I do think that measures such as the Contingent Convertible Bonds would be a useful step. (I am pleased to agree with Charlie Calomiris on this one.) Some argue that it would be hard to know when to invoke the contingency clause. It strikes me that this argument largely vanishes when one realizes that the clause would of necessity be invoked by the time we got to the stage of a Bear Stearns or Lehman Brothers bankruptcy.

CoCos would not go very far in themselves toward comprehensive reform of the financial system, if that is the goal. But then no single policy measure would do that. I agree with Gillian Tett: “In theory, I think that CoCos certainly could be a useful additional to banks’ tool kits. However, in practice, the contagion risk suggests it would be dangerous to rely too heavily on an exclusive diet of CoCos for any policy ‘fix’.”

Two related issues are of much bigger import. First, is it a feasible goal to eliminate, credibly, the problem “too big to fail” or “too interconnected to fail,” ,thereby eliminating the critical moral hazard problem? My suspicion is that this is not an achievable goal, when push comes to shove, ex post, in a crisis; and if I am right, then it is very important that we don’t return to the rhetoric of claiming “no bank is automatically too big to fail” and so fail to regulate and collect insurance from the banks ex ante. This would just exacerbate the moral hazard problem. Commercial banks are like river banks in this respect.

Second, would the legislation that is offered by Senator Chris Dodd be a better approach to financial reform than alternative proposals, or even than the status quo? While the 1,000+ page Dodd bill undoubtedly has some good things in it (the CoCos and the principle of a Consumer Protection Agency in lending are probably at the top of the list), I believe it would be very damaging overall. The major reason is that it would seriously undermine the power of the Fed to set fully-informed monetary policy in normal times and to respond effectively in times of crisis. It seems that Barney Frank understands these things much better.

It is also true that having sub debt convert to equity provides a greater equity cushion during failure, but this is not as significant as its ex ante risk-revealing property (especially since the size of the CCC requirement is likely to be small).

The idea of requiring some form of sub debt, and CCCs in particular, has enjoyed widespread support among experts on financial reform for years. A mandatory sub debt requirement was advocated by all the Shadow Financial Regulatory Committees (the US, Europe, Japan , and Latin America ) about a decade ago (see the monograph by the US Shadow Financial Regulatory Committee, entitled "Reforming Bank Capital Regulation," 2000). The Gramm-Leach-Bliley Act of 1999 required that the Fed and the Treasury consider whether a sub debt requirement was a good idea. A Fed study at the time found evidence strongly in favor of its value as a signal of risk, but the Treasury and Fed (led by Messrs. Summers and Greenspan), decided not to require it, under pressure from the large banks who wished to avoid a new mandate. The Treasury's summer white paper proposed a CCC requirement, which has been recently advocated by several other prominent academics. The Pew Task Force on Financial Reform, in which I am a member, is about to issue a bipartisan consensus report on financial reform, which I believe will support a sub debt requirement in the form of CCCs.

If we are going to require CCCs, there are important design features that must be addressed (and which are addressed at length in the US Shadow Committee's monograph), including: restrictions on the armslength identities of holders (so that the signal is meaningful), and the requirement that offerings be floated fairly regularly in the market (to maximize information from pricing). It is also worth bearing in mind that the widespread use of CDS complicates a CCC issuance requirement. To be maximally effective, holders of the CCCs should not be able to lay off their risk, especially to the issuing bank

Data” is the plural of “anecdote.”  Most of us are much more comfortable with anecdotes than we are with careful data analysis.  It is therefore perfectly understandable when newspapers and television feature anecdotes rather than statistical analysis to describe the state or trend of the economy. 

Unfortunately, almost every anecdote is open to competing interpretations.  This was obvious at the end of October when the White House released its summary of 150,000 reports submitted by recipients of federal grants or contracts under the 2009 stimulus program.  The reports were collected to help policymakers and taxpayers keep track of the employment effects of stimulus spending.  According to the Wall Street Journal, a Kentucky shoe store owner gave credit to the stimulus program for creating or saving 9 jobs as a result of an $890 contract to supply work boots to the Corps of Engineers.  While the Journal treated this claim with appropriate skepticism, one can imagine business owners who are persuaded to remain in operation as a result of a modest order that spells the difference between insolvency and a tiny profit. 

In essence, the reports distilled by the White House provided evidence from 150,000 anecdotes.  According to the Administration’s summary, the reports offered evidence that 640,000 jobs have been directly created or saved as a result spending or promised spending under grants or contracts funded by the stimulus package. Jared Bernstein, the Vice President’s chief economist, emphasized that the 640,000 count represents an incomplete tally of the total jobs added or saved as a result of the stimulus package.  It is impossible to collect anecdotes from Walmart, Safeway, or Disney World that would tell us how many jobs have been created or saved as result of higher consumer spending induced by the stimulus package.  When a customer buys groceries or takes a vacation in Florida, how can we tell what percentage of the spending was induced by tax cuts or a bigger unemployment check?  We must rely on elaborate, less transparent data analysis to uncover the indirect effects of the stimulus package.  When the indirect effects are included, White House economists estimate that over a million jobs have so far been added or saved as a result of the stimulus.

The Wall Street Journal suggests that the White House estimate of 640,000 jobs saved or created may overstate direct job creation by 20,000 positions.  Even if the Journal’s estimate is correct, the difference represents less than 2% of the total number of jobs directly or indirectly saved and created by the stimulus.  Economists do not agree on how to estimate all the direct and indirect employment effects, of course.  Most of us would agree, however, that the total job effects are likely to be greater than the 640,000 jobs identified in Recovery.gov.  The current employment situation is certainly grim, and it has gotten much worse since the President took office.  The job market is significantly healthier, however, than it would have been if the stimulus package had not passed.

Unless the labor market deteriorates much further, I am pessimistic about the political prospects for another major stimulus package.  The Administration’s opponents have been successful in sowing doubts about the wisdom of the last stimulus.  According to a recent CBS/New York Times poll, a clear majority of Americans now believes the stimulus package has either made the economy worse or had no beneficial impact.  Only about a third of respondents thinks the stimulus has produced economic gains so far. 

With this political background it is unlikely Congress will pass a major new stimulus package anytime soon.  What is more likely -- indeed, what is essential -- is the continuation of stimulus programs that are currently scheduled to expire.  Last week the House and Senate extended unemployment protection for workers who have lost jobs in the current recession.  These protections ought to be extended until the job market improves significantly and it becomes easier for laid off workers to find jobs.  If unemployment is likely to remain over 9% for an extended time, there is a compelling case for additional public infrastructure investment.  Given high unemployment in the construction and capital goods industries and federal borrowing costs that remain near a post-war low, it makes sense to invest in public capital projects over the next few years.  If the federal government does not have adequate plans for such investments, it should start making them soon.

--Grant, contract, and loan data are only part of Recovery Act funding. The recipient-level data will include reports from recipients of contracts, grants, and loans, representing only part of the overall recovery package. For example, tax reductions, increased unemployment insurance payments, greater nutritional assistance, and much of the assistance to state governments will not be included in the recipient-level jobs data. So far, these other sources of funding have far exceeded the outlays resulting in contracts, grants, or loans. The initial wave of data released on October 15th will include just contractor data, while data on grants and loans made under the Recovery Act will begin to be released later in October.

--Not all recipients are required to report. Reporting is currently limited to “prime” recipients and the first level of sub-recipients. For contracts directly awarded to private companies, for example, second-level sub-contractors will not be required to report. (Prime and next-tier recipients may report estimated jobs created by subsequent sub-contractors, but no direct reporting is required by the lower-tier companies.)

--Only direct employees will be recorded. Recovery.gov’s recipient-level reports will only include the jobs created directly by the recipient. For example, a new construction worker hired to install a new roof will be included, but other factors will be omitted, including:

     a) “Respending” jobs. Data will not include the jobs saved or created by that construction worker’s new spending, such as the car repairs or restaurant dining that results from their additional income.

     b)  “Upstream” jobs. Data will not include the jobs created at the companies that manufacture, transport, and sell roofing supplies at the retail or wholesale level.  Recovery Act investments will increase demand for business supplies and services, leading to greater employment in sectors that support the direct activity. However, these jobs will also not be included in recipient-level reporting.

In fact, the Recovery package has created about twice the amount reported on Recovery.gov. Using standard multipliers from Moody's Economy.com, it looks like the recovery act added about 2.7 percentage points to annualized growth in the third quarter, and a bit more in the prior quarter (details are here: http://www.epi.org/publications/entry/ib265/.) This translates to somewhere between 1.1. and 1.5 million more jobs than would be around if there had been no stimulus.

Is this enough? With unemployment above 10%, it's clear that more needs to be done to specifically target job creation.

The numbers suggests that the opportunity cost of the stimulus bill has been high: private sector borrowing has fallen sharply in recent months. Absent the stimulus bill, private lenders would have either loaned their money to other borrowers in the private sector or spent it. Instead they lent it to the government, leaving that money unavailable to others.

This has hurt private-sector borrowers severely. The Federal Reserve’s flow of funds reports shows how dire the situation has become. While Federal borrowing soared to an annual rate of $1.9 trillion in the second quarter, up 31 percent from the first quarter, business investment fell from disinvestment at a rate of $22 billion a year to $203 billion between the firsts and second quarters. On net, businesses have stopped borrowing. Businesses that want to expand and invest now have much greater difficulty obtaining credit. Many potential business investments cannot obtain funding.

As the ability to fund business investments has plummeted, both investment and job creation have withered. Year on year, equipment and software investment and the number of new hires have fallen by 19 percent 17 percent respectively. Less investment means fewer jobs. The jobs the stimulus has funded have come at the cost of job creation in the private sector.

One has to hope that the Obama Administration does not believe its own rhetoric about the supposed success of its fiscal stimulus program in generating new jobs. For while the Administration assures us that the fiscal stimulus is generating new jobs according to schedule, the US labor market continues to deteriorate at an alarming rate. Failure to arrest this deterioration, threatens to abort the incipient economic recovery and to aggravate an already bleak labor market situation.

            The Obama Administration would like us to forget how reassuring they were about the US employment outlook at the time that they first unveiled their fiscal stimulus package last February. At that time, they told us that the stimulus would create around 3 million jobs. They also assured us that with the stimulus unemployment would not rise above 8 ¼ percent of the labor force, while by the end of 2010 the stimulus will have brought unemployment down to below 7 ¼ percent.

            The sad reality is that far from creating jobs, the US economy has lost around 3 ½ million jobs since the start of this year. While it is true that there has been a moderation in the rate of job losses since the middle of the year, over the last three months the US economy was still shedding jobs at a pace of around 175,000 jobs a month. This latter pace of job loss was similar to that around the peak of the two previous recessions. As a result, by end-October unemployment had risen to a staggering 10.2 percent of the labor force.

            The present headline unemployment rate is now at practically the worst level in the post-war period. More disturbing still is the fact that the headline unemployment measure understates how grave is the current US job market situation. Involuntary part-time employment is presently increasing at more than twice the pace that occurred in previous post-war recessions, while around 55 percent of workers who have lost their jobs now do not expect those jobs to come back. Including discouraged workers and people involuntarily in part-time employment in the overall measure of unemployment, as does the Labor Department’s  U-6 unemployment measure, the unemployment rate today is at an alarming 17 ½ percent of the US labor force.

Across the board, US companies have been taking advantage of the chronic weakness in the US labor market to cut back on both wages and job benefits. This is now resulting in falling wages and stagnating incomes for most US households. With the labor market almost certain to remain weak in 2010, one has to expect yet further declines in wages and incomes.

While falling wages might be good for keeping inflation in check at a time that the Federal Reserve is pumping an unprecedented amount of liquidity into the banking system, it is hardly good for promoting a meaningful economic recovery. For without income growth, one cannot expect any pick up in household consumption, which accounts for as much as 70 percent of GDP in the United States. This would seem to be particularly the case at a time when the banks are cutting back severely on consumer credit and when US households are still reeling from the large losses over the past two years in the values of their homes and their equity portfolios.

Without consumption growth, the US economy risks experiencing a double dip recession next year once the beneficial impact of the fiscal stimulus package fades and once inventory rebuilding has run its course. Whistling in the dark as the Obama Administration is doing at a time when real downside risks threaten the US economic outlook is hardly the way to run the world’s largest economy. One has to hope that the Administration soon smells the coffee and seeks a mid-term correction in its economic policies before the economy experiences a double-dip recession and before an already dire labor market situation becomes even worse.   

The Obama stimulus at best left total employment unchanged.  Start with the fact that according to the proponents’ own theory the “stimulus” in 2009 was not the 1.2 percent of GDP reflected by the signed legislation, but the 6.7 percent jump in the deficit-to-GDP ratio from 2008 to 2009.  Keynesians professing the benefits of automatic stabilizers somehow forget that Obama’s bill was less than a fifth of the “stimulus”.  Whatever the source, if Keynesian pump-priming really worked, 6.7 percentage points of stimulus should have the economy revving toward full employment by now.   1.2, 6.7, or 20 percent, though, are all equally ineffective.

This is not to argue that the cited 650,000 jobs were all phony.  Even granting the number is inflated, one ought to be able to identify a few jobs resulting from throwing a couple hundred billion dollars at the economy.  But the 650,000 figure only suggests the jobs created (or saved, as silly as that is), and tells us nothing about the jobs lost due to the “stimulus”.  A business that only focuses on gross income and forgets about net income fails quickly.

The problem with the idea of pump-priming the economy through deficit spending is that the government must first pump money out of the economy by borrowing it.  Government spending increases public demand; government borrowing reduces private demand.  Governments don’t create purchasing power.  They destroy it through inflation or transfer it through borrowing and spending.   

This isn’t an argument about the money being wasted.  Some of the funds did help families.  Some did go to useful projects that could provide long-term benefits.  Most of the money probably was wasted, but that’s not the point.  The point is – it did not lead to jobs in the short run.

Supporters sometimes reference “idle savings” as a justification, so government borrowing and spending does not reduce private borrowing and spending.  This suggests financial institutions are sitting on vast piles of saving idling on the economy’s sidelines.  To be sure, financial institutions have cautiously parked enormous sums in low-yielding investments.  But those sums are not idle.  They are invested.  They are cycled back into the financial system.  The only truly idle savings are found in mattresses and those savers are unlikely to be inspired to deflate their mattresses at the sight of massive government borrowing.

Proponents of Keynesian stimulus often fall back on vague references to closed economies and economies operating below full employment.  The closed economy response effectively admits the idle savings argument supporting Keynesian policy is specious and so proponents argue we can get the savings from abroad for government to spend.  Would that it was so, but even in the land of wishful thinking the balance of payments must balance.  If we import more saving on net to finance deficit spending, we must also import more goods and services – public demand up, net foreign demand down.

To be sure, Keynesian stimulus would have little appeal if the economy were operating at full employment, but rising unemployment does not render pump priming effective.   Citing the symptom does not provide a cure.  To move the economy toward full employment, producers need reasons to produce more, generating income that is used to buy stuff.  Keynesian stimulus ignores the first and second stages, and pretends that redistributing income changes the amount of stuff the income can buy.   

I am astounded at the claim of my friend Charlie Calomiris that government spending under recession circumstances doesn’t create jobs.   Does he think that the increase in demand doesn’t raise aggregate output, because the federal debt crowds out private production?   That would be hard to believe, at a time when the Fed is keeping interest rates at zero, and long-term interest rates are also quite low.   The lecturing to Democrats about the evils of the national debt takes real chutzpah, after Presidents Reagan, Bush I and Bush II increased it ten-fold during times when no national emergency required it.

Of course the Administration effort to identify specific jobs is more a political exercise than an economic exercise;   the true number of jobs saved, relative to what would otherwise have happened is greater than the White House  numbers.   It is legitimate as a communications strategy to make the benefits concrete by pointing to the many teachers who probably would have been laid off by fiscally devastated state and local governments in the absence of federal government money.   But the exercise doesn’t count the effects of most of the stimulus spending.  

The problem of course is that one cannot estimate accurately, let alone prove, what would have happened otherwise.   Claims by Republican congressmen that one should judge Obamanomics by looking at whether employment is greater than before the stimulus was passed are nonsense.  If there hadn’t been a severe recession (starting on the predecessor’s watch, if you want to get political about it, as Charlie does), there would have been no need for the stimulus.   None of us claims that fiscal stimulus creates a lot of jobs on net when the economy is already expanding. (The increased government spending of the second terms of Presidents Reagan and Bush did not create a lot of jobs.)    The appropriate way to estimate the stimulus impacts is by means of a standard macroeconomic model with a fiscal multiplier in it.  But if you believe that fiscal multipliers are zero, even in a severe recession, then neither a standard macroeconomic model nor anything else will convince you.

Washington thrives on phony numbers produced by political machines that need to make positive headlines (especially when the facts are so bad, as they are these days for the Democrat political machine). The 650,000 number is perhaps the phoniest number of all. As far as we know, the Administration's spending policies have had very little effect on the economy, and perhaps no effect. But economists can say with some certainty that we are suffering negative consequences from the President's pledges to raise taxes dramatically (in the form of higher marginal tax rates on income, and proposed taxation in support of healthcare and environmental initiatives), his protectionist actions and rhetoric, and his decision to pursue a politically motivated adversarial approach toward the financial system, which is now perpetuating and worsening the credit crunch (despite earlier Administration policies that were effective in bringing the worst phase of the crisis to an end). These policies will have and are already having a negative effect on investment and employment decisions, especially by small businesses who constitute the vast majority of jobs in the economy. The bad news is not just that we are suffering hard times, but that lasting improvements (beyond the inevitable spurt of growth in output for 2010) will be hard to achieve because the Administration is so hamstrung by its own ideological commitment to bad economic ideas. Phony facts won't change that unfortunate economic reality. Only elections will.

***If injecting $200 billion into the economy supported 650,000 jobs, then how many jobs were lost by first borrowing that $200 billion out of the economy?***

The White House says zero. Their job numbers assume all $200 billion is “new” and supports jobs that would not otherwise exist.

This is absolutely implausible. How can adding $200 billion to one part of the economy create 650,000 jobs, but removing $200 billion from another part of the economy not cost a single job anywhere?

Some assert that this $200 billion is “new spending” because it was borrowed from “savers.” But that assumes the people who lent Washington the money would have otherwise saved exactly 100% of it. Even if one conservatively assumes they’d have saved half of it, it still means that only $100 billion would be “new” spending supporting new jobs. The other half merely replaced private spending/jobs with government spending/jobs. So cut the “jobs created/saved” figure in half.

But wait, there’s more. Even the money borrowed from savers isn’t “new money.” Savings do not fall out of the economy. They are invested or deposited in banks – which then lend them out to others to spend. Even when recession-weary banks hesitate to loan money, they invest it in Treasury bills instead. They don’t hoard customer deposits in massive basement vaults. Consequently, one person’s savings quickly finances another person’s spending. (And even foreign borrowing is financed by an increased trade deficit, negating the effect.) So borrowing from savers doesn’t add new spending either.

Thus, it is possible that *all* $200 billion in government spending (and jobs) merely displaced private spending (and jobs) dollar-for-dollar and job-for-job. And this is why the unemployment rate is not dropping.

The White House is telling us that adding $200 billion to one part of the economy created/saved 650,000 jobs, but removing $200 billion from another part of the economy has not cost a single job. They need to be taken to task for such implausible economics.

I somehow doubt they realize this.

In the real world -- the world of the globalized dollar economy that we've all lived in for decades -- it's still the case, for now, that the rest of the world wants to hold US dollars as a reserve asset.  (Thank God for that.)  For that reason, the US economy will normally run a trade deficit.  For that reason, the US government will normally run a budget deficit.  Indeed, after allowing for the financial position of the private sector, that budget deficit will normally about equal the trade deficit, medium-term.

No commission can change this.

Medical costs help determine the scale and composition of total spending.  They do not determine the budget deficit.  Cutting medical costs may cut the deficit on paper.  It will not cut it in real life. 

If Medicare and Medicaid costs soar, from an economic standpoint that's just another public sector stimulus. It will raise private incomes.  It will therefore raise tax revenues -- until the budget deficit again falls, roughly to the value given by the trade deficit at the new income level. 

Conversely if Medicare is cut, private disposable incomes will fall.  And then, so will tax revenues, until once again the budget deficit and the trade deficit are in approximate balance.

Yes, I agree -- as everybody agrees -- that health care costs should be brought under better control.

If the ten Canutes are serious about health care costs, they could start by making sure that universal health insurance is enacted – to begin with, by vigorously backing President Obama's health plan. And then they could take on the problem of health care costs directly - in both the private and the public sectors.

But to focus attention on Medicare and Medicaid alone, is just to say that health care costs should be cut for the elderly and the poor alone. That is to say, the proposal would cut costs and services for people who need medical care the most -- and can afford it least. 

Where on earth is the morality in that?

Speaker Pelosi is right.   The idea of a deficit reduction commission is political posturing,  and it's rooted in a failure to understand the underlying economics. 

Commission No Silver Bullet, Actually Could Set Back Deficit Reduction Effort

No bipartisan commission on deficit reduction can magically eliminate the deep divisions that exist today among lawmakers over budget issues.  And, while creating a commission in the face of such divisions may seem harmless, it could actually set back the cause of deficit reduction.

To be sure, commissions have sometimes proven useful when a bipartisan consensus existed on the need for, and the rough parameters of, legislation to address a serious budget problem.   When, for instance, President Ronald Reagan and Speaker of the House Tip O’Neill agreed in 1983 that a combination of benefit cuts and tax increases were needed to keep Social Security afloat, they found it useful to appoint a commission to help craft the specifics of such a plan and build public and Congressional support for it.  Consequently, Congress enacted legislation that secured Social Security’s solvency for more than five decades.

With regard to the Base Realignment and Closure Commission, there was strong bipartisan consensus in Congress on the need to reduce the number of military bases across the nation.  The commission provided a useful tool to overcome the politically difficult geographical issues involved — namely, which bases to close — in order to implement the agreed-upon reductions in the number of bases.  The BRAC commission’s decisions, however, are far different from those that will prove necessary for deficit reduction  — decisions, for instance, about the appropriate level of federal revenues, the role of social insurance and safety net programs, and the tradeoffs between funding for domestic and defense activities generally.

If and when, at some point down the road, a bipartisan consensus exists on budget issues, it may be more efficient for the President and Congressional leaders from both parties to eschew a commission and move directly to crafting the details of legislation themselves.  That’s what happened in 1990 when top aides to the first President Bush, Democratic congressional leaders, and most of the Republican congressional leadership negotiated a budget deal that included tax increases and spending cuts and reduced cumulative budget deficits by $500 billion over five years.

When no consensus exists, a commission is no more likely to produce the desired results than direct negotiations among lawmakers.  That’s what happened when Congress in 1994 created a deficit reduction commission, headed by Senators Bob Kerrey and John Danforth.  Despite the best intentions of the co-chairmen, the commission reached no conclusion about how to proceed with deficit reduction because the fundamental differences between Democratic leaders (President Clinton and congressional Democrats) and Republican congressional leaders prevented commissioners from reaching agreement (and, even had they reached agreement, would have made it impossible to gather the necessary votes in Congress to enact it).  Given that differences between the two parties today on budget issues are at least as great as in 1994, it’s hard to see how a bipartisan commission could succeed.  If the commission members reflected the views of their party, they would fail to reach agreement.  If they did not represent the views of their party, then any agreement they reached likely would die in Congress.

With no obvious path to progress today on deficit reduction, lawmakers and others may be tempted to create a commission on the grounds it will “do no harm.”  But establishing a commission at this time could do some harm by encouraging the two parties to use their appointments to it to demonstrate their undying commitment to positions that are not sustainable in the long run (e.g., no cuts in major spending programs, no tax increases).  That could delay the day when serious bipartisan discussions about the spending cuts and tax increases that will be needed to put the budget on a sustainable path can begin.

And too bad some other Democrats, such as Pelosi, are also opposed. 

In both cases, they are ducking their responsibilities unless they come up with specific proposals to reduce long-term projected deficits – which is not happening and is not likely to happen any time soon. In the meantime, we are courting all kinds of trouble from slower growth, to an economic crisis, along with reduced flexibility to get the economy moving again or handle a new international threat. But perhaps even more important than the effects on the economy is the effects on confidence in government.  

A group of us has been going around the country talking about these issues as part of the Fiscal Wake Up Tour.  We find that citizens are much more upset about the failure of their elected leaders to act than they are about accepting the specific sacrifices that deficit reduction implies. If the two parties could join hands and take joint responsibility for proposing some tough actions the public would go along. 

It has happened before: in 1983 on Social Security reform, in 1986 on tax reform, in 1990 and again in 1997 on the budget. Presidential leadership is needed as well. Too many people on the left think that we can solve the problem by controlling health care costs but it is now apparent that we’ll be lucky if health care reform doesn’t dig the hole any deeper. The bills currently under consideration contain very little that will “bend the long-term cost curve.”  And too many people on the right believe that higher revenues lead to an intrusive and inefficient public sector despite the fact that we are now spending about $1 trillion a year on tax preferences for all kinds of activities, most of which would be better left to the market.

Is the Treasury plan mostly politics? A powerful incentive to pay back TARP funds and avoid the risk of future bailouts? Will it be possible to attract competent management at those companies? Can the Fed be trusted to curb compensation when it never recognized that as a problem before?

Wage and price controls are not a new idea.  They are a very old idea with a consistent history of creating more problems than they solve.  There has always been a stain of thinking among those men and women who consider themselves wiser than the market to believe that they know the value of a product or service.  The only real value is what men and women freely choose to pay in a free market.  Everything else is a power play by special interests and the government bureaucrats that serve them.

The men and women who lost billions of other people’s money and who failed to oppose government policies such as Fannie Mae and Freddie Mac’s existence and the Community Reinvestment Act should be “punished” by losing their jobs and assets when “their” companies went bankrupt.  The government interfered with allowing the market to sort out who is responsible for what.  Trying to guess what salaries should be—paid with other people’s money—is hubris.  Stupid hubris.  Done before and always messed things up hubris.

The White House action to limit the amount of pay at the seven firms receiving government assistance, and to reverse pay decisions made only a few weeks ago, is transparently political, and that is the only thing transparent about it. The political objectives are to increase the President's popularity (everyone hates Wall Street these days) and to send Wall Street a message: "stop opposing 'change'". This policy will hobble the ability of these seven firms to attract good management at a time with management is essential to their turnarounds. That is bad for the firms, their stockholders (that includes us taxpayers), and our democracy, which is now asked to accept micromanagement by the White House regarding which employees at these firms get high pay and which don't, which perks are legitimate and which are not, etc. These decisions are based on the pronouncements of a "pay czar" who is subject to no external review and who acknowledges that his objective was, in large part, to create a solution that would be politically acceptable.

The Fed's announced action is different. Compensation is an integral part of risk management at banks because it determines the incentives of decision makers toward risk. It makes sense, therefore, for the structure of compensation (not its amount) to be regulated as part of risk management. The question is whether the Fed will be able to do this successfully. I am keeping an open mind and look forward to seeing the details of how compensation will be regulated. By requiring delayed vesting and/or clawbacks of bonuses based on long-term outcomes, in theory it is possible to encourage managers to maximize long-term firm value, not just short-term profits. So, if the Fed avoids counterproductive limits on pay amounts, and focuses on pay structure, that could be helpful. (The lack of Fed independence at the moment, of course, raises legitimate concerns about whether the Fed's new pay regulation will be implemented in a sensible way.) Another potential problem is that bankers are smarter than their regulators and will find ways to game any regulatory system. But the fact that compensation regulation will not work perfectly does not mean that it will not improve risk management and value maximization incentives. In my view, regulating the structure of compensation to ensure incentive compatibility of compensation is worth a try.

“The government just announced two sets of actions to constrain the compensation that banks pay to their top executives. First, Kenneth Feinberg, the administration’s “special master” for compensation at the handful of companies that were most thoroughly bailed out by taxpayers, just announced the agreed compensation levels for the top 25 executives at each of those firms. Compensation levels were halved compared to the banks’ requests and a very high percentage was redirected into company stock instead of cash. Second, the Federal Reserve (Fed) announced draft guidelines to avoid compensation practices that might encourage banks to take excessive risks. Here are my brief thoughts on both: Continued Below

1. Feinberg's executive pay plan. Since taxpayers have such a big stake in the success of these companies, I think the main test should be whether the actions are those that a smart private owner would have taken. I think they are not, since they send the wrong message to the people working there or considering working there, which is that their pay will not be determined the same way as on the rest of Wall Street and will be considerably lower and more volatile. This risks losing the best people, since the ones that move are always those who have the best options elsewhere. That said, the plan could have been considerably harsher, so this may be the best we could hope for, given the politics.

       2. The Fed's plan is a good one, but I wouldn't expect big changes as a result. They are focused on situations in which the compensation plan fosters excessive risk, which is very different from the populist concern about how overpaid bankers are. There is no attempt to limit total compensation levels, nor do I think the Fed should try.”

“The Treasury executive compensation proposal focuses on compensation for top executives at 7 institutions that have accepted exceptional assistance from the federal government. For any institution that accepts taxpayer dollars, reasonable restrictions are part of the territory. It should be noted that Congress has imposed restrictions on TARP companies by limiting tax deductions and prohibiting any incentive compensation.

The Treasury proposal correctly focus on reducing excessive risk-taking and eliminating those compensation programs that focus on the short-term, rather on the long-term risk horizon. This focus on excessive risk eliminates incentives for executives to maximize quarter-over-quarter profits. This is the correct focus because it benefits the bank, the sales force, and the customer.

While the Treasury has the correct focus, it relies on reducing or banning pay and setting specific dollar limits on all types of pay to achieve its objective. While there are arguments on both sides about whether this is appropriate for the 7 institutions, this approach should not be applied to the broader industry.

The danger created by setting specific pay restrictions is they will be both over-inclusive and under-inclusive at the same time. Each institution and employee is unique and compensation packages need the flexibility to recognize this. Additionally, specific pay restrictions will cause a “brain drain” of executives who will leave the company for compensation based on market forces. Specific restrictions will thus reduce the ability of the company to attract and retain qualified employees, who are needed to help strengthen financial institutions.

The Fed guidance focuses on the entire industry under the Fed’s jurisdiction and potentially applies to all employees working at those institutions. It divides the industry and gives extra levels of scrutiny to the largest 28 banking organizations. The financial services industry did a poor job of managing some of its risks, including ‘compensation risk’, and this contributed to the failure of many institutions.

The guidance from the Federal Reserve shares the same goals as the Treasury proposal of reducing risk, however it achieves those goals with a different carrot. The remedy the Fed proposes is the more effective one. It does not focus on setting specific dollar pay caps, but rather, it is search and destroy mission to attack the root of the problem: excessive risk. The proposal seeks to eliminate any compensation practice that encourages any employee- from CEO to loan officer to trader- from engaging in behavior that exposes customers or the institution to excessive risk. The Fed proposal threads the needles of protecting institutions and consumers and attracting and retaining talented employees.

It is important to note that the financial services industry has already moved to eliminate incentives to take excessive risk and to better align compensation practices with the long-term risk horizon. The industry is using claw backs, salary deferrals, stock options, and long vesting schedules for stock options. These devices will align the interests of all employees with the long-term risk horizon of the company and the customer.

Both the Treasury and the Fed proposal focus on long-term risk, they just achieve their goals in different manners. The Fed method will help individual institutions, the industry, the economy, and the consumer better realize the benefits of financial transactions.”

There is no perfect answer to TBIF but the two most promising approaches are as follows:  First, create a resolution authority (or a special bankruptcy court) so that large banks can be closed down in an orderly fashion without excessive disruption to the system as a whole.  The most difficult part of this approach is resolving international banks and that requires cooperation with other countries, especially other financial hubs such as London.  The resolution process should heavily penalize managers and shareholders and make bond holders take losses.  A special fund should be available to make sure the institution is kept operating until it can be sold off or shut down.  This fund should be drawn from a levy on other financial institutions, especially other large financial institutions.

The second approach is that financial institutions should be required to hold more capital the bigger and riskier they get.  The approach should not be punitive but should capture the additional risks imposed by large and complex institutions on the financial system as a whole.  Large banks should also be subject to additional scrutiny from regulators to make sure they are following sound risk management strategies.

The two biggest problems in the financial crisis were, first, that financial institutions did not have adequate risk management rules or did not follow them if they had them.  Second, regulators pored over the books of the banks but never really tested whether they were keeping their risks under control.  These problems were not specifically problems of size, but of poor management and regulatory practices and these must be changed going forward.

There are means other than draconian limits on size to credibly prevent government bailouts of large institutions. And there are large social gains from retaining large, complex, global financial institutions.

As I argue more at length elsewhere, it is worth preserving large financial institutions four reasons. First and foremost, financial institutions need to be large to operate with global scope because their clients are large and global. Small, local banks simply could not provide global corporations the same physical capabilities for trade finance, foreign exchange contracting, and global capital access that large global financial institutions can. 

Second, there are production economies of scope that offer benefits when financial firms combine different products within the same firm. Economies of scope among products implies economies of scale within finance suppliers, since small financial firms cannot afford the overhead that comes from building platforms with many such complex products.

Third, many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. Among the many examples, perhaps the greatest accomplishment of global finance in the past two decades has been the replacement of crony banking networks in emerging market countries with branches of large global banks. 

Fourth, global financial institutions also have made stock, bond, and foreign exchange markets globally integrated and more efficient.

We can solve the too-big-to-fail problem without destroying global finance.

I am far more comfortable with a regulatory system that gradually penalizes size, however, through progressive higher capital/liquidity requirements. A graduated system of regulatory obligations would more consistent with market-principles, and let the organizations and the market figure out how to best cope with the higher costs their size (and inter-connectedness) impose on the financial and economic system as a whole.

Furthermore, to the extent it does not generate excessive costs of its own, large troubled financial institutions that are being resolved by the authorities (under needed new legislation, giving regulator bank-like resolution powers) should b dismembered so that they don’t come back to haunt us again. But regulators also should have the option not to conduct surgeries if they are significantly more expensive than what they would otherwise do to meet a “least cost resolution” standard.