Friday, January 30, 2009

Fear: How do we kill it?

According to a lot of economists, one of the biggest problems (if not the biggest problem) in the economy right now is a massive feeling of uncertainty in the economy. You may remember that I mentioned it a little while ago, suggesting that the stock market will fall because there is no actual recovery yet.

Well, uncertainty is the subject of a roundtable discussion at the Economist today. Here is IMF Chief Economist Olivier Blanchard leading the discussion:
At the start was the realisation that many of the new complex assets were in fact much riskier than they had seemed. This realisation has now morphed into a general worry about nearly all risky assets, and about the balance-sheets of the institutions that hold them. “Better safe than sorry” is the motto. Unfortunately, while the motto may make sense for individual investors, it is having catastrophic macroeconomic consequences for the world. It is triggering enormous spreads on risky assets, a credit crunch in advanced economies, and major capital outflows from emerging countries.

So, the solution to the crisis is to eliminate some of the uncertainty in the economy, and, more generally, fear of losses.

The REAL question is the following: How the hell do you accomplish that?

That's the subject of the economists responding to the article, who seem to largely agree with Blanchard.

Some of the economists agree with the general concept with a sizable stimulus package, and agree that we shouldn't be too concerned about what might happen down the right (at least in terms of over-stimulating the economy).
The fiscal stimulus would send the message that the government is committed to solving the crisis.

Many also agree with focusing on restoring the health of the financial system, though Thoma says that isn't actually enough.

Tyler Cowen says if we are just going to have policies to make things LOOK better, we should apply a cost-benefit test towards their symbolic value and try to find highly visible-yet-cheap projects that make it seem that the economy is getting better and government is committed to keeping it that way. That's a LOT different from the idea that we should build roads because they improve the economy: Instead, we should build a single road paved with gold, because that is REALLY indicative of a recovering economy (that example is mine, not Tyler's). Boosting things like unemployment insurance would be a good idea, too, since they are automatic stabilizers...meaning that the government is automatically increasing the money it is spending in a crisis, instead of sitting around talking about massive stimulus packages

One commenter added that we perhaps insuring all loans made across the country would be a good idea. I believe this is what was used in Sweden, but I am not entirely sure.

So, how do we reduce uncertainty?

That's a toughy and involves a lot of psychology. Quite frankly, it's not something we're trained to think about at the undergraduate level (and any solution I could come up with is probably much worse than what academic economists propose).

I would devote a lot of effort into the financial system. At this point, I have absolutely no idea how to get this done in an acceptable manner. We could simply buy back all the assets, but that could take an outlay of $4 trillion, and is a bit of a giveaway to banks. Direct recapitalization is a more plausible measure, but it doesn't look like it worked very well with TARP.

Nationalization is probably out of the question.
Forced liquidation (IE, seizing the banks, selling off the good assets to good banks and keeping the bad assets in a government chartered "bad bank") might set the financial system back decades by destroying a lot of banks and scaring private investors away from investing in new banks.

But the financial system is ground zero and that's where we need to be focused. I don't moving them off the balance sheet would be very good at all: a bank that is insolvent is still going to be insolvent, and it will just scare investors even MORE since they don't know which banks have the bad assets.

I would have a sizable, diversfied fiscal stimulus (IE, not just giving jobs to white male construction workers). That will get more people back to work across a broader swathe of the economy...hopefully reducing uncertainty to some extent.

I would increase unemployment insurance as well. Not entirely sure how it works, but tagging it to your income prior to being fired seems pretty reasonable in an economic downturn (IE, you get 60% of your former income from the government). In a strong economy, not so good of a plan. In a downturn, making sure people don't keep too much money on hand because they are scared they will lose their jobs is more important than worrying about people not going back to work because they are living on the government dole.

Unorthodox monetary policy by the Fed is also important

Broader government insurance of loans may be feasible, too. Perhaps not insuring EVERY loan in the country, but offering to sell insurance to private companies on high-rated debt would probably encourage more lending.

Of course, if housing prices continue to plummet and we end up with 2/3 of the nation's households with more mortgage debt than house value, I have no idea if any of the above are going to be enough

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