Thursday, December 31, 2009

R.I.P. '09: The Year When Bad News Was Good

For example, this is what we consider good news these days:

The number of newly laid-off workers filing claims for unemployment benefits dropped unexpectedly last week, another indication that the job market may be healing as the economy slowly recovers.

The Labor Department said Thursday that new claims for unemployment insurance fell by 22,000 to a seasonally adjusted 432,000, the lowest since July 2008. That was much better than the rise to 460,000 that Wall Street economists expected.

The four-week average, which smoothes fluctuations, fell for the 17th straight week to 460,250, the lowest since September 2008, when the financial crisis intensified. The crisis led to widespread mass layoffs, which sent jobless claims to as high as 674,000 last spring.

Economists closely monitor initial claims, which are considered a gauge of the pace of layoffs and an indication of companies’ willingness to hire new work

The number of jobless workers continuing to claim benefits dropped 57,000 to 4.9 million, also better than the increase that analysts expected.

And it is good news for sure, but it is depressing that it is.

This is the traditional day to look back at 2009 and sum it up pithily, but I have no time so I'll pick my favorite summary from an economist much smarter than I: Joseph Stiglitz.

The best that can be said for 2009 is that it could have been worse, that we pulled back from the precipice on which we seemed to be perched in late 2008, and that 2010 will almost surely be better for most countries around the world. The world has also learned some valuable lessons, though at great cost both to current and future prosperity - costs that were unnecessarily high given that we should already have learned them.

The first lesson is that markets are not self-correcting. Indeed, without adequate regulation, they are prone to excess. In 2009, we again saw why Adam Smith's invisible hand often appeared invisible: it is not there. The bankers' pursuit of self-interest (greed) did not lead to the well-being of society; it did not even serve their shareholders and bondholders well. It certainly did not serve homeowners who are losing their homes, workers who have lost their jobs, retirees who have seen their retirement funds vanish, or taxpayers who paid hundreds of billions of dollars to bail out the banks.


The second important lesson involves understanding why markets often do not work the way they are meant to. There are many reasons for market failures. In this case, too-big-to-fail financial institutions had perverse incentives: if they gambled and succeeded, they walked off with the profits; if they lost, the taxpayer would pay. Moreover, when information is imperfect, markets often do not work well - and information imperfections are central in finance. Externalities are pervasive: the failure of one bank imposed costs on others, and failures in the financial system imposed costs on taxpayers and workers all over the world.

The third lesson is that Keynesian policies do work. Countries, like Australia, that implemented large, well-designed stimulus programs early emerged from the crisis faster. Other countries succumbed to the old orthodoxy pushed by the financial wizards who got us into this mess in the first place.

Whenever an economy goes into recession, deficits appear, as tax revenues fall faster than expenditures. The old orthodoxy held that one had to cut the deficit - raise taxes or cut expenditures - to "restore confidence." But those policies almost always reduced aggregate demand, pushed the economy into a deeper slump, and further undermined confidence - most recently when the International Monetary Fund insisted on them in East Asia in the 1990's.

The fourth lesson is that there is more to monetary policy than just fighting inflation. Excessive focus on inflation meant that some central banks ignored what was happening to their financial markets. The costs of mild inflation are miniscule compared to the costs imposed on economies when central banks allow asset bubbles to grow unchecked.

The fifth lesson is that not all innovation leads to a more efficient and productive economy - let alone a better society. Private incentives matter, and if they are not well aligned with social returns, the result can be excessive risk taking, excessively shortsighted behavior, and distorted innovation. For example, while the benefits of many of the financial-engineering innovations of recent years are hard to prove, let alone quantify, the costs associated with them - both economic and social - are apparent and enormous.

Indeed, financial engineering did not create products that would help ordinary citizens manage the simple risk of home ownership - with the consequence that millions have lost their homes, and millions more are likely to do so. Instead, innovation was directed at perfecting the exploitation of those who are less educated, and at circumventing the regulations and accounting standards that were designed to make markets more efficient and stable. As a result, financial markets, which are supposed to manage risk and allocate capital efficiently, created risk and misallocated wildly.

We will soon find out whether we have learned the lessons of this crisis any better than we should have learned the same lessons from previous crises.

Regrettably, unless the United States and other advanced industrial countries make much greater progress on financial-sector reforms in 2010 we may find ourselves faced with another opportunity to learn them.

Well-said. Whatever my defense of Bernanke, the real judge of his tenure will be how well he gets the next bit right: the regulation of the banking industry. We have learned a lot about the nature of financial markets and their failures - now we need to get the fix right. So this is my main hope for 2010.

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