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Well, Now What?

The reluctant admission that Syria has probably used chemical weapons on its own people puts the Obama Administration in a real bind. Its most probable response is to reinterpret the meaning of “use.”

For over a year the Administration has dithered, seemingly unaware of the enormous strategic importance that the fall of the Assad regime would have for American policy. When, against all expectations and hope, a substantial portion of the Syrian people rose up against one of the Middle East’s most brutal regimes, the President seemed hardly to notice. Rather than realize that the regime’s fall would immediately give hope to strong popular dissent in Iran and isolate Hezbollah from its main source of financial and military support, Obama seemed more concerned about the inconvenience of upsetting the status quo. While the Administration eventually decided that Assad should go, it has done almost nothing to help bring this about, its inaction sending a strong signal to both allies and adversaries about American determination.

In one area, however, the President has been bold. Several times Obama has warned Assad not to use chemical weapons, declaring that doing so would be crossing a red line. If words have any meaning, then the implication can only be that serious American action would follow. Since any actions that we would take in response to the use of chemical weapons are actions that we should be taking anyway given the strategic importance of replacing Assad, it is unclear why the President drew this line. Perhaps he naively thought Assad would never cross it. Perhaps he did not even think that far, but was merely responding to an opportunity to provide leadership on the cheap. In any case, the line has apparently been crossed.

What to do now? Given the President’s reluctance on Syria, it is hard to believe that he will suddenly see the merits of risking American life and treasure in exchange for an opportunity to fundamentally shift the balance of power in the Middle East. More likely there will be some sort of redefinition of the line. Something along the lines that a small use of chemical weapons does not justify a disproportionate response. And in a perverse way this makes sense. After all if, we allow Assad to carpet bomb his people with impunity, then why object to a little sarin?

The Administration has never had a real policy for the Middle East. Given the tremendous promise, as well as risk, posed by the political and economic turmoil that the region is undergoing, this exposes both the country and our allies to unnecessary risk. It also makes clear to everyone that America is neither a reliable ally nor one capable of recognizing and acting on its true interests.

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How Do We End Too-Big-To Fail?

On Tuesday of this week the Peterson Institute held a panel event devoted to the problem of financial institutions that are too big to fail.  The panel consisted of Sheila Bair, Jon Huntsman, Simon Johnson, and Senator Sherrod Brown.  The more I listened to the panel the more convinced I became that they were really missing the point, and in missing the point came to the wrong solution. Efforts to shrink financial institutions to a size where political leaders no longer feel compelled to bail them out are unlikely to be successful. A much better solution would be to amend the bankruptcy laws so that politicians have more confidence in their ability to handle large bankruptcies.

The common wisdom regarding too-big-to-fail institutions is that they are so important to the general economy that the failure of any one large bank would threaten the financial system and therefore the economy. As a result, regulators will always have to rescue the company’s creditors. However, this in turn will create moral hazard because both the financial institution and its creditors will feel free to engage in riskier behavior than they otherwise would. The solution proposed by all of the panelists is to penalize bigness.

I have no opinion on bigness. In the early 1990s officials in the first Bush Administration worried that large Japanese banks were eclipsing American ones and that the American banking industry was too fragmented. On the other hand, the trend in other industries has been away from large conglomerates because they were seldom able to achieve the efficiencies promised by their proponents. Absent regulatory intervention, I would expect many of today’s largest financial institutions to gradually sell off parts of their business as they face greater pressure from shareholders and the full costs of Dodd-Frank regulation became clear.

But I am fairly certain that government efforts to break up the banks are a poor solution. First, they assume that proponents of this strategy can obtain the political capital to accomplish it.  This seems highly unlikely given that stronger language did not make it into the Dodd-Frank legislation and the difficulty regulators are having implementing the Volcker rule.  Second, even if they had the statutory and Constitutional powers to force downsizing, I doubt regulators possess the detailed knowledge of markets and institutions to do in wisely. Especially in finance, the market is too complex and evolves too quickly.  Most of all, however, bigness is not really the issue.

During the panel discussion, Sen. Brown mentioned his support of the auto bailout in which the government intervened in the bankruptcy of General Motors and Chrysler. The bailout was financed by a highly strained interpretation of the authority given to the Administration under the Troubled Asset Relief Program (TARP) and accounted for most of the taxpayer losses under it. The central arguments for government intervention were the same for GM and Chrysler as they were for the financial institutions: that the consequences of bankruptcy to the broader economy were too great to let these companies go through the normal bankruptcy process. In this case the number of jobs lost and the interconnectedness of the supplier network were often mentioned.  Similar arguments might someday be made if other companies such as Boeing get in trouble. And yet no one is talking about breaking these companies up. So I question whether bigness is the real issue.

The real problem is that, when push comes to shove, political leaders often face tremendous pressure to mitigate the fallout from large firms. The current emphasis is on financial institutions because they started the crisis. But similar concerns surround any large company that has a large number of employees, counter parties, suppliers, and customers. Political pressure is part of the problem, but so is a genuine uncertainty about the ability of normal bankruptcy laws to handle large and complex organizations, especially in the absence of a clear buyer with bridge financing. If this is the problem, then the solution is to improve the bankruptcy laws.  Dodd-Frank addressed this problem by requiring companies to prepare living wills and giving the FDIC enhanced powers to liquidate an insolvent financial institution but these solutions are unlikely to work in practice. The plans are unlikely to be sufficiently detailed to help in a crisis and there are serious problems with giving politically appointed regulators the broad powers needed to handle such a crisis successfully.

A better solution would be to deal with the problem directly by amending the bankruptcy code to give the bankruptcy judge and the trustee the necessary powers, many of which are now given to FDIC under Title II of Dodd-Frank. The Pew Financial Reform Project Task Force, which I worked with at the Pew Charitable Trusts did make such a proposal. The Task Force called for the designation of a special bankruptcy court to handle all financial bankruptcies. This designation would reduce the uncertainty about which court would oversee a filing and allow the selection of the judge and trustee most skilled in financial matters. Reliance on bankruptcy would remove political considerations from any liquidation and provide greater certainty to both creditors and potential investors. If one proceeds from the premise that politicians usually do not want to bail out failed institutions (not always true) then giving bankruptcy courts the specific powers needed to enable them to handle large financial institutions would make the most sense.

A few scholars including John Taylor have been working on such a proposal but Congress seems to have no interest in acting on it. Luckily the public is so strongly against the TARP legislation that another bailout is unlikely.

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Predictions following the State of the Union

I was twittering away during the President’s State of the Union speech last week.  In the course of it I made several predictions.  Although it is easy to get carried away during the event, I think the predictions hold up pretty well.  In the interests of posterity I have copied them down here with a brief explanation of each.

1. Despite what he said, this President will never agree to cuts in Social Security and Medicare. Although the president made about as an explicit commitment as possible, I still do not think he has any intention of actually agreeing to cuts. If Obama were serious about entitlement cuts he could have struck a deal with Republicans during his first term.  Instead he raises hopes but repeatedly moves the goal posts anytime there is a hint of compromise from Republicans.  I think his statements were mainly an attempt to convince voters that he is not the one standing in the way of a deal.

2. Tax reform will not be an Obama priority. That means it will not get done. In the best of circumstances comprehensive tax reform would be an exhaustive undertaking. Because it entails great complexity, high stakes, and inevitable disagreement, it cannot be done without strong presidential leadership. There is no sign that Obama is willing to spend significant capital on this issue.

3. The President’s budget will not contain many details on how to pay for the many initiatives he proposed in his speech.  To be fair, he can make others pay the cost of some of them such as the higher minimum wage and pre-K education. But many inevitably will require federal spending. The budget will not indicate how this should be done.  Nor will it indicate which entitlement cuts the President supports.

4.Within 5 years of leaving Afghanistan, the Taliban and Al Queada will have a significant presence in the country. The President has bragged about withdrawing troops from both Iraq and Afghanistan.  He does not talk about the chaos that is likely to grow in both countries once U.S. forces are gone. The Karzai government perhaps does not deserve any further American support, but there is little indication that it can maintain national unity in the absence of significant outside involvement. There is no reason to think that it will be able to maintain national unity in the face of continued opposition from the Taliban based in Pakistan. Iraq is already splintering. Whether this has security implications for America remains to be seen.

5. The President will not make a serious effort to conclude a major trade agreement.  There seems to be little chance of reviving Doha anyway.  But despite the current talk of trade agreements involving Asia and Europe, nothing will get done.  The President did not show any interest in trade negotiations during his first term, although he did finally support free trade agreements that had been negotiated by Bush. Nor has he requested trade promotion authority even though he would likely get it. The Democratic party remains opposed to bringing down trade barriers, even when economic studies show that doing so would boost growth. Even if Obama feels differently, he will not exert energy over the tough concessions that are inevitably required to complete a major deal of this kind.

Lets see how well these predictions stand up over the next four years.

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Is the Fed’s Monetary Stimulus Helping?

On Monday Janet L. Yellen, currently Vice Chairman of the Federal Reserve gave a speech laying out the case for the Fed’s current policies. Ms. Yellen is commonly viewed as one of the strongest supporters for taking action to reduce the current unemployment rate. She is also one of the likely successors to Chairman Bernanke when his term expires. Her views are important.

Ms. Yellen did a compelling job of laying out the costs of the recent recession to workers and homeowners. But is should not really come as a surprise that many people suffered over the last few years. The real issue is whether the Fed’s current policy of trying to lower interest rates by purchasing assets is good for the country. On this important question she had surprisingly little to say. She did cite a prior speech by Ben Bernanke which in turn cites studies showing that the unprecedented purchases have lowered interest rates, but this again should hardly be surprising. When the Fed is buying roughly $80 billion in new assets every month you would expect that. The real questions are whether its policies are jeopardizing our long-term future for a little extra growth now.

The answer to that question depends on a couple of things. One is the impact that government policy can have at this particular time. Ms. Yellen includes a couple of graphs that show that fiscal policy and job growth have been disappointing during the current recovery, but the slides comparing both to past recessions only start at the beginning of each recession.  It would have been interesting to see what the comparisons looked like in the year or two prior to each recession. The Fed seems to believe that the Great Recession was pretty much like its predecessors and therefore the recovery and room for fiscal stimulus should also have been roughly the same. An alternative view is that this time was different. If unemployment was artificially low before the recession, then it should not be a surprise that it has fallen more sharply and recovered more slowly than in the past. If government deficits were larger, then the scope for fiscal stimulus at reasonable deficit levels is also constrained. Finally, if much of the activity and wealth creation prior to 2007 was artificial and never backed by true economic value, then we would not expect the declines in GDP and household wealth to recover their old values. But Ms. Yellen never addresses these issues.

The Fed’s strategy is to lower real interest rates.  This will have three effects. First, it should make it cheaper for consumers and businesses to borrow. Second, by boosting asset values it should make them richer and therefore more inclined to spend. Third, it lowers the income of savers and pension funds. If our long-term problem is a surplus in spending and low savings rates or, to put it another way, too much consumption and not enough investment, then it is not clear that the Fed’s policy is wise. Similarly, if the rise in asset values is temporary and artificial, then the Fed’s wisdom is also questionable.  Again, there is no discussion of this.  The Fed’s assumption seems to be that we simply need to jump start the economy and then it will take off on its own momentum. But other researchers, notably Carmen Reinhart and Ken Rogoff, have argued that, because this was a financial recession the recovery will be longer and less responsive to stimulus.

A second criteria for judging Fed policy is whether it harms the future. It is certainly hard to argue that inflation is a problem. Not only is current inflation low, there are few signs that people expect higher inflation in the future. But the real test will come when the economy begins to grow rapidly and the Fed has to raise interest rates and unwind its position.  Just as buying assets lowered interest rates, not buying them will raise them. The recent history of the Fed is that it has been slow to raise rates when economic growth resumes. In its defense, any rate increases are always met with political opposition because they slow growth from what it might otherwise have been. In such a circumstance, inflation expectations may rise. In fact, Ms. Yellen’s speech invites such a conclusion when she makes it clear that a rise in inflation expectations would not necessarily cause the Fed to pull back if unemployment was still high. It is clear that future stores of wealth such as private savings, pension plans, and college endowments will all be lower because of the current policies.

The lack of serious public discussions of these problems gives one the impression that the Fed is winging it: pursuing unprecedented increases in its balance sheet largely because it feels pressure to do something and worrying about the consequences later. Such strategies often turn out poorly.

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Reforming the Affordable Care and Dodd-Frank Reforms

Two things seem obvious to me by now.  First, neither of President Obama’s most significant legislative accomplishments, the Affordable Care Act and the Dodd-Frank, are working nearly as well as their proponents hoped. In fact, each is likely to be increasingly bogged down by complex rule making and unintended consequences. Second, neither can be substantially changed without Democratic support. This is partly because Republicans will not control the Presidency and both house of Congress for at least four years. But it is also due to the fact that both address a widely recognized policy problem and contain positive aspects that should be kept. So what can be done to improve them?

The conventional wisdom seems to be that neither bill can be reformed because the Administration will not accept any changes that are not carefully limited in scope and pre-negotiated with the opposition. I believe this is overly pessimistic. Sensible reforms are possible, but only if Republicans and industry are willing to pursue a disciplined strategy that gives the President a reason to accept reform. Although this observation applies to both pieces of legislation, the following discussion focuses on financial reform because that is the issue I know most about and worked personally on.

The first observation is that, especially in this climate, the opponents of both acts cannot beat something with nothing. As mentioned above, both pieces of legislation addressed what were widely perceived to be serious national policy problems. Rather than put forward legislation that responded to the popular demand for a solution, Republicans and industry by and large opposed all efforts to pass a bill. This is not an unusual strategy for the minority party and successfully stopped legislation on climate change. However, it failed with health care and financial reform. Any effort to substantially change those bills now will have to be proceeded by the development of one or more well-defined partial reforms that truly do a better job of addressing the social problem that the public perceives.  Right now such an alternative does not exist.

The second observation is that the Administration must be increasingly aware of the vulnerabilities created by its current unilateral approach. Although health care costs have increased at a slower pace for the last few years, this is not due to the Affordable Care Act and is likely to be temporary. At the same time, there are strong indications that employers and providers are likely to respond to the Act in ways that will upset the public. Insurers are indicating that they will ask for significant price increases, employers are exploring whether to reduce workers hours or raise premiums, some employees will likely have to buy insurance that is too expensive for them, and almost half of the states are opposing implementation in one way or another. In financial reform at least three problems are increasingly obvious: 1) Dodd-Frank did not fix the too-big-to-fail problem and may have made it worse; 2) regulators are struggling with the complexity and market consequences of reigning in such a large and fluid industry; and 3) the legal position of the Consumer Financial Protection Bureau is questionable. On the last item, there is a strong chance that the President’s appointment of Richard Cordray as its director was unconstitutional. If so, it would negate much of the rulemaking that the Bureau has done so far.  Even more serious, the Administration cannot be certain that the Bureau itself is constitutional.  Its concentration of power in one person and its freedom from appropriations makes it largely immune from control by either Congress or the President.

In this atmosphere, it is possible that a well-articulated and defined reform that better addressed one or more of the most problematical aspects of either bill could obtain the support of voters and some Democratic members. This would put pressure on the administration to at least consider reforms. The Administration might be even more amenable to changes if it was clear that accepting them would place a clear bipartisan stamp on the broader approach and eliminate much of the political and industry opposition to implementation. Control of the House assures Republicans that they can pass legislation through at least one chamber, raising the visibility of their alternatives. For Dodd-Frank two of the most sensible reforms would be the addition of a new chapter dealing with financial institutions to federal bankruptcy law and structural reforms to CFPB to subject it to appropriations and place it under a bipartisan commission rather than a single director. A new bankruptcy chapter should substantially reduce the too-big-to-fail problem by providing an alternative to government takeover of a financial institution. A deal on the CFPB could include the appointment of designated individuals to the commission and affirm all prior regulations issued by it, thus giving the Administration certainty that its work would continue.

The problem is that Republicans have not developed such a firm alternative. A good model for an alternative can be found in the Pew Financial Reform Project which convened at Task Force of bipartisan financial experts to develop a consensus plan for reform.  The plan called for many of the key components of financial reform but did so in a way that addressed the legitimate concerns of both sides of the debate. Although the proposal was  never translated into legislative language, it remains a possible template for ideas. Without offering the public or the Administration a better alternative that meets its legitimate needs, Republicans and industry will continue to find themselves following rather than leading the debate.  Both pieces of legislation may eventually run into more serious obstacles, but even if they do, the public will likely continue to trust Democrats on the issue. For industries struggling to adapt to rapid change and a party in need of revival, that is not a prescription for success.



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A New Mary Meeker Post

Mary Meeker just gave another detailed presentation about trends in the Internet and mobile communications.



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Why Vouchers Will Probably Expand

Jay Matthews, who does a great job of covering education issues for the Washington Post, recently posted an article questioning the applicability of the D.C. school voucher program.  The article largely misses the real issues underlying the voucher movement, however.

For a better view of Mr. Matthews’ opinion on vouchers, you should read the op-ed that he links to at the end of this article.  It refers to his “internally inconsistent view that there is nothing wrong with vouchers, but they are too politically poisonous to help many kids.”

There is a lot that can be said in defense of vouchers, we do after all base the GI Bill on them, but I will only make four points.  First, the article that Mr. Matthews cites contains many positive points about the D.C. voucher program, including that more than half attend Catholic schools. It sites three schools that might be marginal, but interviews only one parent about why they presumably think that the private school is better for their children than the public alternative.  The answers might indicate that even in a sub average private school, most students receive a better overall education.

Second, the only inherent difference between public schools and private schools is in who owns the equity and it is not clear why we should care about this.  Both types of ownership structure have to pay for the full marginal and capital costs of educating students.  Public schools pay for the use of capital through interest on the bonds they issue.  Private schools pay for it the same way or, if they are for-profit institutions, by earning an excess of revenue over costs that compensates shareholders for the use of their capital and for the risk of uncertain returns.  The state could make both operate under the same set of laws if it wanted to.  But if this works both ways.  It implies that a public school should face the same standards and sanctions that private schools face.  I care less about the specific standards the state imposes, as long as it imposes it without favoring public schools.  Too often, however, public schools are allowed to remain open long after any similar private institution would have been closed.

Third, there would not be a strong voucher movement if most schools were providing a safe, quality education that also stressed values.  But they are not, they have not for a long time, and there is little prospect that they will.  The article upon which Mr. Matthews’ comments states that D.C. spends an average of $18,000 per student each year.  The voucher for a high-school student is $12,000.  Even if vouchers did no better at educating kids, they would still be 33 percent more efficient.  For that reason they can be expanded over time to include all students.  My prediction is that they will unless public schools finally improve the performance of the schools at the bottom.

Finally, it is somewhat odd that vouchers are widely accepted for the GI bill, housing and food stamps but fiercely resisted for primary and secondary education. The main reason is that vouchers in K-12 education represent an alternative to a well-entrenched set of providers who have no incentive to make it easier for parents and students to bypass them.  Yet there is little real prospect of improving the quality of education that our worst institutions offer.  If they could reform, they would have long ago.  Once a district accepts charter schools, there is no logical reason to oppose vouchers.  The only real debate beyond that point should be about the rules that schools ought to follow in order to be eligible to accept vouchers.

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