Kevin Drum

Wall Street's Temper Tantrum

| Wed May 26, 2010 12:29 PM EDT

John Heileman’s recent New York piece on financial reform tells us, among other things, that "it’s hard to find anyone on Wall Street who doesn’t speak of Obama as if he were an unholy hybrid of Bernie Sanders and Eldridge Cleaver." It's always fun to link to someone else's rant, so here's James Kwak's response:

Wall Street CEOs like to think they are the adults, the big men in the room, the ones who know how the world works. Well, you know what? They screwed up their own banks, the financial system, and the economy like a bunch of two-year-olds. Every single major bank would have failed in late 2008 without massive government intervention — because of wounds that were entirely self-inflicted. (Citigroup: holding onto hundreds of billions of dollars of its own toxic waste. Bank of America: paying $50 billion for an investment bank that would have failed within three days. Morgan Stanley and Goldman Sachs: levering up without a stable source of funding. Etc.) The financial crisis should have put to rest for a generation the idea that the big boys on Wall Street know what they’re doing and the politicians in Washington are a bunch of amateurs. Yet somehow the bankers came out of it with the same unshakable belief in their own perfection that they had in 2005. The only plausible explanation is some kind of powerful personality disorder.

It really is pretty mind boggling. I mean, obviously I get the fact that no one likes government interference in their business, no one likes being regulated, no one likes to make less money, and everybody has a million excuses for their own mistakes. But considering the epic FUBAR the bankers laid at our feet and the Obama administration's obvious efforts to protect them from the worst of the populist backlash by keeping the financial reform bill toned down — well considering that, and considering the fact that even bankers ought to occasionally take the long view and understand that better rules might be in their enlightened self interest, you'd think they could restrain themselves a bit. But no. I guess there's a reason that their nickname is Big Swinging Dicks.

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Quote of the Day: Bipartisanship

| Wed May 26, 2010 12:09 PM EDT

From Sen. Lamar Alexander, commenting on the fact that no progress was made during a "good and frank" meeting yesterday between President Obama and congressional Republicans:

We simply have a large difference of opinion, which [will] not likely ... be settled until November.

Well, I'd say he's half right.

Federal Spending and Private Investment

| Wed May 26, 2010 11:35 AM EDT

Tyler Cowen points today to some interesting new research on government spending. Three researchers at Harvard took a look at what happened to federal earmarks when a state's senator or congressman took over chairmanship of a key appropriations committee. Answer: the state's earmarks went up a bunch (by 50% for senators and 20% for House members). No surprise there. So what happens to economic activity after this bounty starts pouring in? From the paper:

Seniority shocks result in economically and statistically significant declines in firm capital expenditures. Across all measures of seniority, the declines are large and highly significant....The coefficient implies a 1.2% drop in scaled capital expenditures []. Since firms have average capital expenditures of 8 percent of assets, Senate chairmanship causes a roughly 15 percent reduction in the representative firm’s capex.

Italics mine. So when federal spending goes up in a random way (committee chairmanships are generally unrelated to broader economic activity), capital expenditures by private industry goes down. A lot. Researcher Joshua Coval takes a crack at explaining why:

Some of the dollars directly supplant private-sector activity — they literally undertake projects the private sector was planning to do on its own. The Tennessee Valley Authority of 1933 is perhaps the most famous example of this. Other dollars appear to indirectly crowd out private firms by hiring away employees and the like. For instance, our effects are strongest when unemployment is low and capacity utilization is high. But we suspect that a third and potentially quite strong effect is the uncertainty that is created by government involvement.

Italics mine again. These are interesting results. But they need some followup. Even if you believe that government spending crowds out private spending in a serious way, the effect here is enormous. How can you possibly get an 8% drop in private sector capital expenditures from the relatively trivial increase in federal spending that comes from earmarks? There has to be something more to this story.

On the other hand, it makes perfect sense that whatever effect there is, is more pronounced when unemployment is low. That's exactly when you'd expect government spending to crowd out private sector spending. However, it probably doesn't tell us much about current stimulus spending, which is taking place in an environment of zero-bound monetary policy and extremely high unemployment. We haven't had an environment like that since the Great Depression, which means that empirical evidence one way or the other on this kind of federal spending is just very hard to come by. I'd certainly be surprised if the 2009 stimulus bill provoked any significant private sector crowding out.

What Went Wrong in the Gulf?

| Wed May 26, 2010 1:47 AM EDT

So what caused the Deepwater Horizon oil rig to fail? Here's the latest:

BP previously told investigators that a "negative pressure" test, which checks for leaks in the well, was inconclusive at best and "not satisfactory" at worst. But in the meeting Tuesday, BP went further, saying the results were an "indicator of a very large abnormality" but that workers — unnamed in the memo — decided by 7:55 p.m. that the test was successful after all. That may have been a "fundamental mistake," BP's investigator said in the meeting, according to the memo.

Next up is a "top kill," in which mud is injected into the well in order to plug the broken pipe. According to one expert, "There's always a trade-off between making it better and making it worse. This probably has the least amount of risk of making it worse." Why does that not make me feel especially comforted?

Global Financial Reform Update

| Wed May 26, 2010 1:30 AM EDT

The Washington Post reports that efforts to coordinate global financial reform aren't going so well. Among other things:

European diplomats are alarmed by a measure, introduced by Sen. Susan Collins (R-Maine), that they say could force European financial companies to shift significant amounts of capital to their U.S. subsidiaries to cover potential losses....Geithner has said that new capital standards are at the heart of reforming the global banking system, and the financial overhaul bill on Capitol Hill largely defers to the Basel committee to set the standards. Some Europeans complain they have found it hard to coordinate with the United States over the Basel process.

Well, look: Collins's amendment requires banks to hold more capital. That will indeed force European banks to shift capital to their U.S. subsidiaries, but only if European negotiators insist on the new Basel accords having toothless capital standards. Conversely, if they adopt standards similar to Collins's, then European banks will simply need to carry similar levels of capital every place they do business.

Now, maybe European banks don't like Collins's capital standard and want Basel to adopt a looser one. What happens then?

The outcome, for instance, could be very different ways of banking in New York and the financial capitals of Europe, prompting leading American firms to shift their riskiest activities overseas beyond the purview of U.S. regulators.

And that right there is the whole enchilada. If we adopt tough rules and banks decide to move their risky activities in Europe to take advantage of their looser rules, then Europe will be taking a big chance. But they'll be doing it with their eyes open. They can reduce that risk anytime by adopting stricter standards. Every country and every region always has that option.

I'm pretty much convinced that the Basel standards are almost certain to be inadequate unless the rest of the world is essentially forced to accept tough standards. And the only effective way to make that happen is for the United States to adopt strict standards first, thus giving Europe an implicit choice: agree to make strict standards global or else accept becoming the worldwide hub for risky investment. Hopefully they'll choose the former.

Are We Japan 2.0?

| Wed May 26, 2010 12:46 AM EDT

A balance sheet recession is different from a normal recession. It's caused not by inventory cycles or monetary manipulation by the Fed, but by a debt fueled boom that eventually bursts and leaves the economy in the doldrums until debt levels get back to normal. That's the kind of recession we went through last year, and it's the kind of recession that wracked Japan in 90s. Mike Konczal points us today to a paper written a few months ago by Richard Koo of Nomura Research that compares what we're going through today to Japan's earlier experience:

As Koo argues, the economy will not enter self-sustaining growth until the private sector balance sheets are repaired. Even with zero interest rates, there are no borrowers of newly generated savings and debt repayments. With no borrowers, the economy will continue to lose aggregate demand.

And how long will it take for balance sheets to get back to normal? Here's Koo on Japan's experience:

With their balance sheets in a shambles, people had no choice but to reorient their economic priorities from the usual profit maximization to debt minimization in order to put their financial houses in order. This shift, in turn, nullified the effectiveness of economic theories and
policies based on the assumption that the private sector always seeks to maximize profits.

....Those whose balance sheets are underwater will try to pay down debt as quickly as possible to restore their credit ratings, regardless of the level of interest rates. By 1995 Japanese interest rates were almost at zero, but instead of borrowing more, Japan’s corporate sector became a net repayer of debt until 2005 — fully 10 years later — as shown in Exhibit 4....No economics or business textbook recommends that the private sector pay down debt when interest rates are at zero, but that was precisely what happened in Japan for a full ten years.

Exhibit 4 is below. Japan's property bubble was roughly similar in size to ours, and their recession lasted 16 years. Between 1995 and 2005, net corporate borrowing was negative despite interest rates of zero percent. Monetary policy simply lost traction: you can't force businesses that are deeply in debt to borrow even more no matter how cheap you make it. So what to do? Koo argues that the only answer is fiscal stimulus and plenty of it, even if that means piling deficits on top of deficits. "Now that the experience of Japan is available for anyone to see," he says, "there is no reason for the U.S. to repeat the same mistake....The U.S. government should not embark on fiscal retrenchment until it is absolutely certain that the private sector is healthy enough to borrow and spend the funds left unborrowed by the government."

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Why Now for DADT Repeal?

| Tue May 25, 2010 6:29 PM EDT

OK, so what caused Barack Obama to change his mind and actively press for repeal of DADT this year? Offhand, I'd say there are three leading contenders:

  • Nothing changed his mind. His plan all along has been to do it this summer or next, and he was willing to stay quiet and accept the hostility of advocacy groups before this because he knew that a bit of discretion on his part offered the best chance for enacting permanent change with broad public support. This is more or less Mark Kleiman's view.
  • Strong pressure from the gay community forced his hand. In other words, this is an example of that old FDR legend where he wants to do something, but tells his supporters they have to "go out and make me do it." (It's worth noting that this apocryphal story1 is pretty popular among liberals as a story, but we all sure hate it in practice.)
  • Obama (and congressional Democrats) are afraid they're going to lose their majority in November and will then lose their chance to push this through for good.

Because I'm a milquetoast centrist sellout, I'm going to punt and say that the answer is all three. Obama really has planned to do it all along during his first term but without a more specific timetable; the pressure from gay and lefty advocacy groups helped push congressional leaders into action and they in turn pressured Obama; and there was probably some additional political calculus related to the possibility of Democrats losing their House majority in November. That's my guess, anyway.

1At least, I assume it's apocryphal. I managed to find a reference to it from I.F. Stone in 1969 once, but I've never been able to track it back any further than that.

Lies, Damn Lies, and Polls

| Tue May 25, 2010 5:07 PM EDT

Jon Chait, after judiciously conceding that it's possible that "Rasmussen is right and everybody else is wrong," basically makes the case that Rasmussen's polls are, in fact, just right-wing hackery. Their questions are often loaded, they pick odd topics, and even when they poll on ordinary subjects they produce results that are wild outliers compared to everyone else:

Rasmussen polling occupies an odd place in the political culture. In the conservative world, it is the gold standard. If you go to a conservative [site] on basically any random day, you'll see somebody touting a Rasmussen poll.

....The habitual practice by conservative pundits of quoting only Rasmussen polling reinforces conservatives' overweening certainty that they embody public opinion. It's an important component of right-wing epistemic closure, the Republican base having its own pollster who always tells them what they want to hear. In theory, there ought to be a corrective dynamic. If Rasmussen is wrong about the 2010 elections — and, again, you can't be certain he will be — in theory, this would cause Republicans to question their reliance upon his unusual findings. But it's entirely possible that Republicans would simply question the validity of the results themselves. It's massive voter fraud! Obama dirty tricks!

Some time ago I decided to ignore all Zogby polls for everything other than plain-Jane election projections, and over the past year or so I've added Rasmussen to that list. I don't write about them to debunk them, I don't write about them when they happen to produce a result I like, I just treat them as null data. Now, I might be wrong about this. On Zogby in particular, I don't even quite remember what it was that prompted me to put him on my permanent shitlist. But that's where things stand: with the exception of campaign polling, where the questions are straightforward and house effects are generally modest (though rising in Rasmussen's case), I just don't trust either of these outfits.

That said, I think Rasmussen does provide a public service: it gives us some idea of where public opinion will be once Republican talking points enter the civic consciousness. Ask people what they think about financial reform and they'll tell you X. Ask them what they think about, say, financial reform that includes a fund to bail out banks, and they'll say something else. Is that a loaded question? Sure, but that's how Republicans are going to attack it, so it's useful to know what public opinion might be once they start repeating that talking points a few dozen times a day. It's not exactly an accurate reflection of the public mood, but it can still be useful information.

Checking Up on Financial Reform

| Tue May 25, 2010 2:25 PM EDT

If financial reform is passed — and it looks like it will be — how can we tell if it's working? Mike Konczal offers a couple of metrics:

The most obvious problem would be if the market finds resolution authority non-credible and starts lending to the five biggest firms as if they had a permanent government and Federal Reserve backstop....The next thing to watch is whether derivatives are reformed, and how much the laws are gamed in general. Will Goldman Sachs drop its bank holding company status, add a 20 percent non-financial wing and declare itself an end-user, and whatever other complicated acrobatics the lawyers are dreaming up? That all depends on the wink-winks that the regulators will give, and we will never see those on the outside. All we can do is watch for the effects.

I'd add a couple of other things. The first is leverage. This is easy to hide and hard to measure, so it's imperfect. Still, there are various good measures of leverage in the banking industry, and if reform works they should stay at moderate levels even when the economy picks up.

The second is easier: industry profitability. If reform works, Wall Street should be less profitable. Not because anyone is trying to punish them (though obviously plenty of people would like to), but because a safer, more real-world-oriented banking sector is inherently less profitable than the trading and finance-oriented one we have right now. If industry profits stay at 2005-07 levels, it's solid evidence that nothing has changed and they're acting pretty much the same way as always. So that's four things to watch for:

  • Borrowing rates for large banks
  • Derivatives trading
  • Leverage ratios
  • Industry profitability

My guess is that on all four of those metrics, we'll end up improving on where we were in 2005-07 but not by as much as we should. But at this point, any improvement at all is a big win.

High-Stakes Testing in San Antonio

| Tue May 25, 2010 1:52 PM EDT

A reader emails me regarding a story about Sam Houston High School in San Antonio, which has finally met state standards for academic achievement:

It's actually a very sad story about kids who are getting screwed by the system and by some educators, and perfectly encapsulates so much of what is wrong with education reporting. At least twice officials explain to the reporter (apparently without realizing they are doing so) why the results being touted are bogus, and yet the paper still presents this as good news about a success. And the school held a pep rally.

Let's take a look. Here's the first explanation:

“I think the main thing is we tested less kids,” English teacher Richard Acuña said. The school identified additional special-needs students who qualified to take tests that aren't counted when the state determines accountability ratings, he said.

And here's the second:

The state requires a 60 percent pass rate in math to reach the academically acceptable threshold. Though Sam scored lower than that, it is still set to receive the acceptable rating because last year the state introduced a new tool that allows schools to get credit for some students who did not pass the TAKS if they appear to be on target to pass in the future.

The formula, the Texas Projection Measure, uses a student's current test scores in several subjects as well as a previous year campus average score to project the student's future test performance. With the TPM, Sam's pass rate in math is 72 percent, enough to put it into academically acceptable territory.

For what it's worth, I'd add a third: the school's passing rate in science jumped from 38% to 62%. In one year. I mean, maybe that's legit, but if it is, they need to figure out how to bottle it and sell it. I'd usually be impressed by a five-point rise in a single year. A 24-point rise hardly seems believable.

As longtime readers know, I have pretty ambivalent feelings about high-stakes testing. I've heard too many horror stories, both in the press and from friends, to be a big fan, but at the same time it's not clear what better option we have. But even if you are a big fan, there's just too much anecdotal evidence that a lot of success in testing regimes comes from gaming the system and lowering the standards of the tests when necessary. Both seem to be in play in this story.