Testimonials from professional economists in favor of my writings on economics

Response from Professor Edmund Phelps, Winner of Nobel memorial prize in Economics, 2006.

Date: February 16, 2010

Very interesting. I myself never had much patience with "learning by doing". Several of your remarks coincide with my views. I suppose you have looked at the Center on Capitalism and Society's improved website www.capitalism.columbia.edu

Where are you?

Edmund Phelps
Sent via Blackberry by AT & T

(Professor Edmund Phelps' comment was made in response to my article, "Review of the first two Annual Arrow Lectures held at Columbia University")


Response from Professor Kenneth Arrow, Co-winner of the Nobel Memorial Prize in Economics, 1972.

Date: March 19, 2008

You have thought with some depth about the problems of analyzing the economy and, in particular, the role of commitments over time ... ... I regret that I cannot pursue in more detail the analytic questions you raise, especially since they do not admit of simple answers. I do note one point, that you correctly note that the issue is the presence of time per se but rather the difficulty of defining the relevant uncertainties (and, in particular, getting some agreement on them).

(Professor Kenneth Arrow's comment was made in response to my article, "A New Perspective on the Role of Markets in an Economy")


Response from Professor Edmund Phelps, Winner of the Nobel Memorial Prize in Economics, 2006.

Date: May 5, 2008

Thank you. I arrived too late in the studio to hear that exchange between Stiglitz and Engle. But I am very much part of the conversation with both of them in BBC Debates: The Insiders. You will be interested, I believe. (Go to www.bbc.co.uk/worldservice/index.shtml) See also my serious op-ed in the March 14 Wall Street Journal, "The Uncertain Economy."

(Professor Edmund Phelps's comment was made in response to my article, "Update 2: A Marginalistic Interpretation of the GARCH model")


Response from Professor Edward Prescott, Co-winner of the Nobel Memorial Prize in Economics, 2004.

Date: December 19, 2008

Say's Law holds. Supply creates its own demand.

You don't spend your way to prosperity. Output and income are equal to the product of productivity (output/market hour) and hours worked. There is no shortage of wants. Cutting marginal effective tax rates increases hours worked. High productivity results from good legal and regulatory policies.

(Professor Edward Prescott's comment was made in response to my article, "Some Perspectives on the Relevance of Keynes to the Modern Economy")


Response from Professor George Akerlof, Co-winner of the Nobel Memorial Prize in Economics, 2001.

Date: July 12, 2007.

Thank you so very much for sending it to me. I am not sure that we are thinking about things so very differently.

(Professor George Akerlof's comment was made in response to my article, "Effective Philanthropy in India")


Response from Professor Martin Shubik, Department of Economics, Yale University.

Date: April 14, 2008

I am in substantial agreement with most of your observations. The length of time participants are in trade is often a highly important variable ... ... As I believe that your observations indicate some careful thought I will note them to others who may be in a position to consider them.

(Professor Martin Shubik's comment was made in response to my article, "Update 1: Housing Example in Role of Markets")


Response from Professor Jeffrey Frieden, Department of Government, Harvard University.

Date: March 27, 2008

Got it. It seems very interesting, with lots of promising ideas ... ... So I doubt this is particularly useful to you, as I am no expert on the subject. Nonetheless, I did think the ideas were provocative and engaging.

(Professor Jeffry Frieden's comment was made in response to my article, "A New Perspective on the Role of Markets in an Economy")


Response from Professor Alvin Roth, Department of Economics, Harvard University.

Date: March 18, 2008

Dear Dr. Selvakumaran: thank you for your interesting email. ... ... I'm not an expert on contract theory, but you might look into it to see if it helps you develop the ideas you are struggling with.

(Professor Alvin Roth's comment was made in response to my article, "A New Perspective on the Role of Markets in an Economy")


Response from Professor John Roemer, Department of Economics, Yale University.

Date: March 19, 2008

Thank you for sending me your proposal. I am impressed with your knowledge of economic theory ... ... Several recent writings occur to me as relevant to you ... ... There is also an article, recently, in the AER, by Martin Weitzman, with a fairly sophisticated attack on rational expectations. This would seem to be close to your interests ... ... Another reference is Oliver Williamson ... ... I attach some notes of mine on the roles of markets as providing coordination and incentives. This is quite distant from your proposal, but you might find it of interest. What it shares with your proposal is a desire to understand what a market really is.

(Professor John Roemer's comment was made in response to my article, "A New Perspective on the Role of Markets in an Economy")

Some observations (in addition to Professor Krugman's criticism of the Geithner plan) that indicate that the Geithner plan is going to cause serious damage to the economic recovery

Introduction

The Geithner Toxic Asset Plan is expected to be announced tomorrow (Monday, March 23, 2009). The details of this plan has been released in advance to the media and to professional economists. An FAQ on this plan has been posted by Professor Bradford DeLong on his blog site. The broad outline of the Geithner plan is as follows:

Through some selection process, the government chooses several hedge fund managers as partners to form a public-private partnership entity. The hedge fund managers invest 30 billion dollars. The government invests 150 billion dollars (this money comes from the remaining TARP funds). This public-private partnership entity then borrows about 820 billion dollars from the Federal Deposit Insurance Corporation (FDIC). The loan from FDIC has no recourse. That is, if this public-private partnership fails at some point in time, the FDIC would not be able to recover its loan. Anyways, note that the contributions from the government, the hedge funds and the FDIC add up to a total of 1 trillion dollars. Now, the public-private partnership entity uses this money to buy the toxic assets from the financial institutions. It is estimated that the financial institutions hold about two trillion dollars (in book value) of toxic assets on their residential and commercial mortgage portfolios.

The Geithner plan proposes that the public-private entity indefinitely hold the toxic assets that it plans to buy from the financial institutions with its 1 trillion dollars of funds. The plan's line of reasoning is as follows. After the economy gets out of recession, there would be robust growth and employment opportunities in a year or two. At this point, the toxic assets would fetch decent prices. Then they could be sold off in the market. Note that the Geithner plan allows for the possibility that these toxic assets would never rise back to their break-even prices, in which case, they would have to be held to maturity. Meanwhile, by holding the toxic assets patiently until such a time of profitable prices or until maturity, the public-private entity collects the payments made by home-owners on those tranches of their mortgage loans, that correspond to these toxic assets. In this way, the public-private partnership entity is expected to make money, and its profits are to be shared between the government and the hedge fund managers in the same ratio as their capital investment (i.e., 150:30).

In September 2008, when the toxic asset purchase was first proposed by the then Secretary of Treasury, Henry Paulson, the main criticism of that proposal focused on the pricing of the toxic assets. If the government pays too much for these assets, then the taxpayer has to bear hundreds of billions of dollars in losses. On the other hand, if the government pays the going market price for these toxic assets, then the financial institutions would be effectively insolvent, because the toxic assets are being valued at fire-sale prices in the market. To address this criticism, the treasury has formulated a public-private partnership this time around. The treasury's argument is that since the hedge fund managers have an interest in seeing the public-private partnership entity succeed, having invested 30 billion dollars of their own money, these managers are properly incentivized to ensure that the correct price is being paid for the toxic assets.

In his criticism(s) of the Geithner plan, posted on his New York Times blog-site, Professor Krugman raises two main points. The first is that the Treasury has bet that the toxic assets are trading at fire-sale prices now, only because of a temporary panic in the markets. This temporary panic was caused by irrational fears of bankruptcy and has led to a liquidity freeze. The Treasury believes that once the toxic assets are taken off the books of the financial institutions, they would not be paralyzed by fears of bankruptcy. They would go back to lending, and the credit crunch would somehow go away. However, as Professor Krugman points out, the financial institutions have indeed made a lot of 'lousy' loans. And with house prices falling, unemployment rising and consumer spending falling, the home-owner is under increasing pressure to foreclose. The dire economic situation, if it continues for long, would drastically increase the number of foreclosures.

The risk of foreclosures are reflected in the largest proportions onto the lowest tranches of the mortgages, which are exactly the same entities that constitute the toxic assets carried by the financial institutions. Hence the uncertainty in the economic conditions bear directly on the uncertainties involved in pricing the toxic assets. So, there is no way of knowing for sure what the correct value of these toxic assets are. There is a real possibility that the prices of the toxic assets drop down by 18% or more after the public-private partnership entity purchases these assets. In such an eventuality, the public-private partnership entity is insolvent, since it has financed its investment at the leverage ratio of 820:180. Thus, as Professor Krugman argues, we are again back at the same problem of the insolvency of the financial institutions that this Geithner plan is supposed to solve.

The second point that Professor Krugman makes is that the hedge fund managers are only investing 30 billion of the total 1 trillion dollars of funds raised by the public-private partnership entity. With their investment amounting to only 3% of the whole venture, the hedge fund managers would take to reckless gambling, precisely in the same way that got us into this severe financial crisis in the first place. Believing that they have massive profit opportunities before them, these hedge fund managers are going to overpay for the toxic assets. Then the risk of the overpayment would be borne largely by the FDIC and the government, because they have supplied 970 billion dollars out of the 1 trillion dollars of funds. While I agree, most certainly, with Professor Krugman on these two main points that he raises, I do not agree with his conclusion that the solution is to nationalize the banks.

My analysis of the Geithner Plan

My analysis of the Geithner plan starts with asking where do the 820 billion dollars for the FDIC loan come from. This money comes directly from the drastic rise in consumer saving from 0% to 5% in the last few months. Fearing a severe downturn, consumers have been cutting back on their spending. This belt-tightening has led to surplus money in savings and checking accounts. Now, in a sane world, this would be considered as a remarkable achievement. It would be a testament to the free flow of information in a democratic society where citizens are well-informed about the economic conditions that afflict them. However, the liberals have been suggesting, based on Keynesian economics, that the rise in savings, while good for individual households, is bad for the economy as a whole, since cuts in consumer spending could prolong the recession. Because of these confusing leads from the policy-makers about how to treat the rise in household savings, there is no general consensus that the savings be handled prudently. Hence the Treasury has felt free to take these hard-won savings and invest them with the public-private partnership entity.

Imagine a world without central banks. In that world, in the event of a recession, people would worry about their financial situation. Consequently, they would cut back on their spending and save more. Anticipating a slowdown in sales, corporations, in turn, would postpone or cancel their plans for business investments. These decisions by the consumers and the companies increase the supply of funds, and reduce the demand for loans. As a result, the interest rate on loans drop down. When they have dropped down sufficiently, companies realize that their business plans are now more viable because credit is available more cheaply. Simultaneously, consumers find that shops are announcing price cuts and discounts on their products. Thus business investments and consumer spending are encouraged, which results in the economy getting out of the recession.

However, sometimes when the recession is particularly hard, there is a serious danger that the self-correcting process described in the previous paragraph could become a self-destructive process instead. If the companies cut down too much on their production, they could lay off a large number of employees which could result in a drastic reduction in consumer spending. Such negative developments could also feed on the psychology of the people which could lead to a panic. The companies lay off even more people, and for lack of income, consumers spend even less, and the crisis feeds on itself in this way.

The first function of a central bank is to maintain calm among economic participants by providing them with reliable price signals and other important information about the economy. The second function is to provide price stability. Only as a third function, the central bank should try to speed up the above self-correcting process by easing its monetary policy slightly more quickly than the markets would do by themselves. However, the Federal Reserve has already cut interest rates to a range of 0 - 1/4% long before a recovery is in sight. The Federal Reserve Chairman showed up at the US Congress in September 2008, along with the then Secretary of Treasury, Henry Paulson, to argue in favor of the $700-billion TARP bailout package. The Federal Reserve spent hundreds of billions of dollars bailing out struggling financial institutions like Bear Stearns, AIG, Citigroup, etc. In addition, hundreds of billions of dollars have been spent to purchase loans, commercial paper and asset-backed securities directly from the market. Recently, the Fed has announced plans to spend an additional $750 billion for purchasing mortgage securities, and $300 billion to purchase treasury securities.

A consequence of all this expansionary monetary policy is that the Fed's balance sheet is expected to increase from $900 billion a year before to $4 trillion a few months from now. These actions of the Federal Reserve demonstrate that the Fed has been emphasizing its third function (trying to speed-up a recovery, even though one is not in sight), at the expense of its first function (reliable information on the economy). As a result of its arbitrary meddling in the economy, severe distortions in the price signals have resulted. Moreover, the vastly expansionary policy followed by the Fed has encouraged China to announce its own fiscal spending program of 4 trillion yuan. Soon, other emerging market economies are going to follow suit. And in the long run, they are going to emerge stronger, because they do not need to spend all their money on a financial crisis.

In the fiscal front, the situation is slightly better. The stimulus bill has been sensibly re-designed to provide structural re-adjustment rather than a stimulus by back-loading much of it to 2010. Its size has been cut down to $800 billion. However, the fiscal deficit for 2009 is expected to be at an unprecedented level of 1 trillion dollars. In short, neither the Federal Reserve nor the government has much more room to plan for further spending, apart from the spending programs they have already announced.

Next, let us turn to the private sector. Recall that in Question 1 of my "FAQ on the Current Financial Crisis", I had explained that the financial crisis is concerned more with the accumulated capital of the American economy rather than its working capital. At that time, I had cited this factor as the reason why the real economy was so resilient throughout the fall of 2008, even while the financial institutions went down one after another. A large portion of the accumulated capital has been tied up in mortgage investments. The investments that the Wall Street banks had made in the securitization of mortgages return at least 20% on their capital (assuming just 24 to 1 leverage ratio, and 0.8% difference between the interest rate paid out and that received). Even in a boom time, this investment is a hugely lucrative venture. Hence the financial institutions have always held on to the good assets in their mortgage portfolio, because these good assets provide great returns on minuscule risk.

The lowest tranches on the mortgages which carry significant risks are the ones very difficult to put a value on. These are the toxic assets. Before the crisis set in, the Wall Street investment banks had been trading them from time-to-time for liquidity purposes. When the mortgage crisis hit, the market for these toxic assets dried up. However, the investment banks didn't trade with their good assets in lieu of their toxic assets. Similarly, even if the Geithner plan buys up the toxic assets from the financial institutions, they are not going to start trading with their good assets. They are going to hold them since these assets provide over 20% profits on their capital, and there are not many business investments that can provide such huge returns steadily. Hence the accumulated capital of America that is tied up with mortgage securities is going to continue to be tied up. There is no reason why the credit crunch, which the liberals feared so much in the latter half of 2008, would not persist.

In recent months, the working capital of the American economy, i.e., the funds available with the community credit unions, the commercial banks, and the credit card companies, has been getting depleted because companies have been announcing drastic fall in their profits in view of the severe recession. Until a few months ago, profits of small businesses and corporations constituted the main source of savings in the American economy, since household savings had been at 0%. As I explained above, neither the government nor the Federal Reserve is in a position to add substantially to the working capital since they have already committed to a lot of spending, a large part of which goes towards unfreezing the frozen accumulated capital. However, for an economic recovery it is the working capital that is more relevant than the accumulated capital.

Thus the only saving grace has been the rise in household savings from 0% to 5% in just a few months time. The Geithner plan proposes to take away this savings which would go towards the working capital under normal circumstances. By investing this money in mortgage securities, the Geithner plan ties up this money with the accumulated capital of the American economy, which is already frozen because the financial institutions are hoarding their safe assets. Thus the Geithner plan would seriously damage the economic recovery, and I recommend that it be amended substantially.

Please hire me for an academic position

I request the Professors to provide me with full-time academic employment so that I can carry out my investigations of the prolonged crisis in the American economy in a more effective manner. Currently, I am working full-time in the US software industry. Hence if I could get a post-doctoral position or a tenure-track position at the Economics Department of a top university in the US, I could devote more time to the current economic crisis. I have many new ideas in economics that I could pursue seriously if I had an academic position. I have already written more than 18 articles on economics since 2008. I have received favorable comments on my articles from several Professors -- four of whom are Nobel prize winners in Economics. All my articles, along with comments from the Professors, can be accessed at my blog-site: http://selvasblog.blogspot.com

Comment on Professor Joseph Stiglitz's article "How to Fail to Recover" on Project Syndicate
(Date Written: March 16, 2009)

Professor Joseph Stiglitz discusses two issues in the above-mentioned article -- (i) the stimulus package, and (ii) the crisis in the financial markets. I have some points of my own to make on these two issues:

(i) Misconception: if the stimulus bill is not large enough, it would not deliver a recovery.

By the end of Summer 2008, political support for a new stimulus bill began to gather in earnest. At that time, it was not known for certain whether the American economy was in a recession. Now, in recent decades, a large number of research papers have been written combining insights from Keynesian theory with business cycle theory towards the aim of smoothening the fluctuations in the business cycle. In fact, the boom in East Asian economies that extended to more than 25 years before 1997, and the 63-year long recession-less growth in the world economy since the end of the second world war, lent credence to the view among academic economists that a recession could be made short and shallow, if not altogether bypassed. As a result, throughout Fall 2008, many economists repeatedly stated that if the stimulus bill is not large enough, it would not lead to a recovery.

Sometime during the winter of 2008, NBER announced that the American economy had actually been in recession since December 2007. It was after this announcement that there was a realization that the current economic recession is a really serious one, and cannot be wished away by a massive one-time stimulus bill. Till then, economists had been pre-occupied with preventing the crisis in the financial system from spreading to the real economy. However, the realization of a serious economic crisis came too late. The political momentum for a massive one-time stimulus bill had already been set in motion. Moreover, since it was now getting very difficult to justify a huge one-time stimulus bill on a theoretical basis, some political compromises had to be made to get bi-partisan support. As a result, a large part of the $800-billion stimulus bill was marked for tax cuts.

However, there were some sensible last-minute adjustments. With the economy already mired in a serious recession, a massive stimulus spending would be like flogging a dead-tired horse. So, the sensible approach was to change the focus of the bill towards structural re-adjustment rather than a stimulus, and back-load much of the spending to 2010. Keynesian theory requires continuous monitoring of the markets to enable the central bank or the government to step in and take corrective measures whenever it is obvious that the resource allocations made by the markets would not be optimal in the long run. There is no provision in Keynesian theory to spend several trillion dollars at one time, so that a recession can be postponed by a decade, say. Hence, it would have been better to enact a series of small spending bills to come into effect every three months or so. With the flexibility of tuning the spending according to how the economy reacts to the current recession during each three month interval, it would have provided a much better support for the economy to fight its way out of the recession.


(ii) Financial markets.

Recently, Professor Nouriel Roubini has argued that the US financial system is effectively insolvent (Ref: his March 5, 2009 article on Forbes.com). By his calculations, the total losses in the financial system is about $3.6 trillion, of which about half ($1.8 trillion) would have to be absorbed by US financial institutions and the other half by foreign institutions. But the total capital in the US financial institutions is only about $1.4 trillion. Hence the financial system is insolvent, and it needs to be nationalized quickly, in his opinion. Here, I would like to point out that it has always been the case that the estimates for losses in any crisis keep changing dynamically. For example, during the 1989 - 91 S & L crisis, initial estimates for the bank losses ran up as high as 500 billion dollars during 1988 - 90. However when the American economy grew robustly after 1992, the Resolution Trust Council (RTC) was able to sell off the foreclosed assets at reasonably good prices, and reduce the total losses to as low as 100 billion dollars.

Secondly, Professor Roubini's solution to the insolvency of the financial system is that the banks should be nationalized quickly. This solution is fraught with grave danger. Nationalizing banks would lead to the problem of 'socializing losses and privatizing gains', which Professor Joseph Stiglitz points out above. Just today (March 16, 2009), a Wall Street Journal article disclosed that more than two-thirds of the $173 billion of Federal aid given to bailout AIG so far has gone to counter-parties to cover their damages in their CDS and insurance contracts with AIG. These counterparties include (i) municipalities within the US, (ii) foreign institutions, and (iii) well-known US financial institutions like Citigroup, Merill Lynch, Bank of America, Goldman Sachs, Morgan Stanley, etc. The fundamental truth is that the financial system benefits some people more than others. No matter how quickly Professor Roubini is able to get the government to nationalize insolvent banks, he would find that well-connected financiers have already returned the institutions under their charge to profitability, mostly by using public money, all done through perfectly legal means.

An alternative solution proposed by Professor Kenneth Rogoff is for the Federal Reserve to print a lot of money and invest it with the financial institutions. This would re-capitalize the financial institutions and save them from bankruptcy. Moreover, in a few months, there would be widespread inflation. This would help the home-owners because inflation would reduce the relative severity of their mortgage debts. Since a large percentage of the households in America are also immersed in credit card debt, inflation would help them there as well. In addition, the government could spend massively by way of fiscal deficits to ensure that deflationary forces are surely defeated. This solution has the additional feature of fitting in nicely with the Rogoff doctrine, which recommends that Western economies go through a period of sub-optimal growth in order to avoid a global price war for commodities. (The Rogoff doctrine was published in the Financial Times on July 29, 2008).

China was quick to wake up to Professor Rogoff's solution for the financial crisis. Inflation would benefit everybody inside the United States in their current predicament of debt obligations that are disproportionate to their incomes. However, it would severely affect those countries, like China and Japan, which are holding trillions of dollars as foreign currency reserves. To preserve the relative value of its dollar reserves, China has announced its own two-year fiscal spending program of 4 trillion yuan to ensure that its annual GDP grows at a rate of 8%+. The biggest losers in this inflation game would be the poor countries who could not possibly finance their deficits. Even if they did, many of the poor countries do not have a democratic framework in order to hold their rulers to account for the deficit spending.

In October 2008, I proposed a simple low-cost solution for the financial crisis (Ref: Question 5 in my "FAQ on the Financial Crisis"). I would like to make one point here that I have not made elsewhere: my solution has the unique feature that it is sustainable. To make this point clear, consider the phenomenon of consumer spending. The global supply chain connects to factories where goods are produced. These factories, in turn, connect to the distribution channels that apply just-in-time technology to stock their retail outlets. The consumer then goes through the shopping experience at the shopping malls or online stores. Consumer shopping trends are cyclical, with each annual cycle having several seasonal cycles as well. In case, there is an over-production of goods during one particular shopping season or a dullness in consumer demand, the stores immediately announce discounts and price cuts.

These price reductions benefit the consumer directly, and they work all the way back through the distribution channels and the supply chain. In this way, a sustainable feedback loop helps to implement an 'informal contract' between the consumer at one end, and all the other participants of the supply network at the other end. And this unwritten contract, in effect, extends over many years. In fact, this mechanism for price adjustments has become an integral part of the consumer culture of the 20th century. My solution for the mortgage crisis aims to provide an analogous feedback loop that connects the security-owners on Wall Street with the home-owners on Main Street.

Comment on Professor Bradford DeLong's article "Stimulus Ostriches" on Project Syndicate
(Date written: March 9, 2009)

The liberals are facing increasing opposition to stimulus spending because of several fallacies in their argument. I have analyzed two of these fallacies here:


(1) Quoting Keynes to claim that if the stimulus package is not large enough, it could not deliver a recovery.

There is no provision in Keynesian theory that says one can spend several trillion dollars today in order to postpone a recession by a decade. As I explained in an earlier posting, the market mechanism, even in its most efficient functioning, tends only towards a random walk of price movements. Whereas in the functioning of the economy, most day-to-day decisions are made based on assumptions of continuity. Because of this fundamental discrepancy, the allocation of resources that the market mechanism makes in the short run, may not turn out to be optimal in the long run. Hence there is a role for an external agency, like the government or the central bank, to step in and take corrective measures whenever it is obvious that the functioning of the markets would not be optimal in the long run.

Now, the only tool that Keynesian theory provides for looking into the long-term future is time value of money. To wit, it was by employing this tool that Keynes envisioned "Economic Possibilities for our Grand Children" in 1931. The rationale Keynes provided in that essay for time value of money to stay above inflation, was that a 2% annual growth in productivity seemed a safe assumption, in view of technological progress in recent centuries. At the macro-economic level, the procedure by which policy makers can ensure a positive inflation-corrected, time value of money is to aim for a positive inflation-corrected growth rate in annual GDP. The most effective way to do this in a market-based capitalist economy is, of course, to let the markets do their work.

But, as explained in the first paragraph, Keynes identified that the market could be malfunctioning sometimes, at which times corrective measures from the state and the central bank are needed. The state's role could be to spend money in order to sustain consumer demand and to reduce unemployment to the extent possible. Thus Keynesian theory advocates a constant monitoring of the economy to ensure that the functioning of the economy is made close to optimal, with co-ordination between the markets, the central bank and the state. Keynesian theory does not prescribe a one-time huge spending to avoid all possible troubles in the next decade.

Now, in recent decades, a lot of research papers have been written exploring the possibilities of smoothening the fluctuations in the business cycle and even further, of avoiding a recession altogether. This line of investigation gains credence especially in light of East Asia's 25-year long boom before 1997, and the world economy's 63-year long growth without recession, from the end of the second world war to 2008. My own assessment is that due to changes in the circumstances, the assumptions made in these research papers would no longer hold in the current severe crisis situation -- the single major factor being that the American economy cannot be mathematically modeled any longer with the assumption that it is predominantly an isolated entity.


(2) The enigma of the credit crunch.

I had already explained in October 2008 (ref: Question 1 of my "FAQ on the Financial Crisis"), that this current crisis has more to do with the accumulated capital rather than the working capital of the American economy. In particular, I had stated that "the funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep business investments, payrolls and consumer spending going on in the near-term". In contrast, starting from September 2008 or so, nearly all the liberal economists forecast a massive credit crunch that was to unfold on Main Street. This led to a huge uproar demanding that the Fed cut interest rates quickly, and that the economy be flooded with liquidity. The TARP legislation was hurriedly enacted to enable the government to spend 700 billion dollars at its complete discretion. No consideration was given to the event that an economy going into a recession might not need as much credit. Did the liberal economists plan on avoiding the recession altogether, just by scaring the government into implementing all of their policy recommendations? When the new government took office, the demand from the liberal economists took the form of a massive stimulus package. The spending so far, on account of this economic crisis, has exceeded four trillion dollars and no end is in sight.

Admittedly, I had missed one important point regarding the credit situation in October 2008. To explain this point, let us assume that a Wall Street Investment bank has invested in mortgage securities with a leverage of 24 to 1. This means that the bank's own capital makes up only 4% of the money invested in the mortgage securities. Now, the mortgages on homes are divided into tranches, with the risks of foreclosures reflected in progressively larger proportions as one went lower down the tranches. Assume that the mortgage on a typical home is divided into 20 tranches of equal face value, and also that the bank has made equal investments in all the 20 tranches. Note that this means that the bank's capital of 4% falls just short of covering the lowest of the tranches (the 20th).

Now, the stories heard in the media, if correct, imply that the 'toxic' mortgage securities are trading for 20 cents on the dollar. This already wipes out the bank's capital, if only the lowest tranch (the 20th) is toxic and all the other tranches are trading at full-maturity prices. If the situation is far worse than this, the banks could not have survived for so long, the mortgage crisis having come to light as early as January 2007. The bank's auditors and accounting rules would not allow for losses exceeding several times the capital. So, the banks must be in a situation where only the lowest tranches are trading at fire-sale prices, and the other tranches are valued in the market at close to full-maturity value.

The point I had missed in October 2008 is this: with the situation as described above, the Wall Street banks have an added incentive to simply keep holding their mortgage securities, freezing up their investments, so to speak. This is because their investments in mortgage securities were highly lucrative, in view of their huge leverage ratios. In fact, with the above 24 to 1 leverage ratio, just a difference of 0.8% between the interest rates obtained from the home-owners' mortgages, and the interest rate paid out to the banks' lenders, would ensure that the Wall Street banks recover profits of 20% on their capital. This means that their whole capital would get replenished in less than five years. So every month the banks could just let the profits flow in, and take losses on selling off the toxic assets just enough to offset the profits. If they could do this for a year or two, they could have already sold off a third of their toxic assets, and who knows, by then the economy could have recovered to get much better prices on their securities? Because of this added incentive for the investment banks to hoard their funds, there could be a scarcity of credit. It is this dynamic nature of the profit-inflow/toxic-asset-selloff combination that I had missed in October 2008.

However, even though I had missed this point, I could still see that with the economy going into recession, the freezing up of funds among the investment banks was not the main concern, because of my belief that the crisis did not directly involve the working capital of the economy. Moreover, my solution for unfreezing the credit crunch was to hold a public auction of the mortgage securities directly for the home-owners. The home-owners could purchase the tranches from the security owners on Wall Street, and they could use the purchase towards reduction in their debt. No re-writing of the mortgage contract is necessary. No investment of $700 billion TARP funds is necessary. Neither nationalization nor Good bank/Bad bank is necessary. Moreover, all of these alternative methods do not address the moral hazard problem (The moral hazard is that the home-owners who paid their mortgage dues sincerely are being ignored, and the irresponsible home-owners are being bailed out. On the bankers' side, the moral hazard is that banks who lent recklessly are being bailed out by the TARP and other government funds). Only my solution addresses the moral hazard problem squarely. Lastly, the technology for implementing such a public auction among the home-owners already exists among software companies like eBay, Verisign, Amazon, Google and PayPal. In conclusion, having spent much of their political capital chasing the ghost of credit crunch, the liberals are now finding that the economic crisis has gotten out of hand.


Update:

(i) I did not receive any response from any academic economist about my comment. However, a few days after the above comment was posted, Professor Bradford DeLong took part on a round-table discussion on Economist.com, which was held in response to Professor Dani Rodrik's article in the Economist print issue that global financial regulation should delegate a large part of the supervision to individual nation-states. In his response, Professor Bradford DeLong had criticized this view citing the important role that a global hegemon could play -- betraying a strong bias towards empire-building, in my opinion. An anonymous comment to Professor DeLong's response, from a user named NotAGenius, had this to say:

March 15, 2009 18:43

Thanks for taking time out from losing the debate on Keynesian economics to share your thoughts.

(ii) Date: June 17, 2009. Reading this post three months it was written, it seems that I should explain why I had framed my argument with "There is no provision in Keynesian theory that says one can spend several trillion dollars today in order to postpone a recession by a decade". After the financial crisis hit in September 2008, the liberals were badgering every one with the question why the American economy was not headed for a repeat of the Great Depression of the 1930s. Professor Paul Krugman was the leader of this movement, and he even put up a straw-man and burnt it down. The straw-man was Professor Robert Lucas who had made some statements some years ago to the effect that the risks of the American economy deteriorating to the Great Depression, and their remedies, were well-understood now. It is not so useful to keep dwelling on the business cycle. Economists should concentrate on long-term growth instead. Professor Krugman made an elaborate ceremony of kicking down the straw-man. He even wrote a new edition of his 1999 book, The Return of Depression Economics.

At the same time that the liberal intellectuals were scaring the general public that the American economy was headed for the Great Depression, they were also saying that if the stimulus bill is not large enough, it would not lead to a recovery. Here was the inconsistency. If the existing theories in macro-economics could not explain why the American economy would not continue to deteriorate through the Fall and Winter 2008, and Spring of 2009, how come these very same liberals were claiming that if a stimulus bill, massive enough to their satisfaction, was enacted, there would be a recovery? Suddenly, they were claiming that the crisis is understood well-enough that they could even show us a way towards the recovery. If this was the case, while we are at this recovery business, why not spend several more trillions to postpone the recession altogether for a decade? This was the basis of my argument. As of date, the liberals are still claiming that there are serious risks of the return of the Great Depression.

In response to the New York Times article "Matters of Principle" co-authored by Professor John Geanakoplos and Professor Susan P. Koniak. The article appeared on Thursday, March 5, 2009

Dear Professors Susan P. Koniak and John Geanakoplos:

I am writing in response to your joint article, "Matters of Principle", in today's edition of the New York Times. As my response, I would like to refer you to the 5th question on my "FAQ on Current Financial Crisis", which I had sent out to economists at several top schools, including Yale, Berkeley, Stanford, Harvard, Columbia and Chicago in October 2008:

"Q5. Why have the markets for mortgage securities continued to remain illiquid?

A. The main reason that the markets for mortgage securities have been illiquid for a prolonged period of time is that the home-owner who is the only party with a credible and serious interest as a buyer of the mortgage securities has been shut out of the market. Instead of directly involving the home-owner, Wall Street has been peddling bizarre theories about risk management that has resulted in this huge mis-allocation of this $700 billion recently. By providing the information for a direct match-up of the home-owners on Main Street and the security-owners on Wall Street, the government could implement a low-cost eBay-type bidding system that would enable the home-owners to bid for the various tranches in the mortgage securities issued on their homes -- those tranches that the banks want to get rid of. This way the home-owners stand to benefit from a reduction in their debt obligations. The security-owners gets a floor on the prices of the mortgage securities and because of the decent prices, their capital gets replenished. Moreover, the home-owners' debt reduction can be structured in a way that encourages good behavior, and timely re-payment of the rest of the mortgage loan. This process would cost less than $1 billion for the government and achieves the objectives of liquidity and re-capitalization stated in the $700 billion bill. In addition, this direct match-up plan reduces foreclosures by reducing the home-owner's debt. Professor Martin Feldstein has also proposed a plan to reduce foreclosures. In his plan the government re-negotiates the home-owners' loans to provide debt reduction through low-interest loans, in return for enhanced claims on the home-owner. In my plan, the government's role is solely to provide reliable information."

(Written in October 2008)


Please note that, unlike your solution, my solution does not suffer from the moral hazard problem. (The moral hazard is that homeowners who had sincerely paid all their mortgage dues are ignored and the irresponsible homeowners are being bailed out).

My solution also has the unique feature that it helps to unwind the complexity of the financial products in a natural and smooth manner. One of the major problems about the current economic crisis was that the financial industry had created financial instruments that were so complicated and arcane, and that these instruments had been used so pervasively that there was a huge systemic risk even if the status quo is altered slightly. In my solution, I connect the security-owner directly with the home-owner in a win-win deal, so that the unwinding of the complex financial system happens automatically.

Professor John Geanakoplos had proposed solutions twice earlier and had appeared on CNBC television channel each time to explain his solutions. I must say his solutions, along with Professor Martin Feldstein's, were more thoughtful than the others I have seen so far. But none of the solutions proposed in public come close to my solution for solving the mortgage crisis.

When I proposed my solution in October 2008, there were three prevailing views at that time. Professor Paul Krugman was writing in his New York Times blogs that the government not doing anything is not a solution, which I took to mean that the government must spend hundreds of billions of dollars to solve this crisis. Professor Nouriel Roubini went further and actually said that trillions of dollars would be required by way of fiscal deficits to avoid the Great Depression. Professor Kenneth Rogoff was writing that America has a lot of money to spend, and a lot more things must go wrong before the America economy would suffer serious damage.

I suppose that because of these prevailing views, my solution (which spends only $1 billion) was ignored. So, now that trillions of dollars has been spent in the five months since October 2008, and with no end to the mortgage crisis in sight, I am hoping that my solution would be taken more seriously. Thank you.

Sincerely,
T V Selvakumaran


Note:

(i) There is a correction to my e-mail. I had mentioned that Professor John Geanakoplos had written two earlier articles on the mortgage crisis. In fact, on at least one of them as well, Professor Susan P. Koniak was his co-author. However, I only saw Professor John Geanakoplos appearing on CNBC on the two earlier occassions following the publications of his articles on the mortgage crisis.


(ii) I had copied the above e-mail message to the following list of professors of economics:

Martin Shubik, Yale University
Philippe Aghion, Harvard University
Kenneth Rogoff, Harvard University
Martin Feldstein, Harvard University
Paul R. Krugman, Princeton University
Avinash K. Dixit, Princeton University
George Akerlof, University of California, Berkeley
Robert J. Shiller, Yale University
Kenneth J. Arrow, Stanford University
Gary S. Becker, University of Chicago
Edmund S. Phelps, Columbia University
Vernon L. Smith, Chapman University
Nouriel Roubini, New York University
Robert Engle, New York University
Joseph Stiglitz, Columbia University (e-mail bounced)

The Inaugural Kenneth J. Arrow lecture

“Helping Infant Economies Grow: Promoting Innovation and Learning in Developing Countries”

Bruce Greenwald and Joseph Stiglitz

With discussants: Philippe Aghion and Robert Solow

Wednesday, November 12, 6PM

at Casa Italiana, 117th Street and Amsterdam Avenue

Dear Professor Joseph Stiglitz:

A couple of days ago, I came to know about the Inaugural Kenneth J. Arrow lecture held at Columbia University on Wednesday, November 12, 2008. In that lecture-discussion, you, Professors Bruce Greenwald, Philippe Aghion and Robert Solow had discussed the topic, "Helping Infant Economies Grow: Promoting Innovation and Learning in Developing Countries", with concluding remarks by Professor Kenneth Arrow himself.

Over the last couple of days, I have watched the video of that lecture-discussion a few times. You had raised several questions in that lecture-discussion about ways to increase the learning capacities of societies, especially in the developing countries (infant economies, as you call them). In this regard, I have been writing an article about strategies for promoting innovation and learning in developing countries. My article is entitled, "Effective Philanthropy in India: A Case Study for Contributing to the Strengthening of the Foundations of a Developing Nation". I have attached a copy of this article (in its current form), to this e-mail. My article can also be accessed at my blog-site:
http://selvasblog.blogspot.com/2006_09_01_archive.html

Please note that I am taking a different perspective, from the Greenwald-Stiglitz perspective that was discussed in the Kenneth J. Arrow lecture, about the ability of societies in the developing world to learn and compete in a knowledge-based global economy of the future. To give a brief introduction to my approach, please recall that in your lecture-discussion, you had mentioned the example of Korea -- that based on the classical comparative-advantages theory, Korea was advised by the World Bank and the IMF in the 1950s to keep focusing on growing rice, and let the Western economies focus on technology.

My line of attack is not on the comparative-advantages theory itself, but to question the assumption that, in the 1950s, the advanced Western economies were much better placed than Korea was to produce technology-intensive goods. So much better placed it would seem that a clear division of labor for growing rice in Korea and making technology-intensive goods in the West could be envisioned. This assumption, of a division of labor between Korea and the West, seems especially questionable in light of later evidence that Asian students have been the highest scorers on math and science tests, at the high school level, consistently for several decades now.

I am copying Professors Philippe Aghion, Kenneth Arrow and Bruce Greenwald as well (I could not get the e-mail address of Professor Robert Solow). I hope to hear from at least one of you so that I can explain my ideas further. I also hope that you would consider favorably about employing me for a post-doctoral or a tenure-track position.

Sincerely,
T V Selvakumaran


CC: Prof. Bruce Greenwald, Prof. Philippe Aghion, Prof. Kenneth Arrow, Prof. Michael Woodford

(The above e-mail was sent on March 2, 2009 to Professors Joseph Stiglitz, Philippe Aghion and Kenneth Arrow on March 2, 2009. However, since the e-mail bounced from Professor Stiglitz's mailbox, I sent it again, this time to Professor Michael Woodford, the host of the Kenneth Arrow lecture, on March 4, 2009, with copies to Professor Philippe Aghion and Kenneth Arrow. In a header to the e-mail, I asked Professor Michael Woodford to kindly forward the body of the e-mail message to Professor Joseph Stiglitz. I didn't receive any response from any of the recipients. I had actually sent Professor Joseph Stiglitz my philanthropy article first on July 17, 2007. I didn't hear from him then too. I am somewhat concerned about not receiving any response from these professors because they are now taking perspectives on trade and growth that overlap with the viewpoints I have been pursuing in my philanthropy article, which I started writing in the summer of 2006).