Strong as an ox?

The future of finance

Inside the banks

Blank cheques, bankruptcy, nationalisation: the options are dire, but governments must choose between them

“STARTING today,” President Barack Obama declared in his inaugural address from the Capitol, “we must pick ourselves up, dust ourselves off, and begin again the work of remaking America.” In fact his first, urgent task is to remake finance. As Mr Obama spoke in Washington, DC, the markets in New York were sinking under the weight of failing banks despite the promise of a plan from his economic team. A day earlier Britain had put forward its second attempt to get its banks to lend. Others, such as Germany and Italy, may before long need to step in; France, Ireland and Denmark already have.

The crisis has shown up flaws in financial markets and the global economy. Huge flows of capital into debtor nations like America and Britain pumped up asset markets (see article). These fed the instabilities of financial markets—which, as our special report explains in this issue, were themselves plagued by poor regulation, dangerous incentives and the reckless use of mathematical models. Fixing this will take a lot of work over the next 18 months or so, when legislation should be ready, but already a picture of a new finance is becoming clearer: smaller, better regulated, more conservative.

That vision is worth keeping an eye on, but the immediate priority is the imperilled banking system. Just now, with finance in ruins, the nexus of markets and non-banks that make up the “shadow banking system” has failed. Decent businesses are being starved of credit and driven into bankruptcy. For their sake, and for the people who work for them, it is time to admit that the first round of bank rescues was not enough. With talk of huge public subsidies—nationalisation even—the question is what to do next?

A sinking feeling

Nothing at all is one answer. Because last year’s efforts cost hundreds of billions of dollars, some may conclude that saving the banks is wasteful and pointless. In fact the first rescue succeeded in one important respect. The excessive lending of the boom has to be brought under control. That inevitably brutal change can take place in two ways. It could be relatively orderly as borrowers scale back and lenders strengthen their balance sheets. Or it could cause a mass-panic that would wreck banks and businesses as it did in the 1930s. Just such a panic was in the air in October. Today’s recession is grave but in sparing the banks, however undeserving, governments spared their citizens from something worse—at least so far.

If a rescue makes sense, what sort? Last autumn the rescue of Britain’s banks—perhaps the sorriest in any large economy—became a template for others. Britain is in the lead once more, but this time round its effort is likely to be remembered for all the wrong reasons. The main part of the government’s new plans is to insure the banks against their worst losses on their worst assets. Nobody (not even the government) knows how much that will cost; just that Gordon Brown has once again thrown all his ideas at the problem, including the kitchen sink.

The prime minister should do his bit for the building trade and order a bigger sink. The markets were unimpressed by the scale of his effort. Shares in London fell, notably in the very banks the plan was designed to help. Sterling tumbled on fears for Britain’s economy and the government’s finances.

Saviour of the universe

For any government setting out a rescue, this reception holds two lessons, concerning the scale and the shape of a rescue. First, its scale must surprise everyone. Because economies everywhere are suffering from excessive fear as well as over-borrowing, part of the aim is to convince investors that the downward spiral in confidence has been broken. Britain’s plans were caught in a contradiction: seeking both to save the banks, which need a staggering sum, and also to mollify voters, who (understandably) resent handing over a single penny.

Scale is important in this crisis. As the recession rips through the economy, banks are bound to face further losses. Shareholders worry that these losses will continue to eat away at the banks’ reserves. Back in October governments’ promises to save the banks stabilised markets. But in this topsy-turvy crisis these promises are now pressing down on banks’ share prices. If a bank looks about to suffer large losses, investors fear nationalisation is imminent—and head for the exit.

And that leads to the second broad lesson from Britain: the design of a rescue matters and history shows that it is hard to get right (see article). One possibility is government guarantees and insurance. Another is to take the hit up front, by putting the toxic assets into a “bad bank” that acts as a cordon sanitaire. And a third, which has been gaining traction of late, is outright nationalisation.

Each of the three has its strengths. Guarantees can quickly swing into action and the assets remain with managers who know most about them. Bad banks create a clean break that enables the good bank left behind to get on with the real job of raising capital and lending it out. Even nationalisation has something to say for it. Gone are the difficulties of valuing assets and of the bank’s shareholders plotting to grab taxpayers’ money—because the government is on both sides of the deal. Expect to hear that argument a lot more over the coming months, not just in Europe but also in America.

As a capitalist newspaper, we reject a deliberate policy of wholesale nationalisation. To be sure, state ownership may make some sense as a tactic for specific financial institutions. We argued for it with both Fannie Mae and Freddie Mac in the United States and with Northern Rock in Britain long before politicians in either country succumbed to the inevitable. Like it or not, it may be the least bad option in many cases ahead. But the difficulties are legion. Unless nationalisation takes place at market prices, it undermines property rights and raises the long-term cost of capital. And even if expropriation is avoided, there are difficulties. Although nationalised banks could increase the supply of credit by restoring confidence, their record at allocating it is even worse than private banks’. If the idea is state-directed lending, the banks will waste a fortune and kill enterprise. If the plan is to offer the banks a brief shelter in a storm, it looks fanciful. Large bank privatisations are unlikely for several years.

But what of the other two options—bad banks and insurance? Britain chose insurance alone and, at the moment, it looks as if it has made a mistake. The suspicion is that the government preferred insurance for political reasons because it is a promise-now, pay-later scheme. It would have done better to reach for that kitchen sink and do both—buy the worst assets at their market value and put them in a bad bank, as well as insure the healthy assets that remain against catastrophe. With a clean start, the remaining good banks would be able to raise capital. The idea would be to examine each bank on its merits, cleaning it out, partially insuring its remaining risks, and recapitalising it with government equity where necessary. At some banks that might leave the government as the biggest shareholder, as the British government is at the Royal Bank of Scotland, or the sole owner, as at Northern Rock. In such cases nationalisation is not an end in itself, but a consequence of the policy that most rapidly returns the banking system to health. It is a heavy cost, but there is no alternative. If taxpayers own a bank, pretending that they don’t only exacerbates the harm.

This crisis is so huge that seeing beyond it is hard. Yet even now policymakers need to plan for the future of finance—partly to convince voters that today’s rescue is preparing for a better system; partly because finance’s shortcomings and the taxpayers’ guarantees make an overhaul of regulation necessary; and partly because sensible reforms are hard to devise.

Having seen finance wreak havoc, the temptation will be to bind it in a regulatory straitjacket. Some tighter regulation is in order, especially if it is aimed at making the system more transparent. But this crisis was born of economic excess as well as financial folly; given the torrent of capital flowing into America, Britain, Spain and so on, almost any financial system would have gone wrong. Financial re-regulation is not the only reform—it may not even be the most important. Yet finance makes the rest of the economy work. Mr Obama’s prize for remaking finance will be measured in prosperity and jobs. The work should begin now.

Strong as an ox?

China's flagging economy

Strong as an ox?

China’s annual GDP growth falls to 6.8%. How much worse can it get?

THE beast which gives its name to the Chinese new year that begins on January 26th is meant to symbolise prosperity through fortitude and hard work, offering hope that China will soon regain its economic vigour. But an ox is often a castrated bull—which may be an apt description of China’s economic pain. New figures show that China’s GDP growth fell to 6.8% in the year to the fourth quarter, down from 9% in the third quarter and half its 13% pace in 2007. Growth of 6.8% may still sound pretty robust, but it implies that growth was virtually zero on a seasonally adjusted basis in the fourth quarter.

Industrial production has slowed even more sharply, growing by only 5.7% in the 12 months to December, compared with an 18% pace in late 2007. Thousands of factories have closed and millions of migrant workers have already lost their jobs. But there could be worse to come. Chinese exports are likely to drop further in coming months as world demand shrinks. Qu Hongbin, an economist at HSBC, forecasts that exports in the first quarter could be 19% lower than a year ago. 2009 may well see the first full-year decline in exports in more than a quarter of a century.

Economists have become gloomier about China’s prospects, with many now predicting GDP growth of only 5-6% in 2009, the lowest for almost two decades. The most dismal view comes from Albert Edwards, at Société Générale, a French bank, who thinks China may be sliding into outright recession. He points to a fall in electricity output of 6% in the year to the fourth quarter, down from average annual growth of 15% over the previous five years.

In the past, the growth in GDP and electricity use have tended to move together (see chart). Mr Edwards reckons that a decline in electricity output may mean that GDP is falling, no matter what the official figures say. Equally worrying is the OECD’s leading indicator of economic activity in China, which has plunged to its lowest level in its 26-year history, lower even than during the slump in 1989, the year of the Tiananmen Square protests and massacre.

This makes for a compelling story. But the relationship between GDP and electricity consumption has been distorted by the uneven nature of this slowdown. Energy-guzzling heavy industries, such as steel and cement, bore the brunt of China’s downturn late last year. So it is not surprising that electricity use slumped.

Moreover, too much weight may be given to the declining exports, because it is often wrongly assumed that the slump in China’s growth has been caused mainly by a collapse in its exports to America and other rich economies. Yet in 2008 the fall in net exports (exports minus imports) accounted for less than half of its slowdown. More important was a collapse in housing construction, caused by the government’s efforts to deflate a potential bubble. This, in turn, reduced the demand for materials such as steel. So by the fourth quarter there had been a huge build-up in stocks, exacerbating the fall in production: steel output was 12% lower than a year earlier.

GDP growth is likely to continue to fall during the first half of 2009, sounding alarm bells among those who repeat the official mantra that China needs to grow by at least 8% a year to avoid social unrest (even though that number has no sound economic basis). But there is good reason to hope that by midyear the economy will perk up as destocking comes to an end and the government’s fiscal stimulus kicks in.

China’s 4 trillion yuan ($585 billion) package of infrastructure spending, subsidies and tax cuts for businesses has been trashed by many commentators as another “Chinese fake”. Most of it is not new money, they claim, and the central government will finance less than one-third of the planned spending; most of the rest will have to come from banks, which in the current climate may be reluctant to lend.

It is true that some of the extra spending had already been announced, but what matters for economic growth is how much spending will actually increase this year. The answer is a lot. For example, JPMorgan forecasts that transport investment will expand by an impressive 70% in 2009. HSBC estimates a total spending boost of 6-7% of GDP over this year and next.

Since the November package, the government has introduced other measures to support the economy. On January 21st it announced extra spending of 850 billion yuan over three years to improve health care. From February rural residents will get a 13% rebate on purchases of goods such as refrigerators, TVs and washing machines. Consumer spending will be dented by job losses and smaller wage rises but has so far remained strong, with retail sales up by 18% in real terms in the year to December. Interest rates have also been cut five times since September and, much more important, controls on bank lending have been scrapped. To help the property sector, minimum down-payments have been reduced from 30-40% of a home’s value to 20%, the transaction tax has been waived for properties held for at least two years, and more public housing is to be built.

The all-too visible hoof

Chris Wood, at CLSA, a brokerage, says the effectiveness of the stimulus hinges on the extent to which China is now a capitalist economy. The more “capitalist” it is, the deeper the downturn now; the more it is still a command economy, the better the chance of recovery in 2009. State-controlled firms, which account for one-third of industrial output and almost half of all investment, have been “asked” not to cut jobs and capital spending. All the big banks are state-owned and their chairmen are appointed by the government. If they get a phone call telling them to lend more, they are likely to do so.

Banks already seem to be following Beijing’s orders: total lending surged by 19% in the year to December. China is one of the few large economies whose banking system has not been crippled by the global credit crunch. Andy Rothman, also at CLSA, argues that “in China, there is only a credit crunch when the political leadership wants one”. He believes the economy will revive by midyear and achieve GDP growth of close to 8% for 2009 as a whole.

The obvious concern is that although heavy-handed government meddling may be more effective than market-based tools to pull an economy out of a deep downturn, it comes at a cost. Public investment will inevitably include some wasteful spending, and politically directed lending could add to excess capacity in some sectors and create new bad loans for banks. This may hobble the bull in the future. But first it needs to regain its virility.

Can Fiscal Stimulus Revive the US Economy?

Can Fiscal Stimulus Revive the US Economy?

by Frank Shostak

On Thursday, January 8, 2009, US President-elect Barack Obama said,

I don't believe it's too late to change course, but it will be if we don't take dramatic action as soon as possible. If nothing is done, this recession could linger for years.

Most economists and various commentators are in agreement. They hold that the US government must sharply increase its spending in order to arrest the economic crisis that could turn into a prolonged slump.

According to the Congressional Budget Office (CBO), in the absence of a stimulus plan, the unemployment rate could jump to above 9% by early 2010. Some other experts are of the view that without the stimulus plan the unemployment rate could easily surpass the 10% mark.

Most experts hold that on account of the economic slump and the consequent underutilization of resources, economic output in the next two years will be strongly below the potential output. For 2009 and 2010, the production loss is estimated to be in excess of $2 trillion (the gap between the potential GDP and the actual GDP).

Therefore they believe that the effective way to close the gap between the potential output and the actual output is through the fiscal stimulus package — a large increase in government outlays.

Given the possibility that the gap could exceed the $2 trillion mark it seems that the Obama's fiscal stimulus plan of around $800 billion is not going to "do the trick."

Even if one were to allow for the so-called "multiplier effect," Obama's plan will not close the output gap and thus "fix" the problem, so it is held. In Obama's plan, only about $480 billion consists of public spending, which has a multiplier of around 1.5. (That is, a dollar of government expenditure supposedly raises GDP by around $1.5.) The rest of the package consists of tax cuts, which most experts don't believe would boost spending and thus activate the multiplier.

This way of thinking follows the ideas of John Maynard Keynes. In a nutshell, Keynes held that one cannot have complete trust in a market economy, which is inherently unstable. If left free, the market economy could lead to self-destruction. Hence there is the need for governments and central banks to manage the economy.

Successful management, in the Keynesian framework, is done by influencing the overall spending in an economy. It is spending that generates income. Spending by one individual becomes income for another individual.

"The government doesn't create any real wealth, so how can an increase in government outlays revive the economy?"

What drives the economy then is spending. If during a recession consumers fail to spend, then it is the role of the government to step in and boost overall spending in order to grow the economy.

In the Keynesian framework, an output that an economy could generate without causing inflation, given a certain pool of resources — i.e., labor, tools, and machinery, and a given technology — is labeled potential output. Hence the greater the pool of resources, all other things being equal, the more output can be generated.

If, for whatever reasons, the demand for the produced goods is not strong enough, this leads to an economic slump. (Inadequate demand for goods leads to only a partial use of existent labor and capital goods.)

In this framework then, it makes a lot of sense to boost government spending in order to strengthen demand and eliminate the economic slump.

What is missing in this story is the matter of funding. For instance, a baker produces ten loaves of bread and exchanges them for a pair of shoes with a shoemaker. In this example, the baker funds the purchase of shoes by producing ten loaves of bread.

Note that the bread maintains the shoemaker's life and well-being. Likewise, the shoemaker has funded the purchase of bread by means of shoes that maintain the baker's life and well-being.

Now, the baker has decided to build another oven in order to increase the production of bread. In order to implement his plan, the baker hires the services of the oven maker.

He pays the oven maker with some of the bread he is producing. Again, what we have here is a setup where the building of the oven is funded by the production of a final consumer good — bread. If, for whatever reasons, the flow of bread production were disrupted, the baker would not be able to pay the oven maker. As a result, the making of the oven would have to be aborted.

From this simple example we can infer that what matters for economic growth is not just the existing stock of tools and machinery and the pool of labor but the adequate flow of final goods and services that maintains individuals' lives and well-being.

Now, even if we were to accept the Keynesian framework that the potential output is above the actual output, it doesn't follow that the increase in government outlays will lead to an increase in the economy's actual output.

It is not possible to lift overall production without the necessary support from final goods and services or from the flow of real funding or the flow of real savings. (For instance, out of the production of ten loaves of bread, if the baker consumes two loaves, his real saving or real funding is eight loaves.)

We have seen that by means of a final consumer good — the bread — the baker was able to fund the expansion of his production structure.

Similarly, other producers must have final, saved, real consumer goods — real savings — to fund the purchase of goods and services they require. Note that the introduction of money doesn't alter the essence of what funding is. (Money is just a medium of exchange. It is only used to facilitate the flow of goods; it cannot replace the final consumer goods.)

The government as such doesn't create any real wealth, so how can an increase in government outlays revive the economy?

Various individuals who will be employed by the government will expect compensation for their work. The only way it can pay these individuals is by taxing others who are still generating real wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic recovery. (We ignore here borrowings from foreigners.)

The only way fiscal stimulus could "work" is if the flow of real savings (i.e., real funding) is large enough to support (i.e., fund) government activities while still permitting a positive rate of growth in the activities of the private sector. (Note that the overall increase in real economic activity is, in this case, erroneously attributed to the government's loose fiscal policy.)

If, however, the flow of real savings is not large enough, then, regardless of any increase in government outlays, overall real economic activity cannot be revived.

In this case the more government spends (i.e., the more it takes from wealth generators), the more it weakens prospects for a recovery.

Thus when government, by means of taxes, diverts bread to its own activities, the baker will have less bread at his disposal. Consequently, the baker will not be able to secure the services of the oven maker. As a result, it will not be possible to boost the production of bread, all other things being equal.

As the pace of government spending increases, a situation could emerge where the baker will not have enough bread even to maintain the existing oven. (The baker will not have enough bread to pay for the services of an oven-maintenance technician.) Consequently, his production of bread will actually decline.

Similarly, other wealth generators, as a result of the increase in government outlays, will have less real funding at their disposal. This, in turn, will hamper the production of their goods and services, thereby retarding, not promoting, overall real economic growth.

As one can see, not only does the increase in government outlays not raise overall output by a positive multiple; but, on the contrary, this leads to the weakening in the process of wealth generation in general. According to Ludwig von Mises,

there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens' spending and investment to the full extent of it quantity. (Human Action, chapter 29, section 1)

Americans ‘Get’ TARP, They Just Can’t Stand It

Americans ‘Get’ TARP, They Just Can’t Stand It: Caroline Baum

Commentary by Caroline Baum

Jan. 22 (Bloomberg) -- Barack Obama begins his term as 44th president of the United States with an ambitious agenda in addition to the pressing problems posed by an economic and financial crisis.

Before he can get to either, the new president needs to take some time for community outreach. Specifically, he should explain to the public why bailing out ailing banks with taxpayer dollars isn’t throwing good money after bad. Both scientific opinion polls and less formal sentiment gauges suggest most Americans aren’t convinced.

A Jan. 15 Gallup poll found that 62 percent of those surveyed said Congress should block the release of the remaining $350 billion in Troubled Asset Relief Program funds until more details are provided on how those funds will be spent. (The survey was taken before the Senate voted to release the remaining $350 billion last week.) Twelve percent didn’t want any more money released. Only 20 percent were in favor of releasing the funds.

What’s more, a majority of Americans (80 percent) think the TARP isn’t working. It’s not clear from the Jan. 16 CNN/Opinion Research Corporation Poll exactly why or how the folks surveyed came to this conclusion. Could it have something to do with the fact that the banks keep coming back for more? Perhaps it’s the message inherent in the imploding share prices of banks like Citigroup Inc. and Bank of America Corp., both double-dippers at the government trough.

What Banks Do

Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson have tried to explain why financial institutions are different from, say, industrial companies. Banks are financial intermediaries, taking in deposits from those with excess funds and lending the money out to businesses and consumers that want to borrow.

In their role of middlemen -- the job description used to include due diligence on the borrower -- banks make credit allocation more efficient than if a borrower had to scout around to find a willing lender.

When this process shuts down, the economy ceases to function.

If the average American was beginning to grasp why banks are different, he was thrown for a loop when the government put General Motors and Chrysler on the too-big-to-fail (at least right now) list. Insurance giant American International Group made the cut as well last September, right after Lehman Brothers was cut loose.

No wonder the public is confused, not to mention angry. That anger is palpable everywhere you turn.

Truth Serum

Driving in the car Saturday morning, I was listening to “Washington Journal” on C-SPAN radio. Callers were voicing their opinions -- grievances, mostly -- on Obama’s proposed economic stimulus plan and the bank bailouts. One woman wanted to know why it is “when rich people need financial assistance from the government it’s called a bailout, but when low-income people need assistance from the government it’s called welfare.”

Another caller conceded that bailing out the banks was necessary “to save the economy, but it makes me mad.” She went on to say that she didn’t have good credit because of medical bills several years ago and pays “very high rates on credit cards.” Somehow banks “don’t mind taking my tax dollars to bail themselves out, but when I ask for help from them, they don’t help us out,” she said.

‘Smoke and Mirrors’

One man said the whole bank bailout was “smoke and mirrors,” which is not too different from the verdict handed down by TARP’s Congressional Oversight Panel earlier this month. Another asked how the government could “spend like crazy” when it has no money. Someone else advocated cutting the corporate tax rate to re-energize animal spirits in this country. Still another put the blame at the feet of the government, including the Environmental Protection Agency, “which makes laws and tells people how to run their businesses.”

To be fair, it’s generally the opponents of any policy that have the loudest voices. So there may be an inherent bias to the feedback.

Still, what struck me about the polling results and the call-ins was their essential truth; some kernel, at least. Ordinary Americans, it seems, “get it.”

They understand that financial stocks are trading at such depressed levels because shareholders anticipate a significant injection of new capital, that in the current circumstances no one but the government is going to provide it, and that existing shareholders will be at the end of the line when it comes to any cash dividend or voting power.

They understand at a fundamental level that rewarding failure is not only a bad idea but antithetical to the principles on which this country was founded.

And they understand that, as a practical matter, the need to save the banking system may supersede even principles, as bad a precedent as it sets.

What ordinary Americans also understand is the current initiatives aren’t working. Come to think of it, maybe the public is way ahead of even the new administration.

U.S. Stocks Fall on Profit, Recession Concern; Microsoft Drops

U.S. Stocks Fall on Profit, Recession Concern; Microsoft Drops

Jan. 22 (Bloomberg) -- U.S. stocks slid, erasing about half of yesterday’s rally, as companies from Microsoft Corp. to EBay Inc. reported disappointing earnings and data on housing starts and jobless claims signaled the recession is deepening.

Microsoft slumped 8.3 percent after saying it’s no longer able to give sales and earnings forecasts for the rest of its fiscal year as the economic slowdown crimps demand for software. EBay sank 12 percent as fourth-quarter profit fell 31 percent and forecasts missed analysts’ estimates. All 10 industry groups in the Standard & Poor’s 500 Index retreated after initial claims for unemployment benefits matched a 26-year high and housing starts slumped to a record low.

The S&P 500 fell 1.9 percent to 824.31 at 10 a.m. in New York. The Dow Jones Industrial Average lost 140.98, or 1.7 percent, to 8,087.12. The Russell 2000 Index decreased 2.5 percent.

“Just about everybody is saying, ‘I just don’t know about the future,’” said Ralph Shive, the South Bend, Indiana-based manager of the $800 million Wasatch 1st Source Income Equity Fund, which has beaten 99 percent of rivals over the past five years. Microsoft’s inability to forecast results is “confirmation the recession is bigger, broader and worse than a normal recession.”

The S&P 500 is down 8.7 percent this year after analysts cut earnings estimates by a record 83 percentage points. The index surged the most since Dec. 16 yesterday as President Barack Obama’s plan to shore up lenders and Bank of America share purchases by company executives sent financial equities to their biggest rally in two months.

Europe’s Dow Jones Stoxx 600 Index slipped 0.5 percent. The MSCI Asia Pacific Index rose 0.3 percent.

Profit Slump

U.S. analysts now forecast a 28 percent drop in profits for the fourth quarter after saying in March 2008 that earnings would rise as much as 55 percent. Nine of 10 industries in the S&P 500 may show lower fourth-quarter profits, the broadest slump since Bloomberg began compiling the data in 1998. The biggest losses may come from metal processors, financial institutions and companies reliant on consumer spending.

Microsoft lost $1.61 to $17.77. The world’s biggest software maker also said it will eliminate 5,000 jobs as it cuts costs to match a slump in demand. Second-quarter net income was $4.17 billion, or 47 cents a share, compared with $4.71 billion, or 50 cents, a year earlier. Sales were $16.6 billion in the period. Analysts predicted profit of 50 cents a share and sales of $17.1 billion, according to a Bloomberg survey.

EBay, Motorola

EBay retreated $1.58 to $11.70. The world’s largest Internet auctioneer expects to earn as much as 34 cents a share in the first quarter, excluding some items. That trailed the 39- cent average estimate from analysts in a Bloomberg survey.

Motorola, the second-biggest U.S. seller of mobile phones, fell 19 cents, or 4.2 percent, to $4.32 after larger rival Nokia Oyj forecast a 10 percent slide in industry sales.

Apple Inc. rallied 5.5 percent to $88.28. The maker of iPhones, Macintosh computers and iPod players reported first- quarter sales and profit that topped analysts’ estimates late yesterday.

Citigroup Inc. lost 14 percent to $3.18 after rallying 31 percent yesterday. The bank that received $45 billion in U.S. government funds named former Time Warner Inc. Chief Executive Officer Richard Parsons to head its board of directors, replacing Chairman Win Bischoff after posting a record $18.7 billion net loss last year.

Bank of America Corp. fell 8.2 percent to $6.13.

JPMorgan Chase & Co. rose 1.3 percent to $22.92. After the market closed yesterday, Chief Executive Officer Jamie Dimon disclosed that he bought $11.5 million of JPMorgan stock last week.

Obama’s nominee for Treasury secretary, Timothy Geithner, pledged an expanded and prolonged government role in everything from stabilizing banks to ensuring credit for small businesses.

Geithner, who today may take a step toward confirmation with a Senate Finance Committee vote, told lawmakers yesterday “we’re at the beginning of this process of repairing the system, not close to the end.” He committed to “much more substantial action” on a “very dramatic scale.”

Conservatives Have Answered Obama's Call

Conservatives Have Answered Obama's Call

On the other hand, the data show that liberals need a nudge to give.

ARTHUR C. BROOKS

"What is required of us now," President Barack Obama said in his inaugural address this week, "is a new era of responsibility -- a recognition on the part of every American that we have duties to ourselves, our nation and the world." It is a message that nonprofit organizations would like our nation to take to heart, as 2009 fund-raising begins.

Unfortunately, we nonprofit leaders, like our for-profit counterparts, are laying awake nights. The end of 2008 was disappointing for philanthropy, and some believe that 2009 will be difficult as well. Indiana University's Center on Philanthropy publishes the Philanthropic Giving Index (PGI), which tracks the predictions of nonprofit leaders about charitable giving. Like the more-famous Consumer Confidence Index, it shows a level of gloom not seen in years, falling from 83 to 65 (on a 0-100 scale) in just six months.

The PGI is useful, but it is a blunt tool for predicting charitable giving by individuals or to specific charities. It does not tell us that all nonprofits will experience equal pain. Nor does it tell us that all givers will lower their giving by the same amount. In fact, there is good evidence that some Americans will maintain their giving levels far more than others in spite of the recession. One beleaguered group in particular promises to hold up their charitable end in spite of the sputtering economy: political conservatives.

Over the past several years, studies have consistently shown that people on the political right outperform those on the left when it comes to charity. This pattern appears to have held -- increased, even -- in 2008.

In May of last year, the Gallup polling organization asked 1,200 American adults about their giving patterns. People who called themselves "conservative" or "very conservative" made up 42% of the population surveyed, but gave 56% of the total charitable donations. In contrast, "liberal" or "very liberal" respondents were 29% of those polled but gave just 7% of donations.

These disparities were not due to differences in income. People who said they were "very conservative" gave 4.5% of their income to charity, on average; "conservatives" gave 3.6%; "moderates" gave 3%; "liberals" gave 1.5%; and "very liberal" folks gave 1.2%.

A common explanation for this pattern is that conservatives are more religious than liberals, and are simply giving to their churches. My own research in the past showed that religion was a major reason conservatives donated so much, and that secular conservatives gave even less than secular liberals.

It appears this is no longer the case, however: The 2008 data tell us that secular conservatives are now outperforming their secular liberal counterparts. Compare two people who attend religious services less than once per year (or never) and who are also identical in terms of income, education, sex, age and family status -- but one is on the political right while the other is on the left. The secular liberal will give, on average, $1,100 less to charity per year than the secular conservative. The conservative charity edge cannot be explained away by gifts to churches.

Perhaps you suspect that the vast political contributions given to the Obama campaign -- $742 million, according to the Center for Responsive Politics, versus $367 million for the McCain campaign -- were crowding out charitable giving by the left. But political donations, impressive as they were this year by historical standards, were still miniscule compared to the approximately $300 billion Americans gave charitably in 2008. Adding political and charitable gifts together would not change the overall giving patterns.

But here's where the charity gap really starts to make a difference for the recession of 2009: Conservatives don't just give more; they also decrease their giving less than liberals do in response to lousy economic conditions.

Economists measure the "income elasticity of giving" to predict how much people change their giving in response to a particular percentage change in their income. It turns out the response in 2008 was dramatically different for left and right. For instance, a 10% decrease in family income for a conservative was associated with a 10% decrease in giving. The same income decrease for a liberal family led to a 16% giving drop. In other words, if this relationship continues to hold, the recession will almost certainly exacerbate the giving differences between left and right.

All this is good news for the health and survival of explicitly conservative organizations, of course. But folks on the political right give to all types of nonprofits -- from soup kitchens to symphony orchestras -- not just conservative groups.

Ironically, few environments are less tolerant of conservatives and their ideas than the nonprofit world. The Chronicle of Philanthropy reported in October of 2008 that employees of major charities favored Democrats over Republicans in their private political contributions by a margin of 82% to 18%. Among the employees of major foundations, the difference was an astounding 98% to 2%.

Reasonable people can disagree on politics, but the numbers on giving speak for themselves. Nonprofit executives, disproportionately politically progressive, do well to remember that many of the folks they will count on in hard times are not necessarily those who share their political views. Understanding this might make for better fund raising in a scary year -- and help us all to give credit where it is due.

Mr. Brooks is president of the American Enterprise Institute, and the author of "Who Really Cares" and "Gross National Happiness" (Basic Books).

Government Spending Is No Free Lunch

Government Spending Is No Free Lunch

Now the Democrats are peddling voodoo economics.

ROBERT J. BARRO

Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called "multiplier" effect of government spending on economic output is greater than one -- Team Obama is reportedly using a number around 1.5.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment.

The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall. So, something deeper must be involved -- but economists have not come up with explanations, such as incomplete information, for multipliers above one.

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports. In other words, the social cost of one unit of additional government purchases is one.

This approach is the one usually applied to cost-benefit analyses of public projects. In particular, the value of the project (counting, say, the whole flow of future benefits from a bridge or a road) has to justify the social cost. I think this perspective, not the supposed macroeconomic benefits from fiscal stimulus, is the right one to apply to the many new and expanded government programs that we are likely to see this year and next.

What do the data show about multipliers? Because it is not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases that are driven by shifts in war and peace. A particularly good experiment is the massive expansion of U.S. defense expenditures during World War II. The usual Keynesian view is that the World War II fiscal expansion provided the stimulus that finally got us out of the Great Depression. Thus, I think that most macroeconomists would regard this case as a fair one for seeing whether a large multiplier ever exists.

I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.

We can consider similarly three other U.S. wartime experiences -- World War I, the Korean War, and the Vietnam War -- although the magnitudes of the added defense expenditures were much smaller in comparison to GDP. Combining the evidence with that of World War II (which gets a lot of the weight because the added government spending is so large in that case) yields an overall estimate of the multiplier of 0.8 -- the same value as before. (These estimates were published last year in my book, "Macroeconomics, a Modern Approach.")

There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases. For one thing, people would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot). Second, the use of the military draft in wartime has a direct, coercive effect on total employment. Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. In any event, when I attempted to estimate directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.

As we all know, we are in the middle of what will likely be the worst U.S. economic contraction since the 1930s. In this context and from the history of the Great Depression, I can understand various attempts to prop up the financial system. These efforts, akin to avoiding bank runs in prior periods, recognize that the social consequences of credit-market decisions extend well beyond the individuals and businesses making the decisions.

But, in terms of fiscal-stimulus proposals, it would be unfortunate if the best Team Obama can offer is an unvarnished version of Keynes's 1936 "General Theory of Employment, Interest and Money." The financial crisis and possible depression do not invalidate everything we have learned about macroeconomics since 1936.

Much more focus should be on incentives for people and businesses to invest, produce and work. On the tax side, we should avoid programs that throw money at people and emphasize instead reductions in marginal income-tax rates -- especially where these rates are already high and fall on capital income. Eliminating the federal corporate income tax would be brilliant. On the spending side, the main point is that we should not be considering massive public-works programs that do not pass muster from the perspective of cost-benefit analysis. Just as in the 1980s, when extreme supply-side views on tax cuts were unjustified, it is wrong now to think that added government spending is free.

Mr. Barro is an economics professor at Harvard University and a senior fellow at Stanford University's Hoover Institution.

A 'Bad' Bank Can Solve Our Problems

A 'Bad' Bank Can Solve Our Problems

Subsidizing institutions that hold toxic assets only prolongs the pain.

DAVID ROCHE

As bank shares plunge to new lows around the world, it seems we have entered the next stage of the financial crisis -- most likely the last chapter in this horror story. The final word will probably be nationalization of the major financial institutions in the United States and the United Kingdom and in many other countries.

Chad Crowe

How has it come to this? The global credit crisis and the ensuing economic slump we are now entering have both ultimate and proximate causes. The ultimate cause was the ingrained social behavior of the U.S., the U.K. and many other economies over the past two decades that put instant gratification of consumption over the ability to pay for it. Thrift gave way to borrowing and excessive spending. That in turn led to huge global imbalances and distortions. The proximate cause of the crisis was how these excesses were financed through liquidity creation in innovative ways and in huge proportions.

Understanding these causes can explain why it has become so difficult to solve the crisis. Desperate to preserve the value of asset prices inflated by this huge liquidity bubble, policy makers have avoided the painful solution. The liquidity injections, the bailout programs, and the fiscal-stimulus packages try to sustain asset prices, when these prices need to fall to market levels so they can be cleared. The policy makers have just prolonged the crisis.

I am reminded of the clear conclusions of the World Bank's thorough analysis in a 2002 paper "Managing the Real and Fiscal Costs of Banking Crises," which examined banking crises over the past 50 years: "Accommodating measures such as open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated recapitalizations and debtor bailouts appear to increase significantly the costs of banking crises. Did these accommodating policies achieve faster economic recovery? We failed to uncover evidence that they did. Indeed, they seem to have prolonged crises because recovery took longer."

As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker.

There is nothing mysterious about the policy steps that need to be taken to get us out of this mess as quickly as possible. It is not rocket science. In fact, it was successfully carried out by the Scandinavian authorities back in 1991. The banks must be forced to disclose their "toxic" assets (the German banks have about 300 billion euros, the U.K. banks probably 200 billion pounds, and the U.S. banks maybe $800 billion). Then these must be written down to market prices with the hit being taken by shareholders and bondholders -- but not depositors. If that means most banks become insolvent, then so be it.

In effect, this function can be executed by the setting up of a "bad bank," as the Swedes did in the early 1990s. The bad bank clears the toxic assets off the books of banking systems by buying them at market prices and forcing write downs by the banks. A good bad bank forces banks to write down their bad assets and cleanse their balance sheets with those made insolvent being recapitalized, nationalized or liquidated by the state. But it is equally possible to use a bad bank to buy the banks' toxic waste at inflated prices so that the bank can start lending again. That's when it becomes a bad bad bank.

Unfortunately, so far, all the policy makers in the U.S., the U.K. and Europe have rejected the good bad-bank approach and we are now entering the third year of credit crunch with most banks already on their knees. Both the new U.S. administration and the current U.K. leadership are still in denial.

Last October, when the U.K. came up with a better blueprint for dealing with the credit crisis through recapitalization than the Bush administration's poorly conceived Troubled Asset Relief Program (TARP), I gave the Brown government credit for doing so, but faulted it for omitting the good bad-bank function. And now the latest U.K. bailout program, introduced because the October bailout is not working, has also eschewed the good bad-bank option and opted instead for an insurance guarantee scheme.

This new bailout package proposes to insure banks against losses on their remaining toxic assets. Banks will pay a 10% insurance fee, payable with either cash or equity. The taxpayers will take on the risk of losses on 90% of the toxic assets insured. The toxic assets remain on the banks' books, but the banks no longer have any risk in their exposure to them.

The government shied away from the good bad-bank solution because if toxic assets had been written down, most of the U.K. banking system would have been bust and forced into nationalization. In the U.S., the Obama administration is also apparently considering both the bad bank and the insurance solution. I fear they will opt for the latter.

It's natural for policy makers to say, "We know where the problem at the heart of the credit crisis is: it is a lack of lending and we must get credit flowing." If only it were that simple. What policy makers on both sides of the Atlantic desire is to sustain household leverage and consumption at any price, when the only exit from the credit crisis involves a return to thrift by the overleveraged. That cannot be achieved painlessly.

Indeed, household debt in the U.S. and much of Europe reached such extremes that today it is lack of demand -- rather than the impaired supply of credit -- that is driving the deleveraging process and deepening the economic recession. So it is unlikely that even politically decreed credit expansion would be effective in turning the economy around.

By not adopting the good bad-bank solution, the system remains as corrupted as before. The bad assets will continue to suck resources out of the economic system in the form of zombie borrowers, misallocation and mispricing of capital, public sector debt, and budget deficits. And as the reaction to the U.K. scheme is showing, avoiding the core problem fails to inspire confidence, so it is unlikely to result in any increase in aggregate credit or even forestall the inevitable nationalization of insolvent banks for long.

In today's money, the U.S. government alone has spent (counting fiscal spending, not Fed liquidity injections) a sufficient amount of money on the credit crisis to fund two Vietnam Wars. Around 90% of this spending has been to sustain lending and consumption, rather than to tackle the root causes of the credit crisis: overleveraged assets financed by excessive credit creation.

I suppose it is possible that the sheer weight of all this largesse will eventually overcome the structural failures of the financial system and produce economic recovery. (I doubt it, but I can't be sure because we've never been here before.) But if such profligate policies do produce economic recovery, they will do so by creating more bubbles, with the same ultimate consequences of collapse, though on an even grander scale.

Such a recovery would be welcomed by the markets and send traders back to the champagne bars of Wall Street and London. Eventually, however, the second crash would make today's look like kids' stuff.

Mr. Roche is president of Independent Strategy (www.instrategy.com), a London-based consultancy, and co-author of "New Monetarism" (Lulu Enterprises, 2007).