Wednesday, January 07, 2009

Rogoff on the Recession

I recommend this nice interview of Ken Rogoff when he talks about the recession, and what is and is not understood by academic macroeconomists. Some key passages:
Region: You start, I believe, with England's default on debt in the Middle Ages and work up to the current period. What can you tell us about the regularities that you found over those eight centuries and the lessons or forecasts that might provide for our current situation?

Rogoff: One thing that we find certainly is that virtually every country experiences serial default on external debt when going through the emerging-market stage of development. They default not just once but many times on external debt.

Another thing we find, less surprisingly, is that the same thing is true, more or less, for high inflation. It's a matter of degree, and countries that were emerging markets in 1700 didn't have the technology that those in 2000 did, but to the best of their abilities, they did the same thing. (By technology, I mean that before the printing press became widely used in the mid-1800s, governments had to resort to clipping coins, using inferior metals and otherwise debasing the currency to achieve inflation.)
I wonder where Iceland would sit in this analysis? Also, to what degree are developed countries immune from default because developed central banks help them out? The Fed's lending line to the EU is quite different from the line it opened to Mexico.
Region: And the long-term growth consequences of that additional debt?

Rogoff: Fortunately, adding a trillion dollars in debt is quite manageable for the United States. Of course, it is not a fun way to spend money, bailing out the financial system. We'd rather spend it on health, education, infrastructure or the environment. (That is, if the expenditures are well crafted and packaged with policy changes and structural improvements.) The fact is that for all the railing against the Bush deficits, the United States grew decently until recently, so that our debt/GDP burden is still modest by European or Japanese standards.

The rising debt burden will have some effect on growth. But I'm more concerned about what happens to our financial sector at the end of this, what's left of it. I just don't know what's going to emerge after the political system works it over. I hope that we do not throw out the baby with the bathwater. If we rebuild a very statist and inefficient financial sector—as I fear we will—it's hard to imagine that growth won't suffer for years.
Whether or not the US Fed deficit adding $1T depends entirely on how much the private sector wants to net save. $1T would be too small, too big, or just right. If it's too small, then we'll see unemployment continue to grow the deficit through falling taxes and rising unemployment claims until it's just right. If it's too big, we'll see inflation in CPI. I am also surprised to Rogoff is concerned about the efficiency of the financial sector. Throwing the baby out with the bathwater is a good idea if it's Rosemary's baby.
We have to rethink banking. Suppose you were putting your money in a bank, and it's being insured up to a large amount by the government. Suppose then the bank is taking the money and putting it at the Federal Reserve and getting interest on it. This arrangement begs the question of what the bank exists for. Should the bank just be charging for markup services on checking? If the government is ultimately going to be the one providing liquidity services, should the whole structure be different than it is now?
He's getting close to a key issue. Under FDIC insurance, individuals are lending directly to the Federal Government. Banks borrow from the Federal Government to make loans, and the tie between their deposit base and the amount they can lend is strictly legal. Different countries have very different limits on fractional reserve limits, and they are all equally pointless. Ken Rogoff is a super smart guy, but I don't think he sees the banking system as it actually is, since its de facto operation is so different from the explanation that they give of it in classrooms. The whole structure should be different from how it is now.


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