Simon Johnson's Blog, page 28

“Some Of These Institutions Have Become Too Large”

By Simon Johnson

In a recent interview with PBS’s Frontline, Lanny Breuer – head of the criminal division at the Department of Justice – appeared to admit that some financial institutions were too big to prosecute.  In the “too big to fail is too big to jail” controversy that ensued, lobbyists and other supporters of big Wall Street firms tried all kinds of complicated ways to spin Mr. Breuer’s words.

Their job got a lot harder yesterday when Eric Holder, the attorney general, stated clearly to the Senate Judiciary Committee,

“I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy,” (Watch the video for yourself.)

According to Mr. Holder, speaking as the top enforcer of the country’s laws, “some of these institutions have become too large.”

Senator Sherrod Brown (D, OH), a leading voice for making the biggest banks smaller, reacted in this way,

“You expect trouble bringing a criminal to justice when he flees to a hostile foreign country; but it’s shocking that the Justice Department cannot pursue criminal activity when somebody simply walks through the doors of a Wall Street megabank. The laws of the United States must apply equally to both a $2-trillion Wall Street bank and a $200-million bank in Ohio.”

American Banker, a trade publication, called Mr. Holder’s statement a “stunning admission” and suggested this could mark a turning point in the debate about the size of very large financial institutions.

Senator David Vitter (R, LA), who is working with Senator Brown on legislation to reduce the size of our largest banks, said, “It’s another glaring example that ‘too big to fail’ is alive and well” (this is in the American Banker piece).  (Any Brown-Vitter legislation would presumably be similar in content to the Brown-Kaufman amendment, which was defeated during the Dodd-Frank Senate debate in spring 2010; you can review Senator Brown’s latest legislative proposal here.)

Senator Elizabeth Warren (D, MA) has been outspoken in her opposition to banks that are “too big for trial.”  Despite being new to the Senate, she has already hammered the regulators on this point.  Following Eric Holder’s statement she said, “Attorney General Holder’s testimony that the biggest banks are too-big-to-jail shows once again that it is past time to end too-big-to-fail.”

Some defenders of the global megabanks claim the issues are very complicated and much more study is needed before we take any action.  The Board of Governors of the Federal Reserve, for example, seems inclined to do nothing.

This would be a mistake.  Eric Holder’s remarks yesterday were not accidental or an aside – he is emphasizing that the world’s biggest banks are now above the law.  The Dodd-Frank financial reform legislation did not end the problems of “too big to fail”.

Will President Obama and his team now do anything about it – such as supporting the Brown-Vitter legislation or helping Elizabeth Warren put more effective pressure on the Federal Reserve to take immediate action?

Will the Department of Justice itself answer the tough questions posed by Senator Brown and Senator Chuck Grassley after the Lanny Breuer disclosures?  Who exactly at the Department of Justice decides that a bank is too big to prosecute – and on what basis?  Is there a rule book or a list of criteria?  Or, more likely, is this something totally made up on the spur of the moment and on an ad hoc basis?

The Justice Department’s budget documents prominently quote Thomas Jefferson: “The most sacred of the duties of government [is] to do equal and impartial justice to all its citizens.”

The attorney general just told Congress and the country that this principle no longer applies to very large financial institution.

Lessons of the Sequester

By James Kwak

The automatic sequester—the across-the-board cuts to discretionary programs that President Obama said “will not happen”—happened. The reason is simple and predictable: Republicans insist that the sequester be replaced entirely by spending cuts, while Democrats insist that tax increases must be part of the bargain.

One of the more controversial positions that I have taken, on several occasions over the past two years, was that the Bush tax cuts should have been allowed to expire completely. Now we see why.

In White House Burning, Simon and I calculated that the Bush tax cuts would be worth 2.5 percent of GDP in the long term. In other words, extending the tax cuts would mean that, in order to stabilize the debt-to-GDP ratio in the long term, we would have to come up with other tax increases or spending cuts equivalent to 2.5 percent of GDP—in today’s terms, about $400 billion per year.

The problem for President Obama is that, now that most of the Bush tax cuts have been made permanent, it is simply impossible to raise taxes without Republican cooperation. That cooperation will not happen. That’s not just because John Boehner says he won’t support any tax revenue increases. It’s because Republicans in the House cannot support tax increases, or else they will be primaried from the right in 2014.

This has been the most important factor in national politics for decades. Since the expiration of a small slice of the Bush tax cuts (for the most part, those for household income above $450,000 per year) has been successfully framed as a tax increase, the Tea Party veto over “more” tax increases has only become stronger.

When it comes to the sequester, the conventional wisdom is that the parties will wait and see which side gets more blame before doing anything. But most House Republicans don’t care what the country as a whole thinks. Since they’re from safe, gerrymandered districts, they only care what local Republican activists (the kind who are influential in primary elections) think. And they don’t want higher taxes—even if the higher taxes would on people other than themselves.

This is why procedural devices like the automatic sequester—which, remember, was originally designed to force Democrats and Republicans to strike a “grand bargain” to reduce the long-term national debt—don’t work. The sequester was supposed to be so painful to both sides that they would compromise, but it’s actually not so painful to politicians who only need to listen to their base. (This is true on both sides, but more so on the Republican side because of the greater coherence and power of their base.)

So how are we going to come up with that extra $400 billion per year (or maybe $300–350 billion, since some of the Bush tax cuts did expire)? Most likely we’re not, at least not during this administration. Republicans will continue to defend the current tax structure, waiting for 2014 and hoping that a softer position on immigration, coupled with a favorable set of Senate races, will get them a Senate majority. Democrats will reject any major plan to cut long-term spending. Most likely we’ll get a couple of small bills—one that rearranges the spending cuts mandated by the sequester, another that cuts spending modestly in order to keep the government functioning past this month.

This is bad for two reasons. The first is that there are obvious things that could be done to increase tax revenues, reduce the “size” of government, and reduce the deficit that sane Democrats and Republicans should be able to agree on. The place to start is reducing tax expenditures—tax breaks that are the functional equivalent of spending programs. In White House Burning, we take aim at no fewer than eight of them, which subsidize employer-funded health care, home mortgages, state and local government borrowing, state and local government tax collections, charitable contributions, investment income, dying (through the step-up of basis), and selling your house.* These are all subsidies that distort economic choices, supposedly to promote policy goals chosen by the government.

The second reason is that it means that we’ll go into the next budget crisis with even less capacity to support Social Security, Medicare, and Medicaid. The budget situation is going to improve over the next few years as the economy recovers. But at some point there will be another recession, or a crisis (financial? military? epidemic? climate?) that requires a large increase in government spending.

When that day comes, deficits will soar and Republicans will launch yet another attack on Social Security and Medicare. One of these decades, it is going to work. The only way to prevent that outcome is to start off with a healthy base of tax revenue. But that goal, unfortunately, has faded out of sight.

* In most cases we recommend either a reduction in the tax break or its conversion into a smaller, more explicit subsidy. For details, see chapter 7.

Maybe It Was Apple

By James Kwak

A little over a year ago, iconic but fading department store J.C. Penney hired Ron Johnson as CEO. Johnson was head of retail operations at Apple—which, in case you didn’t know it, is just about the most successful retailer in the world by a bevy of metrics.

According  to today’s Wall Street Journal article, Johnson quickly eliminated coupons and most sales at J.C. Penney.

“Johnson bristled when a colleague suggested that he test his new no-discounts strategy at a few stores. . . . ‘We didn’t test at Apple,’ the executive recalled Mr. Johnson . . . saying.”

Well, yeah. Apple doesn’t discount because they sell stuff that people really, really want and that they can’t get anyplace else. And they don’t test because Steve Jobs refused to. At Penney? Sales have fallen by about 30 percent.

This doesn’t mean Johnson is stupid, or that he’s going to fail as CEO. Apparently he has partially reversed his early decision, which is a good sign. But it brings up a common feature of external CEO hires. Companies in a perceived crisis often look outside for a new leader, hoping for a superman (or -woman) who can singlehandedly turn around the organization. Not completely illogically, they tend to look for people at successful companies. “Make us more like X,” they pray. In Penney’s case, X = Apple.

There are two important questions they tend not to ask, however. First, was Apple successful because of Johnson, or was he just along for the ride? Yes, he was the main man behind the Apple Store (although, according to Walter Isaacson’s book, Steve Jobs was really the genius behind everything). But was the success of the Apple Store just a consequence of the success of the iPhone?

Second, even if Johnson was a major contributor to Apple’s success, how much of his abilities are transferable to and relevant to J.C. Penney? There’s a big difference between selling the most lusted-after products on the planet and selling commodities in second-rate malls. When someone has been successful in one context, how much information does that really give you about how he will perform in a new environment?

Maybe Johnson will turn out to be a great pick; it’s just too early to tell. But the general problem is undeniable. In the rush to anoint a charismatic savior, hiring committees, search firms, and boards substitute leaps of faith for cold rational inferences, fastening on the bits and pieces of a job candidate’s resume that play to their desire for a superman and overlooking the vast amount they just don’t know (see Rakesh Khurana for more). And this is one reason why external CEO hires tend, in the aggregate, to do worse than people promoted from within, who have the benefit of years of insider knowledge and precisely relevant expertise.

The Importance of Excel

By James Kwak

I spent the past two days at a financial regulation conference in Washington (where I saw more BlackBerries than I have seen in years—can’t lawyers and lobbyists afford decent phones?). In his remarks on the final panel, Frank Partnoy mentioned something I missed when it came out a few weeks ago: the role of Microsoft Excel in the “London Whale” trading debacle.

The issue is described in the appendix to JPMorgan’s internal investigative task force’s report. To summarize: JPMorgan’s Chief Investment Office needed a new value-at-risk (VaR) model for the synthetic credit portfolio (the one that blew up) and assigned a quantitative whiz (“a London-based quantitative expert, mathematician and model developer” who previously worked at a company that built analytical models) to create it. The new model “operated through a series of Excel spreadsheets, which had to be completed manually, by a process of copying and pasting data from one spreadsheet to another.” The internal Model Review Group identified this problem as well as a few others, but approved the model, while saying that it should be automated and another significant flaw should be fixed.** After the London Whale trade blew up, the Model Review Group discovered that the model had not been automated and found several other errors. Most spectacularly,

“After subtracting the old rate from the new rate, the spreadsheet divided by their sum instead of their average, as the modeler had intended. This error likely had the effect of muting volatility by a factor of two and of lowering the VaR . . .”

I write periodically about the perils of bad software in the business world in general and the financial industry in particular, by which I usually mean back-end enterprise software that is poorly designed, insufficiently tested, and dangerously error-prone. But this is something different.

Microsoft Excel is one of the greatest, most powerful, most important software applications of all time.** Many in the industry will no doubt object. But it provides enormous capacity to do quantitative analysis, letting you do anything from statistical analyses of databases with hundreds of thousands of records to complex estimation tools with user-friendly front ends. And unlike traditional statistical programs, it provides an intuitive interface that lets you see what happens to the data as you manipulate them.

As a consequence, Excel is everywhere you look in the business world—especially in areas where people are adding up numbers a lot, like marketing, business development, sales, and, yes, finance. For all the talk about end-to-end financial suites like SAP, Oracle, and Peoplesoft, at the end of the day people do financial analysis by extracting data from those back-end systems and shoving it around in Excel spreadsheets. I have seen internal accountants calculate revenue from deals in Excel. I have a probably untestable hypothesis that, were you to come up with some measure of units of software output, Excel would be the most-used program in the business world.

But while Excel the program is reasonably robust, the spreadsheets that people create with Excel are incredibly fragile. There is no way to trace where your data come from, there’s no audit trail (so you can overtype numbers and not know it), and there’s no easy way to test spreadsheets, for starters. The biggest problem is that anyone can create Excel spreadsheets—badly. Because it’s so easy to use, the creation of even important spreadsheets is not restricted to people who understand programming and do it in a methodical, well-documented way.***

This is why the JPMorgan VaR model is the rule, not the exception: manual data entry, manual copy-and-paste, and formula errors. This is another important reason why you should pause whenever you hear that banks’ quantitative experts are smarter than Einstein, or that sophisticated risk management technology can protect banks from blowing up. At the end of the day, it’s all software. While all software breaks occasionally, Excel spreadsheets break all the time. But they don’t tell you when they break: they just give you the wrong number.

There’s another factor at work here. What if the error had gone the wrong way, and the model had incorrectly doubled its estimate of volatility? Then VaR would have been higher, the CIO wouldn’t have been allowed to place such large bets, and the quants would have inspected the model to see what was going on. That kind of error would have been caught. Errors that lower VaR, allowing traders to increase their bets, are the ones that slip through the cracks. That one-sided incentive structure means that we should expect VaR to be systematically underestimated—but since we don’t know the frequency or the size of the errors, we have no idea of how much.

Is this any way to run a bank—let alone a global financial system?

* The flaw was that illiquid tranches were given the same price from day to day rather than being priced based on similar, more liquid tranches, which lowered estimates of volatility (since prices were remaining the same artificially).

** But, like many other Microsoft products, it was not particularly innovative: it was a rip-off of Lotus 1-2-3, which was a major improvement on VisiCalc.

*** PowerPoint has an oft-noted, parallel problem: It’s so easy to use that people with no sense of narrative, visual design, or proportion are out there creating presentations and inflicting them on all of us.

A Growing Split Within Republicans On Too Big To Fail Banks

By Simon Johnson

An interesting debate is developing within the Republican Party on how to approach the problem of too-big-to-fail financial institutions.

On the one hand, a growing number of influential voices are pushing for measures that would limit the size of megabanks or even push them to become smaller. Richard Fisher, president of the Federal Reserve Bank of Dallas, continues to draw a lot of attention, as does Thomas Hoenig, the former president of the Federal Reserve Bank of Kansas City and now vice chairman of the Federal Deposit Insurance Corporation. And Jon Huntsman planted a strong conservative flag on this issue during his run for the presidency in 2011.

This assessment is now shared much more broadly across the right, as seen in recent opinion pieces by George Will and Peggy Noonan, as well as regular analysis by James Pethokoukis of the American Enterprise Institute, including on the issue I write about today. See this Holiday 2012 survey, provided by the Dallas Fed, with links to views in favor of and against breaking up the big banks.

Senator David Vitter of Louisiana and Jim DeMint, the former senator from South Carolina who now heads the Heritage Foundation, have also come out hard against very big banks. Both men are usually considered to be in the right wing of the party.

But some other Republicans are pushing back, as seen this week in a paper by Hamilton Place Strategies, a group headed in part by communications professionals who previously worked with President George W. Bush, John McCain and Mitt Romney. (The people involved insist that it is not a Republican firm. Of its five partners, four previously had senior Republican jobs, while the fifth worked for Hillary Clinton and other Democrats. Of its three managing directors, two have worked for Democrats and one was a senior staff member on the Romney campaign. Historically, of course, deference to big banks is bipartisan.)

Can Hamilton Place Strategies help turn the tide within Republican thinking? This is not likely, because its paper is not credible and should not be taken seriously for three reasons.

First, it fails to deal with the most important recent work showing the problems with big banks. For example, it essentially ignores the analysis of Andrew Haldane and his colleagues at the Bank of England, which finds no economies of scale and scope for the world’s largest financial institutions (the paper mentions the finding that economies of scale do not exist above about $100 billion but does not go into the specifics of this result). I see no mention of Richard Fisher and Harvey Rosenblum of the Dallas Fed, who explain clearly how megabanks weaken the effectiveness of monetary policy and undermine United States influence over all aspects of our financial system (a direct counter to one main point of the Hamilton Place Strategies paper).

The paper makes vague assertions about bank equity capital now being sufficient to withstand future adverse shocks, but it fails to take on any of the many concerns raised by Anat Admati and her co-authors, which are increasingly gaining traction. Professor Admati and Martin Hellwig have a new book, “The Bankers’ New Clothes,” which will be introduced on Monday at the Peterson Institute for International Economics (where I am a senior fellow); excerpts have been posted on Bloomberg. Anyone who wants to be taken seriously in this debate needs to read the book (and the technical papers already available).

Second, Hamilton Place Strategies denies the existence of too-big-to-fail subsidies for global megabanks. This is laughable. Has it talked to anyone in credit markets about how they price various kinds of risk – and assess the willingness and ability of the government and the Fed to support troubled megabanks? Or have its authors read the report on the SAFE Banking Act, produced by the staff of Senator Sherrod Brown, Democrat of Ohio? The International Monetary Fund, the Bank of England and other sources cited there put the funding advantage of too-big-to-fail banks at 50 to 80 basis points (0.5 to 0.8 of a percentage point, which is a lot in today’s market).

Such subsidies encourage big banks to borrow more – to take more risk and to become even larger.  The damage when such a bank fails is generally proportional to its size.  So this implicit taxpayer subsidy creates serious risks for the macroeconomy and contributes to the further build-up of taxpayer liabilities – when any financial system crashes, that causes a recession, reduces tax revenue, and pushes up government debt.

Even William Dudley, the former Goldman Sachs executive who now heads the Federal Reserve Bank of New York, acknowledges that too-big-to-fail and its associated subsidies continue. Daniel Tarullo, the lead Fed governor for financial regulation, is in the same place. (Again, neither is cited in the Hamilton Place Strategies document.)

Hamilton Place Strategies contends that large banks can be resolved – taken through liquidation by the F.D.I.C. without difficulties – and that the “living wills” process helps to provide a meaningful road map. I talk to people closely involved with these issues, officials and private-sector participants (as a member of the F.D.I.C.’s Systemic Resolution Advisory Committee and as a member of the Systemic Risk Council, led by Sheila Bair, the former chairwoman of the F.D.I.C.). Hamilton Place Strategies is completely wrong on the substance here.

Hamilton Place Strategies also asserts that global megabanks are an essential part of a well-functioning international economy. Again, I don’t know where this comes from. As part of my work at the Massachusetts Institute of Technology and at the Peterson Institute, I talk with people who run companies, large and small, operating around the world; they emphasize that they need financial services provided by well-run institutions and markets that have integrity.

Putting too-big-to-jail banks in charge of financial flows helps no one – except, presumably, the executives at those banks that the Department of Justice has determined are immune from criminal prosecution.

Third, the Hamilton Place Strategies “report” reads as if it is either some form of paid advertising or a sales pitch to potential clients — but the firm refuses to disclose for whom it is working and on what basis.

In response to an e-mail request for such information, Patrick Sims of Hamilton Place Strategies replied:

“While we don’t publicly disclose our individual clients, we make no secret that we do work for large financial institutions, both foreign and domestic, and related associations. It would be fair for you to note that in your writing. But the views expressed in the paper represent the longstanding views of the firm.”

I’m not sure what “longstanding” means, as the firm was founded in 2010. But in any case, this lack of disclosure completely destroys the credibility of Hamilton Place Strategies and its work in this area.

The firm is in the business of influencing opinion. As it says prominently on its Web site, “We show clients how to shape opinion, navigate challenges, make informed decisions and create opportunities.”

While the firm’s clients in this area may not be clear, the language in its report strongly resembles arguments being made by the Financial Services Forum and other lobbying groups for large banks.  For example, an unsigned blog post on the Financial Services Forum’s Web site from November 2011 has the same arguments and similar wording to what is in the Hamilton Place Strategies report. (It also objects to an earlier commentary I wrote.)

Perhaps all this is a coincidence; the firm has not yet been willing to discuss these points.

When I acquainted the firm with what I was writing in this post and sought comment, the only substantive reaction was a request not to characterize it as a Republican firm.

We have seen deceptive lobbying, posing as objective “research,” many times in the financial reform debate – for example, the case of Keybridge Research on derivatives, which I wrote about in 2011.

If a company’s lawyer is quoted in the press, the report will always include mention of the client-lawyer relationship. Everyone is entitled to a spokesperson.

Law firms are not afraid to tell you whom they represent. After Charles Ferguson’s Oscar-winning movie, “Inside Job,” many academics now disclose when they produce a paper on behalf of an industry association (e.g., Darrell Duffie of Stanford disclosed that he was paid $50,000 by the Securities Industry and Financial Markets Association, a lobbying group, to write a paper opposing the Volcker Rule). Karen Shaw Petrou, a leading banking analyst with whom I have also disagreed on too-big-to-fail issues, discloses “selected clients and subscribers” in some detail.

Upton Sinclair once quipped, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”

Hamilton Place Strategies’ decision not to disclose who is paying for its “research” is far more significant than all the errors in its white paper.

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire column, please contact the New York Times.

Michael Lewis!

By James Kwak

On the title page of my copy of The Big Short, in black ink, it says:

“For James Kwak

With admiration”

And then a scrawl that I take to be Michael Lewis’s signature. (Christopher Lydon got the book signed for me, since Lewis was on his radio show a few days before I was.) It may be the only book I’ve ever bothered to get autographed.

So I was especially happy to read that Lewis also wants to break up the big banks (hat tip Ezra Klein):

“Along with the other too-big-to-fail firms, Goldman needs to be busted up into smaller pieces. The ultimate goal should be to create institutions so dull and easy to understand that, when a young man who works for one of them walks into a publisher’s office and offers to write up his experiences, the publisher looks at him blankly and asks, ‘Why would anyone want to read that?’”

When Simon and I made that the centerpiece of the last chapter of 13 Bankers, I thought our chances were slim. When we wrote, in the epilogue to the paperback edition, that a proposal to do exactly that had been voted down, 61 to 33, in the Senate, I thought they had changed from slim to none. It’s still a long shot, but the issue hasn’t died, and if anything is getting more attention now, what with people like George Osborne threatening to break up banks if they don’t reform themselves. Perhaps it isn’t impossible.

Tobin Project Book on Regulatory Capture

By James Kwak

One of the last things I did in law school was write a paper about the concept of “cultural capture,” which Simon and I discussed briefly in 13 Bankers as one of the elements of the “Wall Street takeover.” The basic idea was that you can observe the same outcomes that you get with traditional regulatory capture without there being any actual corruption. The hard part in writing the paper was distinguishing cultural capture from plain old ideology—regulators making decisions because of their views about the world.

Anyway, the result is being included in a collection of papers on regulatory capture organized by the Tobin Project. It will be published by Cambridge sometime this year, but for now you can download the various chapters here. It features a lineup including many authors far more distinguished than I, including Richard Posner, Luigi Zingales, Tino Cuéllar, Richard Revesz, David Moss, Dan Carpenter, Nolan McCarty, and others. Enjoy.

What Is Social Insurance?

By James Kwak

“We do not believe that in this country, freedom is reserved for the lucky, or happiness for the few. We recognize that no matter how responsibly we live our lives, any one of us, at any time, may face a job loss, or a sudden illness, or a home swept away in a terrible storm. The commitments we make to each other – through Medicare, and Medicaid, and Social Security – these things do not sap our initiative; they strengthen us. They do not make us a nation of takers; they free us to take the risks that make this country great.”

Many liberals have been heartened by these words, spoken by President Obama during Monday’s inaugural address. Indeed, they represent one of the few times when anyone, including the president, has even attempted to defend our major social insurance and safety net programs. The usual posture among the type of centrist Democrats who make it into the administration is some combination of (a) simply attacking, as self-evidently evil, anyone who proposes benefit cuts and (b) saying in serious tones that we will have to cut spending one way or another.

Unsurprisingly, most Americans are split between various misconceptions of what Social Security and Medicare are. Many, particularly right-wing politicians and their media mouthpieces, see them as pure tax-and-transfer programs: they gather money from one set of people and give it to another set of people. This feeds easily into the makers-vs.-takers line, with payroll taxes on workers going to fund benefits for non-workers. From this point of view, they are bad bad bad bad bad and should be cut.

Many others, particularly beneficiaries and people who hope to see beneficiaries, see them as earned benefits. The common conception is that you pay in while you’re working, so you earned the benefits you get in retirement. You didn’t “earn” them in the moral sense that people who work hard should get benefits; you “earned” them in the accounting sense that you’re just getting back “your” money that you set aside during your career.

Both of these perspectives are wrong, the latter more obviously so. Most people, during their working careers, do not pay nearly enough in payroll taxes to pay for their expected benefits. This is most obvious for Medicare, since the Medicare payroll tax only covers a small fraction of total Medicare expenses; in addition, given health care inflation, payroll taxes from decades ago would make only a small dent in today’s medical costs. But it’s also true for Social Security: the way initial benefits are indexed (according to average wages, not average costs) pretty much guarantees that the average retiree in some generation will get back more than the average worker in that generation put in.

The problem with the tax-and-transfer argument is only slightly more subtle. Sure, at any given moment some people pay taxes and others collect benefits (and many do both, since Medicare is funded by general revenues). But most of us will both pay and receive at different points in our lives. So both programs are really more like income-shifting arrangements, where we spread income from our working lives into our retired lives—or like repeating intergenerational transfer schemes, which can continue indefinitely (making everyone better off) under the right conditions.

In chapter 6 of White House Burning, we devoted a fair amount of attention to the question of what these programs are. In the inaugural address, I think the president got it basically right. They are risk-spreading programs. You don’t get back exactly what you put in: they have a certain degree of progressivity (although less for Social Security than is commonly imagined). Their main function is to protect people against extreme outcomes by pooling a limited share of our resources.

Yes, rich people end up paying payroll taxes for insurance they end up not needing. But that’s how insurance always works: you pay the premiums hoping you won’t need it. And the key fact is that most young people, whey they start paying payroll taxes, don’t know what their own personal outcomes will be. Social Security and Medicare effectively transfer money from the futures where they turn out rich to the futures where they turn out poor, which makes them absolutely better off. Like any insurance scheme, you can make everyone better off simply by moving money around between different states of the world.

These particular insurance schemes, as the president said, have a moral element to them. They are a way of expressing out solidarity with each other as Americans, people united, however loosely, in a common endeavor. They also have an economic element to them. People protected against bad outcomes are more willing to take the risks needed for a vibrant and prosperous society. They are something to celebrate, not something to be embarrassed about whenever the Republicans come after them.

The Debt Ceiling Confrontation Is Playing With Fire

 By Simon Johnson

Congressional Republicans are again threatening not to increase the ceiling on the amount of federal government debt that can be issued. On Wednesday, they agreed to postpone this particular piece of the fiscal confrontation, but only until May. The decision to turn the debt ceiling into some form of showdown is a big mistake for the Republicans — and dragging out the indecision is likely to prolong the agony of uncertainty and have damaging economic consequences for the country.

I made these points at a hearing on Tuesday of the House Ways and Means Committee, but unfortunately the Republican majority seems determined to persevere with its destabilizing strategy. (The hearing can be viewed on C-SPAN’s Web site; see the playlist on the right.)

In most countries, decisions about government spending and revenue bring with them an implied, even automatic, decision about how much debt to issue. Spending minus revenue in a year gives you the annual deficit (a flow), while government debt is a stock of obligations outstanding.

Think of it like a bathtub. Spending is water coming in from the tap, and revenue is water leaving through the drain. If there is more spending relative to revenue, there is more water in the bathtub – and the amount of water is the debt. In the United States, for odd historical reasons, Congress makes two separate decisions, one on the flow (spending and revenue) and the other on the stock (the allowed limit on the debt, known as the debt ceiling).

But once you have decided on the rate of flow into and out of the bathtub, the stock at any given moment is a given. So what happens if Congress suddenly decides that there should be a cap on the water in the bathtub, without altering the flow in or out?

To complicate matters, keep in mind that some of these fiscal flows have already been committed, for example in terms of interest payments due on existing debt, salaries for active military personnel and Social Security payments. You cannot suddenly grab more revenue out of thin air.

The main problem is that no one knows what would happen if the federal debt were to hit its legal ceiling.

Would the government be forced to default on some obligations to bondholders? Would there be some other form of default – for example, in terms of nonpayment for goods and services already contracted? Or would there just be complete chaos in our fiscal affairs, a throwback to the mid-1780s, before the Constitutional Convention in Philadelphia and before Alexander Hamilton took the public debt firmly in hand?

In the past, the potential for confusion around binding debt-ceiling limits was well understood. The debt ceiling was therefore raised without too much fuss, and the party in opposition would typically object in principle but not put up a real fight. Plenty of other ways are available for Congress to affect revenue and spending (the flow) without throwing everything into disarray by insisting on a stock of debt that is inconsistent with previous commitments.

This changed in the summer 2011 when some Republicans decided to dig in behind the idea that they could force the federal government to default if they didn’t get what they wanted. For some, this was about forcing big spending reductions. For others, federal government default was actually the goal; see this commentary from July 22, 2011, by Ron Paul, a Tea Party favorite and then a member of Congress. (His son, Senator Rand Paul of Kentucky, is currently opposed to increasing the debt ceiling, even on a temporary basis as agreed this week.)

In summer 2011, I warned about the effects of this confrontation over the debt ceiling, contending that it would create a great deal of uncertainty and slow the economic recovery. I particularly stressed the damage that would be done to the private sector – exactly contrary what the House Republicans asserted they wanted. I also testified to this effect before the Ways and Means Committee on July 26, 2011, although I cannot say my arguments had any impact on Republican thinking.

Recent research by Scott Baker and Nicholas Bloom of Stanford and Steven Davis of the University of Chicago looks carefully at what has generated uncertainty about policy over the last 25 years or so. Their Web site is a must-read, as is the latest version of their paper on the topic (updated Jan. 1). This chart from their paper was a main point in my five minutes of opening verbal testimony.

They find that while the financial crisis of 2008 and its aftermath greatly elevated policy uncertainty in general, the debt-ceiling confrontation in summer 2011 produced the highest level of uncertainty since 1985, when their analysis begins.

Uncertainty about policy is important, because it creates doubts in the minds of people about what is going to happen to the economy. The natural response in the face of heightened uncertainty is to delay making decisions – people don’t go on vacation or buy a car, and business owners and companies don’t hire people unless they absolutely need them.

Slap everyone in the face with such concerns after a big financial crisis and you get a slower economic recovery and fewer jobs.

Most economists would say there is no chance that the United States would ever default; this would be an act of collective insanity far in excess of anything ever seen in this country or anywhere in the world. But what really matters is not the view of analysts and commentators. The real issue is whether decision-makers throughout the economy think that default or some other disruptive event could occur.

The evidence from Professors Baker, Bloom and Davis is clear. The debt-ceiling fight in summer 2011 made people more uncertain about what was to come.

This is consistent with the fact that August 2011 was a very weak month for job creation. According to the Government Accountability Office, this political confrontation also pushed up the cost of borrowing for the government. And uncertainty of this kind increases risk premiums around the world, because investors want to be compensated for higher risks. This put more pressure on European sovereign debt at an inopportune moment, pushing up yields across the troubled euro zone (including, but not limited to, Greece).

In the hearing this week, the Republican line was that the debt ceiling offers a “forcing moment.” This is plainly a threat; otherwise there is no sense in which it is “forcing.” What is the threat? No one knows; even the three Republican witnesses could not agree on what would happen if the debt ceiling were breached.

The threat lies between some form of default and some other form of unprecedented disruption to public finances. Expect uncertainty – perhaps at the level of August 2011, perhaps even higher.

This is an irresponsible way to run fiscal policy. As Sander Levin, the senior Democrat on the House Ways and Means Committee put it, “House Republicans continue to play with economic fire. They are playing political games and that undermines certainty.”

The Republicans should take the debt ceiling off the table.

A version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Another Perspective on Bad Software

By James Kwak

Last summer, Lawrence Baxter wrote these two posts about the toxic combination of bad software—actually, software in general, since no software system is perfect—and too-big-to-fail banks. Baxter knows whereof he speaks, as he was previously a technology executive at a very large bank. Here’s what he has to say about it:

I don’t care what a CIO or even a CEO might say:  if they claim that they can eliminate the real risk of such missteps, they just don’t know what they are talking about no matter how good they are.  And if such missteps are inevitable, then we simply cannot avoid the question whether the dangers posed by large, complex financial institutions and systems could outweigh their benefits.

Think about that the next time you hear some CEO talking about his company’s state-of-the-art technology.