Not even the most generous observer would say that the Treasury and the Fed have done a good job of explaining the thinking behind their financial stability plan. I think this note by Douglas Elliott does a much better job than they have. If you want to understand the logic of the administration’s position, have a look.

On the underlying analysis, Elliott is with Geithner and Bernanke most of the way, which lately puts him in the minority of commentators. The main difference is that he is willing to say that outright nationalisation might be necessary for “one or two” large banks, whereas Geithner and Bernanke persist in giving the impression that they will avoid this if at all possible. Most economists who follow this subject now seem to be arguing for outright nationalisation of many banks–or, as they put it, “the banks” (choose your own number). People often seem to be talking past each other. Elliott persuades me that some of the discussion of the Fed/Treasury plan is muddled by terminology.

This week Bernanke said nationalisation is “when the government seizes the bank, zeroes out the shareholders, and begins to manage and run [the] bank, and we don’t plan anything like that… I think that this debate over nationalisation kind of misses the point.” (”Bernanke Pushes Back Against Nationalisation”, said the headline in the WSJ.) But he does not exclude bigger public stakes (with taxpayer upside) and strong control rights: indeed, that is what he is proposing. So, as Elliott says, a lot depends on exactly what you mean by nationalisation.

Elliott also explains the “franchise value” and “legal complexity” arguments for avoiding full nationalisation unless it is really necessary; Bernanke mentioned those points in testimony this week but did not elaborate. The paper carefully goes through the pros and cons of full nationalisation. I’ve been leaning towards that solution but the paper did make me pause. This is how it wraps up.

It] may prove necessary as a last resort for one or two of the larger banks, but should only be undertaken when, and if, it is clearly necessary. More widespread nationalization is unlikely to be needed unless the economy performs substantially worse than most economists expect. Although we all crave certainty, it would be better to wait until we knew that this pessimistic case was likely before nationalizing more widely, given the serious social and financial costs of that extreme step.

Beyond the very small number of full nationalizations that may prove necessary, it may well make sense for the government to take substantial stakes now in additional large banks in a form that some may view as a partial nationalization. The Administration’s plan to perform a rigorous, uniform “stress test”on the nation’s largest banks is a good one…

[If] it becomes clear through the stress test that a bank is already insolvent or is at high risk of becoming insolvent, then it would be better to go directly to the step of full nationalization…

Many observers would say that most of the banking system is “already insolvent” or “at high risk of becoming insolvent”. The Fed and the Treasury evidently think otherwise. (”If a bank does become insolvent then the FDI, of course, will intervene,” Bernanke said on Tuesday, “but we’re not close to that. All the banks are above their regulatory capital.”)

Perhaps Citi and Bank of America–to name two large banks–are or will be insolvent on any plausible scenario; for the rest of the industry it still hinges on the timing and strength of the recovery. Hence the Fed/Treasury stress test. Is the “adverse” case in that exercise–an output decline of 3.3% this year and 10% unemployment in 2010–adverse enough to tell us what we need to know? I wonder. It’s not difficult to imagine a worse case than that.

Anyway, take a look at Elliott’s article. Even if you don’t agree with the conclusion, I think you’ll find it helps to clarify the issues.

Much as I admire Obama, the thought that would not leave me alone as I listened to his speech was “diminishing returns”. It was a good campaign speech, beautifully delivered, and helped by the very flattering comparison with Bobby Jindal’s weirdly robotic response. (How do they get people to accept this assignment?) But it was a speech we have now heard many times. The instant polling suggested that listeners loved it, which surprised me a little. People are inclined to be patient with Obama and know he is not to blame for the mess, but I wonder how much longer they will love this kind of speech. This time next year, an address so heavy on inspiration and so light on policy surely is not going to work.

Granted, one month in, Obama has on the books a massive and mostly good stimulus bill. It is not quite as big or as front-loaded as it looks, or as it should be–see my recent column in National Journal on this [link expires in ten days]. But a president who has got this done can hardly be accused of inactivity. High marks, then, on the stimulus. But where is the banking plan, without which the stimulus won’t work? Barring a perceptible uptick in the anti-banker rhetoric, nothing new on that in the speech.

We heard increasingly confident commitments on healthcare reform, education reform, and alternative energy–all of them potentially very costly, with expenses going way beyond the supposedly temporary provisions in the stimulus. This alongside a restatement of the new promise to halve the deficit to around $500bn by the end of 2012. I am struggling to see how those things fit together, unless Obama is planning much bigger tax increases than he has so far indicated. And, by the way, why promise to halve the deficit by 2012 in any case? Premature efforts to rein in the  budget deficit pushed Japan back into recession during its Long Slowdown. It is too soon to know when or how quickly borrowing should be brought back under control. But it is not too soon to start thinking about how it should be done, when the time is right. I don’t doubt that the administration is indeed thinking hard about that. It just isn’t telling anybody else just yet.

Maybe the budget “blueprint” will tell us more…

Obama’s fiscal responsibilty summit was first-class theatre, but did not advance the discussion very far. Mind you, I don’t think that the theatrical aspect is bad or unimportant. On the contrary. As I’ve argued before, a big part of what Obama has to do is speak to the general public over the heads of Congress about what needs to be done. That is what events like yesterday’s are about. Treating political opponents courteously and radiating calm non-ideological pragmatism are the way he gets the country behind him. But he has to align opinion behind the correct, challenging, substantive policies, not merely behind a mood of can-do co-operation. If you do that and nothing else, you are Tony Blair.

On long-term fiscal consolidation, I don’t see much honesty as yet on what it will take to deal with the problem. Obama’s thinking seems to boil down to greater efficiency and higher taxes on the rich. That will be insufficient even to close the current-policy deficit, let alone pay for all the big new things (universal health care, affordable college for all, etc, etc) Obama wants to do.

I also think it is a mistake to promise to halve the deficit by the end of the first term–even supposing he could do it. If this is an unusually prolonged recession, as it may well be, this  timetable is much too fast. He needs to retain the flexibility to keep fiscal policy loose for as long as necessary. You move to fiscal consolidation when the recovery looks solid, not according to the demands of some pre-arranged schedule. You show you are ready to do it when circumstances allow, rather than promising to do it regardless.

The $787bn stimulus act is not a week old. Vast new initiatives aimed at the US housing market and financial system are still being tweaked. The Treasury is so pressed and understaffed that, when foreign officials call, there is nobody to pick up the phone. This week, for something to do, the administration turns to the rest of the budget and the long-term fiscal outlook.

On Monday this week, the White House hosts a “fiscal responsibility summit” – a meeting of officials, academics, policy advocates and politicians from both parties. President Barack Obama will “lead a frank discussion on how we can address the long-term fiscal problems facing this country”, said his spokesman. On Tuesday, Mr Obama will address his first joint session of Congress, with fiscal priorities a central theme. Then, on Thursday, the White House will publish a budget plan for 2010. Mr Obama says it will be “sober in its assessments” and “honest in its accounting”, and that it will “lay out in detail my strategy for investing in what we need, cutting what we don’t, and restoring fiscal discipline”.

The remainder of the column can be read here. Please post comments here.

The administration’s housing plan seems well thought out. All three parts address clear weaknesses in the present arrangements.

The refinancing element, aimed at borrowers in good standing, allows Fannie and Freddie to refinance loans where the value of the mortgage is between 80% and 105% of the value of the property. Up to now they have not been allowed to do this (unless the mortgage is insured). Many borrowers in good standing have seen their loan-to-value ratios climb into this range because of falling house prices. The rule preventing refinancing at current lower rates is self-defeating from the agencies’ own point of view, since it increases the chances of default. The plan puts this right–helping both the GSEs and their borrowers. (Some complain that the change only helps borrowers with loans owned or guaranteed by the GSEs. Well, yes, those were the loans affected by the restriction in the first place.)

The loan modification part is aimed at borrowers who are at imminent risk of default, and is modelled on the scheme that the FDIC has been testing and advocating for some months. An explicit public subsidy is involved–to the tune of $75 billion–which in effect will be split between lenders/servicers and qualifying distressed borrowers. Lenders and servicers get cleverly structured incentives to reduce monthly repayments to 31 percent of gross income. (Note that modifications up to now have been few and far between, and have often left repayments unchanged or higher than before, once penalties and arrears have been added back.) Lower repayments obviously lessen the risk of default.

The administration says that its scheme does not reward people who recklessly borrowed too much. This is untrue: the plan will certainly help some people who borrowed more than they should have. No doubt, it would be fairer to help only borrowers whose standard repayments (after teaser rates expired) were no more than say 30 percent of gross income to begin with, and/or who borrowed less than 80% of their property’s initial value–in other words, to help only borrowers who behaved prudently, and who are now in trouble because their income has fallen. But of course this would have meant many more defaults. Because foreclosures also hurt innocent bystanders, there is a public interest in limiting them. The second part of the plan, I think, is indeed unfair and does raise moral hazard concerns–but I’d say that is a price worth paying if it stems the tide of foreclosures.

Will it succeed in doing that? It certainly gives loan modification a much firmer push than seen up to now. Lenders will not be forced to modify, but TARP beneficiaries will have to apply the guidelines, and show that they are making an effort. The new prospect of bankruptcy-court cramdowns (this requires legislation) should  also help to focus minds. A standard Treasury-endorsed modification template ought to ease some of the worries servicers have about being sued by investors over unauthorised modifications of securitised mortgages. An important question is how far cuts in repayments will be achieved by interest-rate reductions as opposed to cuts in principal. Many observers reckon that principal reductions would curb foreclosures more effectively. The plan sees principal reductions as a possibility, but the incentives appear to grant that method of reducing repayments no special favours. Maybe this will have changed by the time we get full details of the plan next month.

The third part–$200 billion of new capital for the GSEs–improves Fannie’s and Freddie’s ability to buy mortgage-backed securities, supports the market value of those securities, and keeps downward pressure on the interest rates lenders charge mortgage borrowers. This too makes sense.

I’m sure the plan will reduce the rate of foreclosures–as compared with a no-plan baseline. How much it will reduce them, and whether that will be enough to stabilise the housing market, is impossible to say just yet. But after many months of almost total neglect, this is a big step forward.

My friend Stan Collender, who knows more about the budget process than anybody else I can think of, says my wife is wonderful but takes me to task for my remarks on the length of the fiscal stimulus bill. (Paul Krugman, quite unappeased by my accusing Republicans of hypocrisy on the point, congratulates him on a “fine takedown“.)

What Clive seems to be saying is that, at 1400 pages, the bill could not possibly have been reviewed in detail by many members of Congress before they voted for it given the rush to get it done.  What he doesn’t say is that most representatives and senators generally only review the parts of any bill that are important to them for some reason…

[C]iting the number of pages as a reason to think legislation is bad is ridiculous.  That’s on a par with football commentators talking about the number of minutes one team has had the ball compared to the other or the greater number of plays one team has run.

Stan, please, read what I wrote:

[F]ailing to read the law you are voting for is standard working method in Congress. But that doesn’t invalidate the criticism, certainly not in the eyes of the public. Not every unread piece of legislation costs taxpayers $800 billion. It isn’t too much to ask that the politicians voting for this law, even if they had to make an exception, had read it first.

Well, is that too much to ask? The point is not length as such, obviously, but length in relation to time for consideration. In that very post I said that, on balance, I am for this measure. So I can hardly be accused of saying that any 1,400 page law must be bad. But I cannot think that passing such an enormously expensive and complicated piece of legislation in such a frantic rush is good government–even if it is standard practice.

(Paul reminds us that “War and Peace” is both very long and very good. That made me think of the Woody Allen joke about the fellow who took a speed-reading course and then read the novel. “It’s about Russia.”)

(Stan also has a wonderful wife, by the way.)

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism
By George Akerlof and Robert Shiller
Princeton University Press, £14.95

This is a good moment to propose a re-examination of orthodox economics. The current breakdown, possibly the worst since the Great Depression, was a shock to all but a handful of economists. It calls into question much of what they thought they knew.

Why did things go so wrong? What should governments do now? How do we stop it happening again? In their new book, two of the most creative and respected economic thinkers currently at work, George Akerlof and Robert Shiller, argue that the key is to recover Keynes’s insight about “animal spirits” – the attitudes and ideas that guide economic action. The orthodoxy needs to be rebuilt, and bringing these psychological factors into the core of economics is the way to do it.

Topicality can be a mixed blessing. The book was mostly written before the crisis became acute. A little awkwardly, the authors have tacked an excellent postscript, about what needs to be done, on a chapter about monetary policy. The connections between their thinking on the limits to conventional economics and the issues thrown up by the breakdown are plain, even if they were unable to make every link explicit. Even more than Akerlof and Shiller could have hoped, therefore, it is a fine book at exactly the right time.

Though it calls for a reworking of economic theory, Animal Spirits is not a difficult book. It is short, chatty and anecdotal. The general reader will be engaged and drawn in. But the book is serious, too. Good notes and a bibliography are a guide to the literature that the book aims to tie together. Animal Spirits carries its ambition lightly – but is ambitious nonetheless. Economists will see it as a kind of manifesto.

The first quarter divides animal spirits into five categories. They are confidence, whose role is pervasive and which stars throughout the rest of the narrative; fairness, which influences wage-setting and the working of the labour market; corruption and bad faith, which can especially affect financial markets; money illusion, the propensity to be fooled by inflation; and “stories”, which they could have called “culture”, a catch-all for economically significant ideas about the world and one’s place in it.

The rest of the book shows how thinking about these animal spirits yields answers to big questions that perplex orthodox economics – or force it to make bizarre and implausible assumptions. Why do economies fall into depression? Why is there unemployment? Why are financial prices so volatile? Why does the property market go through cycles? Why are minorities often especially poor? The answer in each case is partly, and sometimes mainly, animal spirits

Chapter by chapter, the analysis is fascinating and usually persuasive. Whether the larger project can be made to hang together, though, I doubt. The authors’ criticisms of the standard model are well taken and not that controversial. The orthodoxy assumes rational optimising behaviour, and is reluctant to contemplate more than minor deviations from that principle; as a result, it often goes astray. Ad hoc modifications, such as those the authors suggest, may get better results.

Without saying how, the book aspires to go further and calls for a new standard model. That is hard to envisage. The assumption of rational optimisation is a gross simplification, no doubt, but despite all the drawbacks emphasised in the book, it has been a highly productive one. Shiller and Akerlof would be the last to deny the power of the insights it has yielded. At issue is whether a psychologically enriched standard model would be too complex to offer useful simplifications. The standard model plus ad hoc modifications suited to the particular case might be the best economics can do.

A different problem arises in moving from explanation to prescription. Akerlof and Shiller argue convincingly that animal spirits give a richer and truer account of economic fluctuations. How to manipulate them for policy purposes, and when it might be right to try, are separate questions. The authors are doubtless sympathetic to the case for “libertarian paternalism” in Nudge, by Richard Thaler and Cass Sunstein – another valuable book that explores the possibilities of “behavioural economics”. What the two have in common is the idea that once you take account of animal spirits, people can be guided, without being forced, to do what is in their best interests.

The question is, what about the claims of liberty? Likening the role of government to a parent’s duty to create a happy home, the authors write: “The proper role of the parent is to set the limits so that the child does not overindulge her animal spirits.” This is an unappealing analogy. I would sooner take up arms against a government that saw me as a child than vote for it.

For all its flaws, the stimulus bill that Congress passed last week and President Barack Obama will sign on Tuesday is better than no bill, and better than further delay. Action is already months late, held up by the election and the protracted White House transition. Mr Obama can claim victory: the plan is similar to the one he first proposed. Unfortunately, though better than nothing, it was a victory that inspires little confidence about where US economic policy goes from here.

Much of the public is sceptical about the measure and Mr Obama failed to win Republican support. Only three Republican senators and no congressmen backed it – awkward for a president who promised to be bipartisan and to seek consensus.

Democrats say the president made good-faith efforts (over their protests) to reach an accommodation with the other side, and was rebuffed. It was a mistake to try and he should waste no more time on them, they conclude. Republicans say his overtures were meaningless, measured against the substance of the bill.

The remainder of the article can be read here. Please post comments here.