Author: R.A. | WASHINGTON

MARK THOMA collects a number of excerpts on new nominee for Vice-Chair of the Federal Reserve Janet Yellen which make for very interesting reading. I think one key takeaway from his post is that debates within the upper echelons of the central bank are carried out within an environment of overwhelming agreement. Central bank heretics aren’t very heretical, and the gap between doves and hawks is really quite small. While there may be lively discussion within the central bank on topics like whether or not to use monetary policy to deflate asset price bubbles, that conversation will take place in an atmosphere of general conservatism and focus on stability. Which isn’t necessarily a bad thing, given the power these individuals wield.

Another key takeaway is that the culture within the Fed can be a little weird. Take, for example, this, from MacroAdvisors’ Larry Meyer, a former Fed governor.

Before the September 1996 FOMC meeting, Janet and I went to see the Chairman to talk about the policy decision at that meeting and at following meetings. This was the only time I ever visited the Chairman (at my initiative) to talk about monetary policy, before or after a meeting. Janet and I were both worried about inflation, even though it was very well contained at the time. We told the Chairman that we loved him but could not remain at his side much longer if he continued, as he had been doing for some time, to push the next tightening action into the next meeting, and then not follow through. He listened, more or less patiently. I recall, though this may have not been the case, that he just smiled and didn’t say a word. After an awkward silence, we said our good-byes. Needless to say, we didn’t win this argument. Yet, we never dissented. That is another matter of etiquette for the entire Board, at least since when I was there: The Board is a team, always votes as a block, and, therefore, always supports the Chairman.

This sounds like a Bible story, and it seems profoundly strange to me. And I suppose I would say that while voting as a block and publicly expressing unanimity, or something close to it, may be important in order to prevent instability in markets, the idea that this kind of deference and near-worship goes on internally is somewhat distressing. Perhaps with the sainted Alan Greenspan out of the Fed, the level of love at the central bank has ebbed. I certainly hope so.

THE invaluable Eric Barker directs us to new research on the lyrical content of pop songs during hard times:

The lyrical content of Billboard No. 1 songs for each year from 1955 to 2003 was investigated across changes in U.S. social and economic conditions. Consistent with the environmental security hypothesis, popular song lyrics were predicted to have more meaningful themes and content when social and economic conditions were threatening. Trends for more meaningful, comforting, and romantic lyric ratings were observed in more threatening social and economic times. Using Linguistic Inquiry and Word Count software, songs with more words per sentence, a focus on the future, and greater mention of social processes and intergroup themes were popular during threatening social and economic conditions. Limitations and possible implications are discussed.

Fascinating! Currently at the top spot on the Billboard charts is “Break Your Heart” by Taio Cruz (featuring Ludacris). I’ve been searching the lyrics for a focus on the future and greater mention of social processes and intergroup themes:

Now listen to me baby
Before I love and leave you
They call me heart breaker
I don’t wanna deceive you

If you fall for me
I’m not easy to please
Imma tear you apart
Told you from the start, baby from the start.

I’m only gonna break break ya break break ya heart.
I’m only gonna break break ya break break ya heart.
I’m only gonna break break ya break break ya heart.
I’m only gonna break break ya break break ya heart.

Now listen to me baby
Before I love and leave you
They call me heart breaker
I don’t wanna deceive you

And so on in that vein. I’m not sure what I think. I suppose some comparison is needed. Here are lyrics from the top song from the same week in 2005, a boom year. I give you Usher’s “Caught Up”:

I’m so
Caught up
Got me feelin’ it
Caught up
I don’t know what it is
But it seems she’s got me twisted
I’m so
Caught up
Got me feelin’ it
Caught up
I’m losin’ control
This girl got a hold on me

Let me go baby
Now listen
My momma told me
Be careful who you do cuz karma comes back around
Same ol’ song
But I was so sure
That it wouldnt happen to me
Cuz I know how to put it down
But I was so wrong
This girl was mean
She really turned me out
Her body was so tight
I’m lookin’ for her in the daytime with a flashlight
My homies say this girl is crampin’ my style
And I can’t figure it out but

I have to say, I think social processes and intergroup themes are more evident in the Usher song. But this is why a proper statistical analysis is so important.

THE news organisations are trumpeting new retail sales data out of America. Here‘s breathless Bloomberg on heroic American shoppers:

Sales at U.S. retailers unexpectedly climbed in February as shoppers braved blizzards to get to the malls, signaling consumers will contribute more to economic growth.

Kind of makes your eyes well up a little, doesn’t it? But of course, every silver lining has a cloud, and this one seems to have a rather dark and foreboding cumulonimbus. February retail sales were up, but only because January’s sales were revised down by about $1.5 billion. Absent the revision, the February numbers would have constituted a decline. Meanwhile, over half of the year-over-year increase in retail sales in February is attributable to purchases of petrol; recall, again, that oil prices have essentially doubled from this time last year. And then there’s this:

In gauging the economic recovery’s trajectory, you shouldn’t forget that this is not a normal tax season.

People who don’t pay income tax are getting an extra $30 billion in refundable tax credits thanks to the Recovery Act, the Joint Committee on Taxation has estimated. Based on the timing of tax refunds in past years, well over half of that has likely been paid out already.

Mark Zandi, chief economist at Moody’s Economy.com, said the extra serving of tax-season cash to modest-income families “helps explain the somewhat surprising strength in retail” in February…

And

Excluding AMT relief, Zandi figures peak stimulus hits this month or next.

This was a stimulus, remember, that was well short of Christina Romer’s $1.2 trillion recommendation, which was itself computed based on data that underestimated job losses by about 1 million.

If that’s not enough of a dark cloud for you, then there’s also the fact that consumer confidence fell in March, for the second consecutive monthly decline. Recovery looks more uncertain by the day.

HENRY FARRELL, in the process of discussing Charlemagne’s views on the meaning of Germany’s support for a European Monetary Fund, makes a very interesting point:

The IMF usually has maximal bargaining power at a country’s moment of crisis – it typically cares far less about whether the country makes it through than the country itself does, and hence can extract harsh conditions in return for aid. But – as we have seen with the Greek crisis – EU member states are far less able to simulate indifference when one of their own is in real trouble, both because member states are clubby, involved in iterated bargains etc, and because any real crisis is likely to be highly contagious (especially within the eurozone). In other words, the bargaining power of other EU member states (and of any purported EMF) is quite limited. If Greece really starts going down the tubes, Germany faces the unpalatable choice of either helping out or abandoning the system that it, more than any other member state, created. In short – any EMF, unlike the IMF, needs (a) to concentrate on preventing countries getting into trouble rather than dealing with them when they are already in trouble, and (b) deal with the fact that any country in trouble likely has significant clout in the architecture overseeing it.

From my sense of the EU integration process, and of the rough bargaining strengths of the actors involved, I imagine that any final bargain will emphasize forward-looking measures, which are intended to forestall problems before they arise. Unhappily for Bundesbank disciplinarians, these are likely to rely more on carrots than sticks – it is clear from previous experience with the Growth and Stability Pact that threats of harsh punishment are not sufficient to produce virtue if these threats are not credible. We can expect moderate levels of fiscal transfers (likely ratcheting up over time), aimed at helping ease the pain of adjustment, together with admonishments (and withdrawal of goodies) for those who fail to live up to their promises.

This is how tighter European integration is likely to happen then. Having tied their fates together, European countries can no longer pretend to be indifferent to the success or failure of other euro zone members. Germany is learning now what that means—that it is economically unacceptable to allow troubled member states to fail on their own, and politically and economically unacceptable to kick them out. And so the options are to be drawn reluctantly and repeatedly into bail-outs or to attempt to act pre-emptively to prevent crisis conditions from emerging—which, of course, means a move toward common European fiscal policy, including regular transfers between states as takes place in America.

Or maybe Germany will try for a last ditch attempt to avoid intervention. But as with Lehman Brothers, officials will often find that a misguided attempt to stay out of a mess may ultimately generate the necessity to intervene quickly, overwhelmingly, and more completely than would have been the case had an orderly solution to the problem been proposed and carried out.

ANDREW SCOTT mounts an argument at Vox today which goes against much of the conventional wisdom among pundits—sovereign debt in the wake of a crisis is no big deal. Mr Scott argues that debt levels tend to spike after a crisis, which will spark concern, but it makes much more sense to adjust back to previous levels of debt over the long-term, rather than trying to do it all at once (particularly if economic weakness persists). And, he says, major economies have done just that and been just fine in the past, even after hitting debt ratios much higher than those predicted for the immediate aftermath of the crisis:

In fact, although economics is quiet on the issue of what it means for debt to be too high it does tell us that in the face of large temporary shocks the optimal response is for debt to show large and long lasting swings. If bond markets are incomplete then we know from Barro (1979) and Aiyagari et al (2002) that debt should act as a buffer to help the government respond to shocks…In other words, in response to large short term shocks government debt should show decade long shifts…these optimal swings may even appear unsustainable for significant periods of time – even though, by design, they are not. Critically, debt is not “mean reverting” – it doesn’t come back down to its previous level.

The logic is simple. The UK and US government have the ability to borrow long term and the option to roll over their borrowing. Rather than abruptly raise taxation and cut government expenditure, fiscal policy should adjust over the long term. Fiscal adjustment in the short run is not enough to produce a surplus and so debt rises for a significant period.

The potential magnitude and duration of these increases in debt can be substantial, but markets have financed much larger levels of debt than are predicted for the UK and US. The largest increases are related to war, but as Japan’s recent experience shows this is not always the case. In the UK between 1918 and 1932 debt increased from 121% of GNP to 191%. It was not until 1960 that debt returned to its 1918 level.

I am sympathetic to this view, but I think there is one glaring problem that makes his argument problematic. Here are two charts from the Congressional Budget Office’s long-term budget outlook. First:

And second:

The first image shows spending and revenues, and you can clearly see that in the immediate aftermath of the crisis debt levels will be higher, but deficits will return to low levels (in practice, close to but just short of primary balance). If things ended there, then there would be no worry over debt. The adjustment back to lower debt ratios might take a while, but it would happen.

But over the longer term, demographic shifts and rising health costs generate a different threat to budget sustainability. And as you can see in the lower image, the path of growth in the debt ratio proceeds onward and upward. In the Alternative-Fiscal Scenario (which incorporates likely policy changes) public debt is over 700% of GDP. That, clearly, is not sustainable.

It’s important to keep this in mind. The problem with the debt isn’t the spending or the deficits from recent years. It’s the fact that there is no time for adjustment in the wake of the crisis before the demographic debt bomb hits. And so something must be done.

It’s still the case that something needn’t be done this year or next year. But by the end of the decade, something must be done.

AS DEBT issues feature more prominently in public debates, policymakers and economists are spending more time thinking about how to close looming fiscal gaps and, specifically, where to find new revenue. Potential policies have been bandied about—the health insurance excise tax, a carbon tax, a financial transactions tax, and a VAT. Some public figures have proposed a major rethink of the tax system.

Wisconsin Congressman Paul Ryan falls into this category, having put out an ambitious reform proposal to balance future budgets and reduce debt. The essence of his plan is fairly simple—significantly cut future government health payments and overhaul the tax system to make it flatter and simpler. There are huge obstacles to implementing something like Mr Ryan’s plan, however. One is that he rather fearlessly slashes beloved entitlement programmes. Another is that for the pain, he doesn’t quite manage to achieve the goal of a balanced budget. And another is this:

Obviously, a tax plan that significantly cuts the tax burden on the rich while increasing it on everyone else will be very difficult to pass. A flatter tax structure might have a ghost of a chance if adopted to fund a more generous social safety net, but that’s clearly not what Mr Ryan is proposing.

Offering a somewhat different tax plan is economist Emmanuel Saez, recent winner of the John Bates Clark award for young economists and investigator of changing income distributions in America. In a presentation (PDF) made to the American Economic Association back in January, Mr Saez detailed a reform proposal that would seek to balance equity and efficiency in the tax code while moving the income distribution in America back to its level at the end of the Reagan administration. He lays out suggestions to broaden the tax base, eliminate deductions and loopholes, and generally simplify the structure of the tax code. And then he begins playing with marginal tax rates:

Ultimately, he proposes a flat initial rate of 15% with a modest exemption for the bottom 90% of earners. The top 10% to the top 1% of individual earners (those making between $80,000 and $280,000) would pay a marginal tax rate of 30%. The top 1% to the top 0.1% (from $280,000 to $1.325 million) would then pay a 45% marginal rate, and earnings above that would be subject to a 60% marginal rate.

He also provides some interesting discussion on how to tweak transfers to reduce the disincentive to work. The above rates will strike some as unreasonable and confiscatory. It may even struggle to win support among some progressives; this, after all, isn’t really how the Europeans address unfairness in the distribution of income:

But perhaps Mr Saez’s plan will have legs. The problem in America has typically been that because the income distribution is very uneven, the very rich have largely financed a government budget with entitlements that largely go to the non-rich. This generates a lot of anger among the well-off, who then fund broad efforts to fight any and all tax increases which might apply to them, successfully roping in supporters among those who would benefit from a more progressive tax system along the way. But now, the rich seem to be getting out what they have put in, in the form of extensive support for financial markets. The accusation that the rich aren’t contributing their fair share is increasingly resonant. Who knows where that may lead?

THE new issue of The Economist picks up the thread on Germany’s export-orientation where I left off yesterday:

Germany is rightly proud of its ability to control costs and keep on exporting. But it also needs to recognise that its success has been won in part at the expense of its European neighbours. Germans like to believe that they made a huge sacrifice in giving up their beloved D-mark ten years ago, but they have in truth benefited more than anyone else from the euro. Almost half of Germany’s exports go to other euro-area countries that can no longer resort to devaluation to counter German competitiveness.

While Anglo-Saxons were throwing money around, Germans kept saving. Domestic investment has not kept pace. The result of Germans’ prowess at exporting, combined with their reluctance to spend and invest, has been huge trade surpluses. Germany’s excess savings have been funnelled abroad—often into subprime assets in America and government bonds in such countries as Greece. It would be absurd to maintain that a prudent Germany is responsible for Greece’s profligacy or Spain’s property bubble (though a few heroic economists have argued this). But it is true that, within a single-currency zone, habitual surplus countries tend to be matched by habitual deficit ones.

Imbalances cannot be sustained for ever, whether they are deficits or surpluses. Yet surplus countries tend to see themselves as virtuous and deficit countries as venal—the implication being that the burden of adjustment should fall on the borrowers. Germany’s response to the troubles of Greece, Spain and other euro-area countries has followed just such a line. A bail-out for Greece, once taboo, is now being debated—and German ministers have even come out in favour of a putative European Monetary Fund (see article). But the idea that Germany should itself seek to adjust, through lower saving and higher consumption and investment, still seems unacceptable to Angela Merkel’s government.

It is certainly true that Germany’s neighbours have a great deal of work to do…But Germany also needs to push ahead with liberalisation…

A bold programme of German structural reforms would do much to boost consumption and investment—and, in turn, to raise Germany’s GDP growth, which remains disturbingly feeble. Germany can also afford growth-boosting tax cuts without ruining its public finances. If only Germany would lift its head, it would see that this is in its own wider interest, both because it would be good for German consumers and because it would help the euro area to which it is hitched.

The new issue contains a full Special Report on Germany, which I’d encourage you to check out.

LET’S survey the economic news coming out this morning. First, jobless claims held steady, more or less, falling slightly 468,000. The four-week moving average ticked upward a bit to 475,500. It’s nice to see that the upward trend that emerged in February has leveled off, but it’s very distressing to note that claims have been stuck at their current level for nearly four months. The wait for the dip back to normal levels continues.

In brighter news, the year-over-year increase in foreclosure filings was only 6% in February, the smallest increase since the bust began back in 2006. Still, just over 300,000 foreclosure filings were reported for the month, which actually marked a slight increase over January’s numbers. The Wall Street Journal credits mortgage modification programmes with slowing the pace of foreclosure growth, but clearly the crisis rolls on.

And then there’s the latest news on America’s current account deficit. It fell, by about $2.6 billion, in the month of January. The drop reflects, among other things, a $1.5 billion decline in automobile imports, and a $900 million decline in petroleum imports. But from January of 2009 to January of 2010, petroleum added nearly $8 billion to the total current account deficit, which itself increased by less than $2 billion—the huge increase in petroleum imports entirely offset improvements elsewhere.

Why the huge leap in petroleum’s contribution to the deficit? Well, in January of 2009, the price of oil had fallen to near $40 per barrel, a product of cratering global demand. Recovery for the economy meant recovery for oil prices; a barrel of oil now costs about $82.

Meanwhile, America’s deficit with China fell 11%, year-over-year, in January after declining 9.2% in December. The improvements continue, in other words. But then there’s this:

Chinese imports increased 45 percent over last year, led by crude oil, after factories stepped up production.

There’s that returning oil demand, and I don’t imagine it will be going away anytime soon. And there’s the target for concern about the American current account deficit, and it’s one American policymakers can address. Rather than complaining about the renminbi, American leaders might focus on the fact that American petrol taxes are dramatically lower than those in other developed nations, and per capita petrol consumption dramatically higher.

CARMEN REINHART and Kenneth Rogoff have been doing their best to place the global economy’s latest financial and economic crisis in historical perspective, most notably in their recent book “This Time is Different: Eight Centuries of Financial Folly“. Concerning the long view, the authors explain in a new NBER paper:

The economics profession has an unfortunate tendency to view recent experience in the narrow window provided by standard datasets. It is particularly distressing that so many cross-country analyses of financial crisis are based on debt and default data going back only to 1980, when the underlying cycles can be half centuries and more, not just
thirty years.

For this latest paper, Ms Reinhart and Mr Rogoff content themselves to look back at just the last two centuries’ worth of crises, using a dataset that covers seventy countries. Here’s one picture of what that looks like:

What you see here are levels of public debt, the share of countries facing default or debt restructuring, and the share of countries with inflation over 20%. I quite like this chart. What you see is a clear correlation between debt loads and defaults and restructurings. It would be an extraordinary aberration if a raft of debt defaults and work-outs didn’t ultimately accompany the latest peak in levels of public debt.

The inflation picture is also interesting. We see four clear peaks in the share of countries with inflation rates over 20%. The first two are associated with the First and Second World War (recall that after the Second World War, America cut its debt load in half through inflation). The third corresponds to the late 1970s, when oil price increases and runaway wage-price spirals fueled inflation. And then there is a fourth in the early 1990s, associated with emerging market debt crises (Brazil experienced a hyperinflationary episode during this period, for instance).

It’s a fascinating image. The authors are right: debt cycles do appear to be somewhat rare and about a half-century in duration. And the struggle to work out recurring debt tends to play out in consistent ways, with increases in default and the occasional bout of rapid inflation.

NO DOUBT you’ve been wondering, how, in this Great Recession, has the tattoo business been holding up? Lucky for you, your blogger gets press releases, all kinds:

In 1936, Life magazine estimated that approximately 6% of the US population had at least one tattoo. By 1997, U.S. News and World Report stated that “Tattooing is the United State’s 6th fastest growing retail business”. National Geographic reported in the year 2000 that 15% or nearly 40 million Americans had tattoos. By 2006, the Journal of the Academy of Dermatology found that almost one in four Americans between the ages of 18 and 50 were sporting tattoos. Since the numbers have continually grown over the years, the fact is proven: that even in a down-turned economy, people are still spending money on tattoos.

Can’t argue with that logic. Tell me more, press release!

Along with the growth of the tattoo industry, tattoo removal is growing just as quickly. According to Dr. Phil Knall of Just Tattoo Removal in Glendale, AZ, about 20% of those who get a tattoo will eventually want it removed.

Among the reasons given for wanting a tattoo removed are, “The name of someone from a previous relationship needs to be removed”, and:

With the economy the way it is today and with the difficulty of finding jobs, many candidates have noticed that with all qualifications being the same, the person without the visible tattoo is getting hired.

There, curiousity sated. To see our previous coverage of tattooing and labour markets in a tough economy, click here.

GERMANY, it is well understood, is an export-oriented economy:

So what, right? Well, Martin Wolf says, Germany’s insistence on staying being like Germany means that other European countries can’t be like Germany, which places strains on the European project.

Unfortunately, the domestic German debate assumes, wrongly, that the answer is for every member to become like Germany itself. But Germany can be Germany – an economy with fiscal discipline, feeble domestic demand and a huge export surplus – only because others are not.

Tyler Cowen says that Mr Wolf is making a mistake here; economic growth is positive sum:

Say that Portugal, Italy, and Greece were more like Germany, economically speaking that is.  Toss in Albania to make the contrast starker.  They would have higher productivity and higher output.  They would export more.  But with their higher wealth, they would import more too.  That includes more imports from Germany, most likely.  German *net exports* might well decline, as Germans buy more olive oil and high-powered computer software from Albania.  But German exports need not decline *on net* (over a longer run of continuing global growth they certainly will not decline) and that should prove good enough for the German model to sustain itself.

No economist thinks that being wealthy is a zero-sum game.  “Being like Germany” isn’t exactly the same as being wealthy, but the German model succeeds (in large part) because of its high absolute level of exports.  “Net exports” is a zero-sum game at any single point in time, but when it comes to secular growth that’s also not the variable which matters.

The bottom line is that people are blaming Germany (and China) a bit too much here.

This is obviously true; a richer, more productive Greece would be good for Greece and Germany, just as a richer, more productive China will ultimately be good for everyone. At the same time, I think it’s worth thinking about the ways that exports figure in development and in economic recovery. Net exports, as Mr Cowen notes, are a zero-sum game at any one point. China’s decision to aggressively pursue growth in net exports as a development strategy will ultimately be good for the world, since 1.3 billion wealthy Chinese citizens will import a lot of things from other countries. But in the meantime, China’s progression along the path of export-intensive development has necessarily prevented other developing nations from walking a similar path.

The problem becomes more acute amid recovery from a deep recession. Economies with weak domestic demand must look to net exports for a lift, but not everyone can export their way out of recession. And here, Germany’s persistent trade surplus is particularly problematic, both because Germany’s economy is doing relatively well and because it poses a threat in the current, disinflationary environment:

Latvia’s model: drop wages to increase export income. Greece: drop wages to increase export income. France, Germany, Spain, Portugal, etc., etc. It’s impossible that the whole of the Eurozone will drop wages to increase export income. It’s especially bad for countries like Latvia or Hungary, where the lion’s-share of trade occurs withing the boundaries of Europe.

And what happens when export income does not provide the impetus for aggregate demand growth? Well, there’s not much left. Can’t devalue the currency (via printing money), and tax revenues will fall faster than a ten-pound weight: rising deficits; rising debt; rising debt service (via surging credit spreads). Sovereign default seems like a near-certainty…

These issues are complicated. Scott Sumner has argued, fairly persuasively, that China’s renminbi policy was highly stimulative and allowed the Chinese economy to continue growing through the recession, thereby placing a floor under global output. And Mr Cowen is correct that it’s unfair to blame Germany for keeping its fiscal house in order, investing heavily in education, and generally being responsible. But while it’s right to not sweat things like market share from a long-run perspective, it’s also true that when the pie isn’t growing or is growing painfully slowly, market share matters a lot. Capturing a larger share is the only way to boost the fortunes of one’s domestic population. And for Germany and China to be completely insensitive to this fact, at a time when they have much more fiscal room than others to cushion their citizens against the downturn, is problematic.

CATHERINE RAMPELL posts an informative chart based on the latest job openings data from the Bureau of Labour Statistics—openings by industry:

That’s the rate at which job openings came available as a share of existing jobs. That education and health services are at the top is no surprise; employment in those fields has actually grown right through the recession. Gains in professional and business services are likely cyclical in nature; that industry suffered a fairly significant increase in unemployment. Down on the low end of the spectrum we see construction and manufacturing. This is a problem:

There are over four million unemployed workers in construction and manufacturing, roughly a third of all unemployed. And the problem for many of those workers is that they’re unlikely to have the skillset and experience necessary to find work in the industries that are adding most new jobs.

MIKE KONCZAL is a finance blogging machine, so I hesitate to disagree with him, but I think he may be off base in an argument he makes today, declaring the government’s bank stress tests to be essentially bunk. He quotes from a letter from Congressman Barney Frank (emphasis Mr Konczal’s):

Many investors in first-lien mortgages have indicated that they are willing to accept the fact of significant losses on those investments in order to move on and use their money for other purposes, rather than having it locked in underwater mortgages with a high and growing likelihood of foreclosure. With the interests of homeowners and investors aligned in this way, it should follow that large numbers of principal-reduction modifications could be made relatively quickly. That is not happening. According to investors, Administration officials, and other experts I have consulted, holders of second-lien mortgages are now a principal obstacle to many modifications. The problem of second-lien mortgages standing in the way of successful principal reduction modifications has reached a critical stage and requires immediate attention from your institutions.

Large numbers of these second liens have no real economic value – the first liens are well underwater, and the prospect for any real return on the seconds is negligible. Yet because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans, which would allow willing first lien holders to reduce principal and keep borrowers in their homes.

Many borrowers purchased homes during the boom while putting almost no money down. But you can’t get a conventional and cheap loan for 100% of a property’s value, so those borrowers would typically take out one big mortgage covering about 80% of the purchase price and then a second mortgage covering 20%. Other homeowners purchased a home with one mortgage but subsequently took out a second, borrowing against their home equity. When the bubble popped, some homes lost 30% or 40% of their value (or more), which meant that even the first loan was underwater; sale of a home at market price wouldn’t cover either of the loans on the property.

This becomes a huge problem when homeowners face difficulties making payments and seek a mortgage modification. Holders of second liens are able to veto many mortgage modification agreements, and they’re willing to do so given the significant loss they’re likely to take from a modification. As Mr Frank says, second loans on massively underwater homes are nearly worthless.

Mr Konczal then goes through work he previously did closely examining bank stress tests and explains that the four largest American banks held about $477 billion in second lien mortages on their books, with an expected loss ratio of something like 13%. He writes:

So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.

And, he adds, this places the government in a bind. If it forces banks to write down worthless second mortgages to clear the way for new modifications, then the banks suddenly look shaky again. If it doesn’t, then lots of homeowners are stuck in loans they can’t modify and may not be able to afford.

I think that he may be overstating the potential pain to banks, however. It is the case that troubled borrowers are very likely to have second liens. But is it the case that second liens are likely to belong to troubled borrowers?

We see that the four big banks hold $477 billion in second lien mortgages. Losses on those mortgages attached to underwater properties with borrowers seeking modifications are likely to be very high—significantly higher than 13%. But 75% of mortgage borrowers in America are not underwater. We would expect second liens to be far less common among borrowers with positive equity, but because there are so many more borrowers with positive equity, it’s not at all clear that most second liens fall into the category Mr Frank describes. And of those homeowners who are underwater and have second liens, not all need a modification. And so I think it’s tricky to assume that losses on these loans are much higher than has been reported.

It would be interesting to know what assumptions the government made about the distribution of second liens when conducting the stress tests. If they believed that most of these mortgages were on properties that were deep underwater, then certainly the loss ratios were understated. But I don’t think we can conclude that from the data we have in hand.

The other thing to note is that home prices have performed well above both the baseline and the adverse scenario in the stress tests, which suggests that some of the expected losses from first loans haven’t materialised, creating room on bank balance sheets to absorb greater than expected losses on second liens.

LAST month I spent some time musing on the ups and downs to a 4% inflation target—a policy which IMF chief economist Olivier Blanchard recently suggested should get some consideration, given the speed with which central banks hit the zero lower bound in the most recent recession. A higher target would typically give central banks more room to cut rates, and it might have other ancillary benefits, like improving the adjustment of real wages. On the other hand, a higher target might make inflation more volatile, and it’s worth asking whether the costs would be worth the benefits given the rarity of extremely severe crises.

At Vox today, IMF economist Daniel Leigh weighs in on the debate, examining the hypothetical effect of a 4% inflation target during Japan’s Lost Decade. He concludes that a higher target might have cut Japan’s output loss in half, which would seem to provide strong support for an increase. But Mr Leigh’s explanation of his work offers some interesting context to this finding:

Second, counterfactual simulations suggest that an inflation target of 4% would have allowed the Bank of Japan to avoid the zero lower bound on nominal interest rates. But merely having more room for rate cuts would not have yielded much improvement in output performance. Without a strong output-stabilisation objective, the additional margin for interest rate cuts would not have been fully used. The higher inflation target raises inflation expectations in this model, but the associated improvement in output is short-lived…

[T]here is evidence that a policy that combines a higher inflation target with a vigorous response to output would have substantially improved the economy’s performance. In particular, the simulation results suggest that such a policy would have reduced Japan’s output losses during the “Lost Decade” by half…

But this immediately raises another question. Mr Leigh argues that a higher target alone would not have much reduced Japan’s losses. A higher target with an aggressive output-targeting regime would have cut losses in half. How much would losses have been cut given a 2% target and an aggressive output-targeting regime? In other words, how much of the work is the higher target actually doing?

After all, and as Ben Bernanke himself has acknowledged, the zero bound did not prevent the Fed from taking additional action. Had the Fed attempted to increase long-run inflation expectations, it could have continued to push down real interest rates. The point of the inflation target, to a certain extent, is that central bankers are simply reluctant to deploy extraordinary measures, and so monetary policy will be more fully utilised if they have more room to cut before facing the need to deploy those extraordinary measures. But if central bankers have a firm commitment to an output target, then they’ll be less likely to blink at the zero bound.

IN THE wake of the terror attacks of September 11, 2001, there was widespread concern that the reallocation of police resources toward terror investigations and away from other beats would lead to a significant uptick in crime. Indeed, reduced focus on financial crime in the years since 2001 has been blamed for growth in the incidence of fraud and other financial misdeeds. But it seems that the effect of terror attacks on crime is not unambiguous:

This paper argues that terrorism, beyond its immediate impact on innocent victims, also raises the costs of crime, and therefore, imposes a negative externality on potential criminals. Terrorism raises the costs of crime through two channels: (i) by increasing the presence and activity of the police force, and (ii) causing more people to stay at home rather than going out for leisure activities. Our analysis exploits a panel of 120 fatal terror attacks and all reported crimes for 17 districts throughout Israel between 2000 and 2005. After controlling for the fixed-effect of each district and for district-specific time trends, we show that terror attacks reduce property crimes such as burglary, auto-theft, and thefts-from-cars. Terror also reduces assaults and aggravated assaults which occur in private homes, but increases incidents of trespassing and “disrupting the police.” Taken as a whole, the results are consistent with a stronger deterrence effect produced by an increased police presence after a terror attack. A higher level of policing is likely to catch more people trespassing, and at the same time, reduce the number of property crimes. The decline in crimes committed in private houses is likely an indication that the tendency for individuals to stay home after a terror attack further increases the costs of crime.

Of course, more aggressive policing and fear of leaving one’s house aren’t exactly pleasant circumstances for average citizens; one would hope to bring crime down through less disruptive means.

I HAVE to say, it is suprising how easily one forgets how frightening the economic climate was during the dark days of December of 2008 and January and February of 2009. It simply wasn’t clear when the end of the decline might come. For a look back at some comments from last March see this and this. But a pat on the back is in order for CNBC’s Mark Haines who, we wrote on March 10 of last year, “called the bottom this morning”. As it happened, he was exactly right:

One year ago today, the Dow hit its lowest point of the crisis. What sparked the turnaround? It was a combination of things—an inflection point in broader economic indicators, huge expansion of the Fed’s balance sheet, the enactment of the stimulus package, growth in emerging markets, and the later announcement of the PPIP banking strategy. Now obviously, the employment picture continued to worsen and output continued to contract after March 10. But I wouldn’t underestimate the psychological impact of the market turnaround (and the effect on household wealth, which partially offset continuing home price declines) on sentiment. The market bottom likely helped to firm up the developing output bottom.

SMALL businesses punch above their weight in creating new jobs—firms employing 500 workers or fewer were responsible for two-thirds of the jobs created over the past 15 years. This is why President Obama’s budget made support for hiring and investment at small businesses a priority (unfortunately, Congress has yet to act on these proposals), and it’s why economists tend to pay close attention to sentiment among smaller firms.

The latest report (PDF) from the National Federation of Independent Business, detailing the economic outlook among small business owners in the month of February, has just come out. The news is a little worrying. The overall optimism index declined slightly:

But the real trouble comes in examining the individual indicators. In particular, the February index showed a major shift in small business outlook, where in January slightly more owners expected conditions six months ahead to be better than they currently are, many more now say that conditions will be worse. Sales expectations, expansion plans, and perceptions of credit conditions also worsened. And while deterioration in hiring slowed, small business owners were still cutting jobs on net in February, according to the NFIB survey.

It’s not a pretty picture. And owners continued to report that their single-most important problem, by far, is low sales levels (rather than taxes, interest rates, or labour quality). That’s worth keeping in mind as conservatives increase the volume at which they argue that high unemployment is due to extensions of government unemployment benefits. The problem is clearly not labour supply. Rather, the economy’s principal job creators are seeing too little demand to justify increases in hiring. That’s the drag on recovery.

OVER the weekend, Germany declared its support for a European Monetary Fund, modelled on the IMF, that would address crisis conditions like those brewing in southern Europe. The French quickly signed on to the idea, indicating that the proposal might have legs. European Commission officials will take up discussion of the policy today in Strasbourg. An EMF would address a sticky situation within the European fold—the IMF is typically the source of emergency funding for countries looking to avoid debt crises, but IMF involvement in Europe would seriously undermine the image of the euro zone as a functioning entity.

It’s worth pointing out that the idea for an EMF was introduced and discussed here at The Economist a few weeks ago, in a guest Economics focus column by Daniel Gros and Thomas Mayer and follow-up roundtable debate on the proposal. Mssrs Gros and Mayer wrotes:

The difficulties facing Greece and other European borrowers expose two big failures of discipline at the heart of the euro zone. The first is a failure to encourage member governments to maintain control of their finances. The second, and more overlooked, is a failure to allow for an orderly sovereign default. To address these issues, we propose a new euro-area institution, which we dub the European Monetary Fund (EMF). Although the EMF could not be set up overnight, it is not too late to do so. Past experience (with Argentina, for instance) suggests that the road to eventual sovereign insolvency is a long one.

The EMF could be run along similar governance lines to the IMF, by having a professional staff remote from direct political influence and a board with representatives from euro-area countries. Just as the existing fund does, the EMF would conduct regular and broad economic surveillance of member countries. But its main role would be to design, monitor and fund assistance programmes for euro-area countries in difficulties, just as the IMF does on a global scale.

Readers interested in how such an organisation might work or potential ups and downs should have a quick read through the piece and the roundtable.

STEVE WALDMAN muses on an intriguing counterfactual:

Suppose the good guys win. Better yet, suppose they had never lost. Suppose banks had never ventured beyond conservatively prudent lending; that there had been no housing, internet, or credit bubble. Forlorn cul-de-sacs surrounded by mouldering homes were never cut from the Arizona desert. Webvan and pets.com were rejected straight off by investors rather than soaring against all reason then dying in an unreasonably sudden collapse.

In a world without bubbles and, let’s not mince words, in a world without fraud in substance if not in law, would we, or how could we, have enjoyed two decades of near “full employment” and apparent growth? Without all the internet companies that were forseeably destined to fail, without all the housing construction, without all the spending by employees whom we know now and should have known then were not actually participating in economic production, without all the spending by people feeling rich on stock or housing gains that would eventually collapse in their or someone else’s arms, what kind of economy would we have built?

Mr Waldman recounts the government interventions that helped build the postwar American middle class, and he hints that in a world without crisis but also without similar government commitments to broad-based growth, the American economy would have looked quite stagnant indeed.

I don’t know (obviously, no one does). Another view might be that had capital and labour not been absorbed into dead-end sectors like structured financial gambling and residential construction, then resources might have flowed elsewhere, to fields less immediately remunerative but perhaps better for long-term growth potential. But one has to then think about why labour and capital flowed to the sectors that it did. And what might the political situation have looked like in the late 1990s if there were no tech bubble? Would government surpluses have been less robust, thereby reducing the attractiveness of large tax-cuts? Would stagnating incomes have become a serious political issue sooner, putting pressure on leaders to respond with investments in education or infrastructure (or tax cuts)? The question becomes intractable rather quickly.

But there is a deeper underlying issue that Mr Waldman helps to bring into relief: did the excesses of the last three decades cause the slow development of structural weaknesses in the American economy, or did they merely temporarily mask them? Were labour and capital pulled away into unproductive sectors by inflating bubbles, or was there really nothing better for that labour and capital to do?

I tend to think that both stories are partially correct. Inattention to fundamentals meant that the American economy navigated a transitional period relatively poorly, but bubbles also crowded out investment in productive opportunities. But I agree with Mr Waldman. As important as regulatory reform and countercyclical policy are, I wish more attention were focused on the broader growth potential of the American economy.

CALCULATED RISK posts this excellent chart:

A couple of things stand out in this image. One is that the American economy went into the latest recession with a relatively high level of long-term unemployment. Over the course of the last four decades, the number of long-term unemployed in the labour force in booms and busts appears to have risen and became quite substantial during the last boom. Second, the comparison between the composition of unemployment during the last major recession, in the early 1980s, and the latest is striking. Thirty years ago the bulk of the unemployment, about 60%, was short-term in duration—no more than three months. Unemployment of 27 weeks or more accounted for just over 20% of all unemployment. In this recession, most unemployed workers have been out of a job for more than 14 weeks. Fully 40% of unemployment is of the 27-weeks and longer variety.

Here’s the problem, then. To cut unemployment from near 11% back to 7% in the early 1980s, you could employ a lot of people who had been out of work for less than six months. And you see that that’s what happened. From the peak unemployment rate to the rate at the end of 1984, unemployment fell nearly 4 percentage points, and three of those percentage points were attributable to declines in unemployment among those out of a job less than six months.

But there’s just not that much room to cut unemployment by putting the short-term unemployed back to work in this latest recession. Only six percentage points of unemployment are attributable to those out of work less than six months. To get the unemployment rate down below, say, 7%, you have to take a big chunk out of long-term unemployment.

And that means putting back to work a lot of relatively low-skilled workers who were previously employed in construction, in manufacturing, and in retail and service industries. In an economic climate in which construction and personal consumption are likely to contribute very little to output growth for the next few years.

That’s a tall order. Not since the Depression has the American economy had to pull off anything like it.