For Übergeeks Only: Why Krugman Is Wrong

A couple of days ago, Paul Krugman wrote a widely cited post where he argued that the Geithner plan would amount to a huge subsidy for banks. The taxpayers, he fretted, would once again be taken to the cleaners. To fill in some background: in the Geithner plan Treasury funds are combined 1:1 with private equity; together they go to the FDIC and obtain a non-recourse loan six times greater than the original principal. Private investors decide how to invest while the Treasury piggy-backs on their expertise, splitting the proceeds with them.

Krugman is skeptical. The fact that the loans are non-recourse, he writes, would mean that investors would likely take greater risks since their losses are capped, costing the taxpayer dearly. I know... he won a Nobel Prize and I didn't. But he's wrong and I'm going to prove it.

Here's the example Krugman cites:

Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100.

But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset?

The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.

Here is what he means. A bid of $130.50 makes the average outcome of the scenarios $0. That is the breakeven point... a higher bid than that will, on average, result in a loss:
In another post, he explains that "two-state numerical examples" are the natural way to think about these things. Really? Just out of curiousity, what would happen if we went to a three-state numerical example?
Huh. When you add a middle scenario, all of a sudden the breakeven point has gone down to $116.28. Of course, in real life outcomes don't isolate themselves into two faraway islands. What if we kept on adding scenarios...
Wow. It looks like if we modelled this more like real life the overbidding Krugman writes about diminishes. If there were an infinite number of scenarios between $50 and $150, as there would be in real life, the degree of overbidding might even be reduced to single digits.

Let's also ask ourselves: is the spread of uncertainty likely to be as wide as Krugman's example? Think about it. There's a 3x spread between the high value and the low value. This would be like saying that a security with a face value of a dollar could as easily cost 25 cents as 75 cents. Remember that investors will have information about the payment history and location and credit history of the borrower, and remember that they have a wealth of prior experience on how similar borrowers have performed before. Isn't it likely they will be able to make far better projections than that? What if we narrowed the scope of uncertainty?
That makes a huge difference. Now the rational investor is only overbidding by just under 5%. But okay, let's say we overshot when we narrowed the spread of the scenarios. After all, no one can really predict economic performance, and that will certainly be a significant variable. Let's widen the scenarios a little to say... 40% on either side. But let's not pretend that there's an equal chance of getting extreme scenarios as opposed to the middle scenarios. Let's weigh the scenarios on a bell-shaped curve, giving more weight to the likelier middle scenarios, and less weight to the unlikelier extreme scenarios:
Still, a rational investor is only overbidding by around 5%. But I hear you say: 5% of a trillion bucks is an awful lot of money. It sure is. But there are other factors we have not considered yet.

First of all, the FDIC loans are low-interest... but they're not no-interest. The government will be making some money on the loans that do happen to perform.

But more importantly, there is a fallacy in our calculations. We're pretending investors are eager to risk capital just for the sake of breaking even. That's crazy. On the day the Geithner plan was rolled out, Bill Gross of PIMCO went on CNBC saying he expected returns in the "low teens." For any investment where the entirety of your capital is at risk, that is the minimum you should expect. So the bids are going to be lower than the breakeven price; they need to factor in their profit. Notice also that profit expectations increase as the range of uncertainty we mentioned above, the risk, increases.

Nor should we forget that it's not cheap to pore over loan tapes and make calculations that are far, far more sophisticated than the ones we've just done. Expenses will be at least 1%... probably more. Lower the bid by that amount. (Meanwhile, our government will have no such expenses.)

Together, these underbidding effects will dwarf any overbidding due to the capped losses. While there is no guarantee that the U.S. will not lose money on this deal, it is far likelier that we will profit. As many economists before, Prof. Krugman has let his theory come untethered from reality.

Update: I forgot to decrease the cap amount as the bid decreases! Still, that doesn't change the numbers too much. In the final case, I still have a number just slightly above 5%. I'll update with correct numbers later. 1:32PM: The numbers are now corrected.

How Long Does Obama Have?

Everyone seems to be asking themselves how long Obama has before the American people start getting -- as Andrew Sullivan puts it -- pissy. Nate Silver looks at polling data and guesses that it will be a year and a half. Blumenthal is skeptical, but not very specific.

I'd like to approach the question not from current poll data but from historical analogy. The other harsh recession since the great depression was the 1981-82 slump, when Reagan was in power. Like Reagan, Obama is a President with a pretty strong connection to the American people, so the comparison is apt that way. Let's look at the unemployment rate since that seems to be the measure that's most connected to popular anxiety, even if it is a trailing indicator for the economy.

Unemployment started going up in July 1981 and peaked in December 1982. Reagan's popularity bottomed around 45% in January of 1983, so it never really cratered. It was above 50% until October 1982. That seems to confirm Nate Silver's guess: about a year and a half, maybe a little less. I would just add two things: Reagan's recession began during his term. He was quite effective in blaming it on Carter, but the timing surely didn't help him. Obama's recession is more closely identified with his predecessor because it was already a year old when he stood on the Capitol steps to take the oath. Also, I would note how fast Reagan's popularity rebounded as the economy improved. Even though the unemployment rate was still above 10% half way through 1983, the economy was showing signs of recovery, so his approval rating was steaming back up to 60% by the fall of that year. Which is to say, if we start getting a visible recovery by Spring 2010, Obama's numbers may not fall below 50% at all.

Same as the Old Boss?

Two full days ago, the following appeared in the Wall Street Journal (emphasis mine):

CIA Director Leon Panetta, in his first meeting with reporters, said the agency will continue to carry out drone attacks on militants in Pakistan. He also said that while CIA interrogations will have new limits, President Barack Obama can still use his wartime powers to authorize harsher techniques if necessary.

Is he saying that the President’s powers as Commander-in-Chief under Article II give him the power to override the law of the land, which includes our treaty obligations such as the Convention Against Torture? I thought we got rid of the people who told us that last election.

Then this is somewhat comforting…

The main change Mr. Panetta has planned, he said, is to establish "a clear set of ground rules" for interrogations and detainee treatment that are "in line with our ideals."

But you have to wonder what he could possibly mean by that, because the big slap in the face is yet to come:

On interrogations, Mr. Panetta said he believes the CIA can be effective if it limits itself to the 19 techniques the military is allowed to use. He said the administration is evaluating the effectiveness of so-called enhanced interrogation tactics such as waterboarding and will make recommendations to the president on what techniques should be allowed. In the interim, only the 19 techniques will be used.

Leon Panetta, head of the Agency that was given leeway to torture during the Bush administration, is now saying that waterboarding not only would be legal but is under active consideration?

I believe profoundly in President’s Obama’s governing project. In the joint address to Congress he said:

And that is why I can stand here tonight and say without exception or equivocation that the United States of America does not torture.

Did he just mean right now? It should be the position of this administration that neither the President nor anyone in his administration has the authority to order torture; that it is already illegal and illegitimate.

What I find a little surreal is the almost perfect silence in the blogosphere about this. Glenn Greenwald? Nothing. Andrew Sullivan? Nothing. Josh Marshall? Nothing. Atrios? Nothing. All the powderkegs of outrage are suddenly powderpuffs of indifference.

The Director of Central Intelligence has just told us that torture is an option… we’re just not choosing to exercise it right now. We are one election away from a torture regime again, and they will be able to say "not only did Bush say we have the right to torture, but Obama agreed." It seems like our national shame is not over.

The Fifth Age

After two disappointing elections, conservatives are wondering where their future lies. The clear-eyed ones realize that their project, as Reagan defined it, is finished if not complete. From 1980 to 2008, the highest marginal tax bracket was lowered from 70% to 35%. Welfare was reformed. The Soviet Union collapsed. Many businesses were deregulated. (Plainly, these items weren’t all their doing, but their wishing was in them.) On the other hand, the more ambitious conservative goals – privatization of Social Security, school vouchers, an imperial American presence worldwide, drastic reduction in the size of government – have little, if any, chance of coming to fruition.

We sometimes see the affinities of our ideological side as permanent. Of course, nothing could be further from the truth. Today, conservatives are known for wanting to shrink the size of the state, but in the first age of American politics, it was the Jeffersonian liberals who wanted to limit the federal; they thought that power should lie with the people, not a King-like figure. The Hamiltonian conservatives, on the other hand, argued for a strong central authority; they considered it necessary in order to resist the passions of the mob. It was an age that was both inspired and spooked by revolutions, both here and abroad.

Since that time we’ve had many inflection points, when the dividing lines between parties shifted. Are we coming to one of those moments? First, let’s consider the prior ones.

The second age of American politics was dominated by the Civil War; it runs from Jackson to the end of reconstruction. The issue that dominated the era was how much power should lie with the federal government, and how much of it should be retained by the states. The south saw the war as a conservative revolution… an attempt to protect a way of life.

The age of reform comes next. It runs from reconstruction to 1932. It is the only age that is not dominated by a single issue, but rather, many discrete questions. During this time, the mechanics of industrial capitalist democracy are refined, and it is largely (though not exclusively) the conservatives who are leading the way, doing some things that today we don’t usually associate with them, like taming large companies and conserving wild land.

The fourth age begins with Roosevelt’s coming to office in 1932. Beginning here, the primary argument is the size and scope of government. In many ways, the debate is framed by the rise and fall of the Soviet Union. Roosevelt wanted to save capitalism from itself, to institute reforms that averted the real possibility of social unrest and even revolt. Reagan wanted to diminish any resemblance to the old Soviet Union, to return to a primacy of the individual and the marketplace.

Today, the argument is largely – though not completely – concluded. “The era of big government is over,” announced Bill Clinton. Barack Obama described the role of government modestly: “Government must do what we cannot do for ourselves.”

Transformational liberal projects remain – universal health care, day care, perhaps others – but liberals have been chastened by their 28 years in the wilderness. Hardly anyone in the Democratic Party hankers for a return to the 70% top marginal rate or welfare as we knew it. Sometime in the next decade or two we will still have arguments about the extent of government… but probably without even realizing it, we will come to some sort of near-consensus on the role of government.

Even today, the size and scope of government is no longer the dominant issue. We are at the dawn of the fifth age of American politics. The great tectonic shift of our lifetime is globalism. China, India, and much of the rest of the developing world are enjoying an unprecedented growth spurt; they will demand power comparable to their financial gains. Problems such as global warming will require coordinated international responses. The great technological innovation of our times, the Internet, is a beast that knows no borders; it will need international authorities. Perhaps as a reaction to globalism, tribal conflicts seem to be on the upswing; they will necessitate multi-lateral responses. Our current financial crisis illuminates how completely trade and investment have bound us together; financial coordination and regulation will need to develop.

It is around these questions that the fifth age of American politics will be organized: pro-globalist vs. anti-globalist; free trade vs. ‘fair’ trade; submission to international authorities vs. maintenance of sovereignty; pro-immigrant vs. anti-immigrant; multilateralism vs. unilateralism; pro-foreign aid vs. anti-foreign aid; seeing the U.S.A as a leader of a new, multi-polar world vs. looking backwards to the U.S. as unipolar superpower.

The next conservative movement will be populist and nativist. They will inherit the socially conservative, church-going constituency of today’s Republican party (social conservatism will never disappear, although with the baby boomers aging past their child-rearing years, it will lose some ferocity.) It will be an anti-immigrant and protectionist movement, strong on defense, but inward-looking in foreign policy. They will heap scorn on treaties, as well as international organizations such as the United Nations, the WTO, the IMF, and others yet to be conceived. On global warming some will be denialists, some will fatalists, others will point to the sins of other nations as an excuse to avoid action ourselves. The new conservatives will lose support from the business community, but they will gain it from an increasingly disenfranchised working class. They will not be scared of government programs, and indeed, will advocate them for their constituencies.

Most surprisingly, these new conservatives are probably just as likely to take over the Democratic Party as the Republican Party. If it were the Republicans, we would probably see the new movement as son-of-Pat Buchanan, a new breed of paleocons. If it were the Democrats, we would probably see them as son-of-Dick Gephardt, pro-union pols in touch with their constituency’s conservative side.

Conservatism is not just a philosophy; it is a temperament. Liberals see social bonds as fraternal; conservatives see them as filial. Liberals identify with the collective, the people; conservatives identify with the nation – the motherland or fatherland. Globalism, the great seismic event of our lifetimes, will inspire a complex of passions close to the conservative heart. The emotions these questions raise will in coming years eclipse the old arguments about how much government we need.

Fix Social Security... So We Can Afford the Stimulus

A couple of weeks before his inauguration, Barack Obama was asked the following:

QUESTION: Mr. President-elect, budget experts, as you know, agree that the real key to controlling federal spending lies with the entitlement programs. How early do you plan on addressing Medicare and Social Security? And what will your approach be?
OBAMA: Well, first of all, as I noted in my remarks, we’re going to be inheriting a $1 trillion-plus deficit. And if we do nothing, then we will continue to see red ink as far as the eye can see.[…] We are working currently on our budget plans. We are beginning consultations with members of Congress around how we expect to approach the deficit. We expect that discussion around entitlements will be a part, a central part, of those plans. And I would expect that by February, in line with the announcement of at least a rough budget outline, that we will have more to say about how we’re going to approach entitlement spending, how we’re going to approach eliminating waste in government, one of Nancy’s tasks.

This is tantalizing, but not an indication that Obama -- in the first year of his first term -- will plunge headlong into the mythical third rail of American politics. Still... should he? Sadly, if Obama were to tackle Social Security most of the resistance would come from his own side. The reasonable argument the left wielded to defeat Bush’s privatization effort was the following: “Social Security ain’t broke. Yes, it will start running deficits in about a decade and exhaust its trust fund in about three decades, but all that is necessary to fix it is some small tweaks – if the assumptions are too pessimistic, maybe not even that. So let’s wait and see how it works out, and in the meantime, let's concentrate on more important matters.”

True at the time, but this position needs to be revised. Why?

First of all, the assumptions don’t look so pessimistic any more. For the 2008 report, the trustees assumed 2.4% GNP growth from 2007 until 2017. We missed that number in 2007, 2008, almost certainly will in 2009, and probably 2010 too. The assumptions are starting to look a little on the rosy side.

Secondly, saying all it needs is some small tweaks was always disingenuous. Yes, the changes necessary aren't large, but in political terms they are monstrously difficult.

But more importantly, there’s this (click to enlarge):


Source: www.zfacts.com

Our debt level as a percentage of GDP is the highest it has been since the Eisenhower administration, when we were paying down the cost of the World War II buildup. Are we at the point when creditors might start wondering about our ability to repay this debt? Are we risking a currency devaluation, massive inflation, a dumping of U.S. debt, the loss of the dollar’s status as the world’s reserve currency, and perhaps in the worst case, a loss of the enormous privilege of servicing our debt in our own currency? We would not be able to fix some of these consequences… they would be a serious and permanent injury to American power, prestige, and well-being.

What is the level of debt where these kinds of risks come into play? People that tell you they know are lying. But informed experts, including Larry Summers, are said to be worrying about such an eventuality.

It’s time to get beyond the liberal orthodoxy and look at a way to reestablish our fiscal credibility –- so that we can afford this stimulus plan and avoid punishment by the debt markets. Social Security is the way to do it. Look at this chart:



Starting around 2035, the difference between outlays and revenues is around 1 percent of GDP. Say we spent $825 billion on the stimulus and did absolutely nothing to pay it off. In three decades it would balloon to $3 or $4 trillion in debt in a $27 trillion economy. It would still probably be cheaper to finance that debt than to make up the Social Security shortfall, which would be around $270BN. By fixing Social Security, we can offset the perceived danger we add to our credit profile by spending on stimulus. And by showing the political will to control our spending, we add even more value to our creditor cred.

Need more reasons? The Democrats will have 58, 59… maybe even 60 seats in the Senate and a very popular President in the White House. When are we going to have more leverage in negotiating a Social Security fix? There is a real possibility we could make this most regressive tax just a little more fair. How to do it? I would favor raising the cap; if that is a non-starter because of the President’s campaign promises, maybe add a surtax for income over $250,000. Ramesh Ponnuru has an interesting suggestion: slow benefit growth to the rate of inflation for those that are well off.

Fixing Social Security would have another significant benefit… it would solidify Obama’s centrist credentials and probably guarantee his re-election. 63% of Americans don’t think they’re going to receive the full benefits they’re entitled to. An electorate that is re-assured on this matter would be enormously grateful.

The Race Card

I've been a supporter of Obama since before the Iowa primary. I haven't volunteered for him (because that's not really me) but I've advocated for him and donated to his cause. Generally speaking, I've been proud of the campaign and its supporters.

However, one of the things that has discomfited me about the behavior of my side is how quickly -- not Obama -- but the supporters of Obama have imputed racist motives on their opponents, whether it be Hillary Clinton's camp or John McCain's.

When we were told that Bill Clinton was a racist because he said Obama's campaign was a "fairy tale" I was confused. I thought 'fairy' was derogative for gays, not blacks. Now, I will admit, not all the protestations about the Clintons were unearned. When Bill pointed out that Jesse Jackson had won in South Carolina too, his meaning was pretty clear: like Jesse, Obama was a marginal black candidate.

Still, over and over, the bloggers supporting Obama have used race as a shield for any criticism of their candidate. Here's one recent example, but it could just as easily be a dozen others:

McCain's latest: claiming that Obama will turn the IRS "into a giant welfare agency." And this even though McCain's rationale for this claim is Obama's support for a refundable tax credit, something McCain himself supports as a centerpiece of his health care plan. Par for the course, really: if you figure in the robocalls and recent ads, McCain's entire campaign is now comprised of innuendo and lies meant to tie Obama to various stereotypes of African-Americans and of course Arab terrorism. His purported foreign policy experience hasn't been part of the campaign's message in weeks. Just black, black, black, terrorist, terrorist, terrorist.

Why go to race? McCain's argument that progressive taxation is akin to socialism is absurd on its face and easily refutable without reliance on unprovable imputations about motives. You see, neither Josh Marshall, nor you, nor I can read minds. So why use an argument that will only be credited by someone who already sees ill will in McCain?

I'm not naive. I have no doubt that Obama's race will cost him among certain voters, and I don't doubt there are people on the Republican side trying to figure out how to maximize that effect. I just don't see the efficacy of calling it out unless it is blisteringly obvious. When you yell "racist!" when someone is just being a run-of-the-mill political heel, you cause a lot of defensive reactions. People develop resentments about their side being falsely accused of an abhorrent trait, and this leads them to be skeptical of any claims for minorities. We pay the cost of heightened divisions without enjoying the benefit of winning over hearts and minds.

Obama has avoided heightening the tensions he spoke of so eloquently in his speech on race. Those of us who support him should follow his lead and do the same.

Sometimes a picture...

... is worth a thousand words.