdown, have been haunted by the specter of war following economic upheaval. Here's Martin Wolf:

Now think what will happen if, after two or more years of monstrous fiscal deficits, the US is still mired in unemployment and slow growth. People will ask why the country is exporting so much of its demand to sustain jobs abroad. They will want their demand back. The last time this sort of thing happened – in the 1930s – the outcome was a devastating round of beggar-my-neighbour devaluations, plus protectionism. Can we be confident we can avoid such dangers? On the contrary, the danger is extreme. Once the integration of the world economy starts to reverse and unemployment soars, the demons of our past – above all, nationalism – will return. Achievements of decades may collapse almost overnight.

Gideon Rachman:

If Europe starts rolling back the four freedoms, the implications will stretch well beyond economics. Protectionism and nationalism are close cousins. The principles of consultation, co-operation and open borders within the EU have helped to repress the old, nationalist demons.

Nice to see a glimmer of optimism from Stephens.

P.S. My one beef with Stephens is that he's fond of straw men:

Those who view politics as an event rather than a process will have been disappointed. So also will those expecting, or pretending to expect, that the summit would fix the global economy. The world is too complex for the instant gratification demanded by 24-hour rolling news channels.

I read a lot of predictions that the summit would be a disaster - none that it would "fix" much of anything. Pleasant surprise, a la Stephens, seems to be a hear-universal reaction. Someone did a nice job lowering expectations. Or was that a broad-based defense mechanism?

P.P.S. Strobe Talbott makes much the same point about Obama's core message to the world as Stephens:

“President Obama embraced, and made his own, a shift in attitude towards a much more pluralistic world order in which the United States is still uniquely influential by virtue of its ability to persuade,” says Mr Talbott. “In essence, President Obama managed to identify himself with a form of American statesmanship that recognises the difference between being a leader and being a boss.”

And from the horse's mouth:

“There has been a lot of comparison here about Bretton Woods [the 1944 conference that set up the postwar economic order],” [Obama] said. “Well, if it is just Roosevelt and Churchill sitting in a room with a brandy – you know, well, that’s an easier negotiation. But that’s not the world we live in. And it shouldn’t be the world that we live in. It’s not a loss for America. It’s an appreciation that Europe is now rebuilt and a powerhouse. Japan is rebuilt, is a powerhouse. China, India, these are all countries on the move. And that’s good.”

Yes, it's good. And it's good to hear an American President say it.

Soft power hit from two sides

As the Bush Administration ran roughshod over multilateralism, human rights and the U.S. Constitution, invading Iraq without international sanction and establishing its torture gulag, critics for years lamented the decline of U.S. influence throughout the world, its undercut authority to protest and deter human rights abuses, nuclear proliferation, and environmental depredation.

How ironic that a swifter and more tangible erosion of U.S. (and western) influence struck from a completely different -- and seemingly unrelated -- direction. Here's the FT's Martin Wolf, assessing one of many seismic effects of the world financial meltdown:

The ability of the west in general and the US in particular to influence the course of events will also be damaged. The collapse of the western financial system, while China’s flourishes, marks a humiliating end to the “uni-polar moment”. As western policymakers struggle, their credibility lies broken. Who still trusts the teachers?

In more detail, one of the erstwhile "students," the U.S.-trained president of the China Investment Corporation, Gao Xiqing, told James Fallows last December:

The simple truth today is that your economy is built on the global economy. And it’s built on the support, the gratuitous support, of a lot of countries. So why don’t you come over and … I won’t say kowtow [with a laugh], but at least, be nice to the countries that lend you money.

Talk to the Chinese! Talk to the Middle Easterners! And pull your troops back! Take the troops back, demobilize many of the troops, so that you can save some money rather than spending $2 billion every day on them. And then tell your people that you need to save, and come out with a long-term, sustainable financial policy.

To an extent, this change is natural and healthy. The unipolar moment had to end; permanent domination of the world economy by a country with 5% of earth's population is not sustainable. Four billion people can't emerge from grinding poverty in a world where the U.S. controls a quarter of the world's wealth. In the short term, too, the financial crisis has heightened U.S. power, since the great emerging economies (and several wealthy countries) depend on U.S. demand to sell their exports. But the violent blow to U.S. soft power, in finance as in politics, is the Bush Administration's singular legacy.

Is there a common thread in the erosion of U.S. credibility in these different arenas? There is: radical Republicans' malign contempt for the rule of law. Conservatism is supposed to be about conserving a society's most valuable norms and traditions. As a political force in the real world, however, conservatism is usually a matter of maximizing the power of those already in power -- ultimately, a lawless proposition. The country with the largest military calls the shots and can't let itself be constrained by the clamor of lesser nations. The President is responsible for the nation's security and can't let himself be constrained by a whining pusillanimous legislative branch. The financial masters of the universe are uniquely qualified to allocate capital where it's most productive and can't be constrained by a bunch of petty curbs on leverage and lending practices.

At the moment when risk management in the financial world radically failed, democracy's ultimate risk management tool -- the ballot box -- kicked in. The Bush Administration's assault on the U.S. Constitution and governmental norms was unprecedented. Obama, on multiple fronts, is trying to implement the most sudden about-face in our history. In his inaugural address, he told the world, "we reject as false the choice between our safety and our ideals...and we are ready to lead once more." We'll learn sooner or later whether it's too late.

B.F. Skinner haunts the banks

A year after first Raghuram Rajan and then Martin Wolf, both writing in the FT, fingered bankers' bonuses as a prime cause of the financial meltdown, Nassim Nicholas Taleb redoubles the attack. The point is not hard to grasp. The banking industry runs on a heads-I-win-tails-you lose incentive structure: take huge hidden risks, reap the rewards of resulting outsized gains, and give up nothing (except perhaps your job, multimillions later) when those gains give way to huge losses.

But Taleb does end with an arresting dictum that's worth a thousand words:

never trust with your money anyone making a potential bonus.

Take that as as a rule of life. Are you listening, education reformers? It translates: never trust with your child anyone making a bonus. There are buried risks in juicing children's apparent performance, too. Skewed incentives also pervert education from the other end. As an opponent of behavior mod programs once said, give children pizzas for reading books, and you'll end up with a lot of fat children who can't read. Incentives focus people's attention on the reward rather than on the act required to get the reward.

I'm also reminded of a wise woman's watchword: never trust what you hear from any man with an erection. Broadly, then: beware of anyone dazzled by overwhelming incentives, by the prospect of immense gratification.

Obama realigns bailout bankers' incentives

Today, Obama made headlines for capping executive pay at banks that accept "major" bailout funds at $500,000. Here, though, is the real news in his statement:

Finally, these guidelines we’re putting in place are only the beginning of a long-term effort. We’re going to examine the ways in which the means and manner of executive compensation have contributed to a reckless culture and quarter-by-quarter mentality that in turn have wrought havoc in our financial system. We’re going to be taking a look at broader reforms so that executives are compensated for sound risk management and rewarded for growth measured over years, not just days or weeks.

That promise gets at the core problem, nicely framed last January in the FT by Raghuram Rajan, former chief economist at the IMF:

True alpha [the value the investment manager's abilities contribute to the investment process] can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

A week later, FT columnist Martin Wolf elaborated:

the only way to deal with this challenge is to address the incentives head on and, as Raghuram Rajan, former chief economist of the International Monetary Fund, argued in a brilliant article last week ("Bankers' pay is deeply flawed", FT, January 9 2008), the central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

We would be better off with Jupiter's 12-year "year", since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

The big points here are, first, we cannot pretend that the way the financial system behaves is not a matter of public interest - just look at what is happening in the US and UK today; and, second, if the problem is to be fixed, incentives for decision-makers have to be better aligned with the outcomes....

All bonuses and a portion of salary for top managers should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five. I understand that the bankers will not like this. Yet one thing is surely now quite clear: just as war is too important to be left to generals, banking is too important to be left to bankers, however much one may like them.

For bailout recipients, that kind of long-term tie-up begins today. In addition to the $500,000 salary cap, Obama announced:

And if these executives receive any additional compensation, it will come in the form of stock that can’t be paid up until taxpayers are paid back for their assistance.

Incentive pay for reducing your bank's contribution to the national debt. Will anyone collect?

UPDATE: Some timely further perspective on distorted pay incentives today from Thomas Frank, lone liberal on the WSJ op-ed page:

...Wall Street's compensation system isn't just aesthetically displeasing to liberal snobs. It is the very heart of the problem. According to Bill Black, a professor of economics and law at the University of Missouri-Kansas City and an authority on dysfunctional financial systems, "It is the compensation system that has proved to be the weak point in everything critical that went wrong, that has produced a global catastrophe."

At each stage of the disaster, Mr. Black told me -- loan officers, real-estate appraisers, accountants, bond ratings agencies -- it was pay-for-performance systems that "sent them wrong."

The need for new compensation rules is most urgent at failed banks. This is not merely because is would make for good PR, but because lavish executive bonuses sometimes create an incentive to hide losses, to take crazy risks, and even, according to Mr. Black, to "loot the place through seemingly normal corporate mechanisms." This is why, he continues, it is "essential to redesign and limit executive compensation when regulating failed or failing banks."

Footnote: Obama ought to keep the malign effects of distorted pay incentives in mind when the subject of pay for performance for teachers comes up. Otherwise, our kids' diplomas may have all the value of an AAA mortgage-backed security.

Down girl, down! Dowd sics herself on Wall Street

Oh dear. Maureen Dowd's gone demagogue, as she occasionally does when her rhetorical weaponry is set loose in a target-rich environment.

On Wednesday she unloosed a fearsome smart-bomb barrage against banking mogul excess. Today, she carpet-bombed Wall Street. Making money from money "must unhinge you." Those who awarded bonuses should be prosecuted, the money disgorged.

Reality check:

1) Done right, allocating capital efficiently is as important as making good widgets. You don't get good new widgets made without the capital. The problem was regulation gone awry (or AWOL), not the existence of people whose function is to make money from money. Like lawyers, they're unpopular but useful. You could argue that poor regulation made the field so lucrative that there's too many of them, but that's different.*

2) Dowd quotes Barney Frank without comment: "Paulson let the cat out of the bag...and it can't be gotten back." Frank's right. You can't claw back, let alone prosecute, unless someone broke a law. TARP was riddle with holes. The Obama Administration and Congress can fix the second half but not siphon back what's been pissed away.

3) Dowd ridicules Rudolph Giuliani for saying that cutting Wall Street bonuses would mean less spending in restaurants and stores. Restaurants, schmestraurants. The bonuses constitute a huge chunk of New York's decimated tax base.

There's a balance to be struck with regard to bonuses. They're more than half of a lot of financial people's yearly compensation, they're supposed to be based on the money you make, and some people did make money for their firms. Yes, TARP should radically limit them, particularly for those with 7-figure compensation and more. More to the point, as first Raghuram Rajan* and then Martin Wolf (hardly a pair of flaming radicals) wrote in the FT a year ago, the bulk of bonus money should be tied to long term performance -- locked up for up to 10 years and clawed back if today's bets wreak mass destruction tomorrow. But the whole system can't be obliterated at a stroke.

*As an index investor, I find them only indirectly useful, as there'd be no indexes without paid professional investors vainly trying to beat them.

**Former chief economist, IMF

The sum of economic fears

What's so scary about a really deep recession or Depression? Behind the prospects of lost jobs and reduced wealth lies the specter of political upheaval. Martin Wolf frames the danger:

Now think what will happen if, after two or more years of monstrous fiscal deficits, the US is still mired in unemployment and slow growth. People will ask why the country is exporting so much of its demand to sustain jobs abroad. They will want their demand back. The last time this sort of thing happened – in the 1930s – the outcome was a devastating round of beggar-my-neighbour devaluations, plus protectionism. Can we be confident we can avoid such dangers? On the contrary, the danger is extreme. Once the integration of the world economy starts to reverse and unemployment soars, the demons of our past – above all, nationalism – will return. Achievements of decades may collapse almost overnight.

From Depression to aggression -that's the road to ruin that lurks at the back of everyone's mind.

Wolf Munch Rock Awards II

cont. from Wolf Much Rock Awards I, here

Martin Wolf, the FT’s chief economics columnist, also wrote an end-of-year retrospective, in this case focused on the likely fallout from the subprime crisis. Like Rachman, he introduces his list of observations casually– in this case, of reasons Why the credit squeeze is a turning point for the world: “Why do I believe this? Let me count the ways.”

Wolf, like Rachman, doesn’t use lists as ideological bludgeons to suggest he’s cornered the market in causality in a neat ideological package wrapped around a simple solution. This is not “The Eight Steps Central Banks Must Take to Avoid a Depression.” In fact Wolf offers up more questions than answers:

Third, the crisis has opened up big questions about the roles of both central banks and regulators. How far, for example, do the responsibilities of central banks as “lender-of-last-resort” during crises stretch? Should they, as some argue, be market-makers-of-last resort in credit markets? What, more precisely, should a central bank do when liquidity dries up in important markets? Equally, the crisis suggests that liquidity has been significantly underpriced. Does this mean that the regulatory framework for banks is fundamentally flawed? What is left of the idea that we can rely on financial institutions to manage risk through their own models? What, moreover, can reasonably be expected of the rating agencies? A market in US mortgages is hardly terra incognita. If banks and rating agencies got this wrong, what else must be brought into question?

Those questions would seem to point toward a need for a firmer government hand on the economic tiller. But the next point tacks the other way:, toward less intervention:

Fourth, do you remember the lecturing by US officials, not least to the Japanese, about the importance of letting asset prices reach equilibrium and transparency enter markets as soon as possible? That, however, was in a far-off country. Now we see Hank Paulson, US Treasury secretary, trying to organise a cartel of holders of toxic securitised assets in the “superSIV”. More importantly, we see the US Treasury intervene directly in the rate-setting process on mortgages, in an attempt to shore up the housing market. Either, or both, of these ideas might be good ones (though I strongly doubt it). But they are at odds with what the US has historically recommended to other countries in a similar plight. Not for a long time will people listen to US officials lecture on the virtues of free financial markets with a straight face.

In fact, each of Wolf’s eight points reads like a discrete essay. Each highlights either lessons learned or questions raised, and in each case, Wolf goes where the evidence takes him. Not all of his essays are so free-form; some point toward a policy prescription. But generally, these pieces are inquiries, not briefs – essays in the original sense of “trials,” thought processes laid out on the page.