Felix Salmon

Ah, volatility. Suddenly, at 2:30pm this afternoon, the US stock market decided it was going to fall off a cliff, and the Dow promptly proceeded to drop about 700 points in the space of mere minutes, before bouncing back up. This is pure market craziness: if any journalist tries to blame “worries about Greece” or anything like that, ignore them — insofar as there’s a simple explanation, it’s probably something to do with a dodgy feed on Procter & Gamble’s stock price, which fed directly into the Dow, and caused a brief spell of utter panic.

I suspect that this is only the beginning of a new era of volatility. Markets are a bit like volcanoes, or earthquakes: they’re inherently unpredictable, but if they’re quiet for a while, the magnitude of the next big event is likely to be that much bigger. The trigger for this particular move could have been anything; the lesson to learn is that given the complexity of contemporary financial markets, correlations can pop up anywhere, and a relatively small uptick in something like Portugese CDS spreads can combine with a glitch somewhere in the equity markets to get magnified into an event which wipes out hundreds of billions of dollars in capitalization in the blink of an eye. Or maybe it was the UK election, or a butterfly flapping its wings in Kuala Lumpur: there’s no way of ever knowing.

To take a little bit of a step back, Dow 10,000 is something which most people would have thought absolutely wonderful if you’d asked them at any point in the first half of last year: there’s a lot of room to fall. As the world has been releveraging for the past year, equity valuations have been increasingly predicated on the sustainability of a rapidly-growing debt pile. The stock-market collapse of 2008 was a delayed reaction to the credit crunch of 2007, and similarly now we might see equity valuations be marked down as the world of credit becomes very dicey all over again. Alternatively, the incredible rapidity of this afternoon’s rebound might reassure investors that the market is self-correcting and pretty safe.

But that would be the wrong conclusion to draw from this episode, I think. My feeling is that we’re going to have a turbulent journey into a world where risk assets all price off each other in highly complex and unpredictable ways: a radical change from the old world where credit instruments traded at a spread to governments, while stock investors took solace in the low spreads and high liquidity of commercial paper. In the new world, devastating correlations can appear out of nowhere — and then disappear again just as quickly. And anybody who wants to stay in the market is going to need a very strong stomach.

My reference library is the internet. But I do have a few indispensible books on my shelves, and right next to the OED is Angus Maddison’s magisterial The World Economy: A Millennial Perspective. The product of a lifetime’s erudition and research, it might get updated over the coming few decades but I doubt it will be replaced for a very long time, if ever.

I just came across Maddison’s name yesterday, as I was reading Matt Ridley’s new book, and he dropped in the fact that China was the only country in the world to have lower GDP in 1950 than it had in 1000. That’s the kind of thing which no one knew, certainly not with any confidence, before Maddison came along.

Maddison died on April 24, I just found out. The Economist has an excellent obituary. But as far as the economic literature is concerned, he’s one of the immortals.

One of the more thought-provoking bits of the Shleifer paper on financial innovation is this part of the model:

Optimism about the profitability of the new claim at t = 0 encourages the intermediary to over-invest in an unproductive activity, eventually triggering a loss… Investment in A occurs only if new securities can be engineered, so financial innovation bears sole responsibility for unproductive investment. It can be argued that the expansion in the supply of housing in the last decade was an example of such inefficient investment needed to meet the growing demand for securitization of mortgages.

To put it another way, it was the excessive and irrational demand for collateralized debt obligations which caused all those Miami condos and Phoenix tract homes to be built in the first place.

That makes sense to me, but it raises an interesting question about the damage caused by synthetic CDOs. Here’s Jesse Eisinger and Jake Bernstein, from their investigation of Magnetar:

By helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, “Econned,” that “Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.”

Certainly the banks and investors who ended up on the long side of the synthetic CDO trade ended up losing lots of money to people like Magnetar and John Paulson who were on the short side of the trade. But in some ways the Magnetar-driven boom in synthetic CDOs was actually preferable to the boom in RMBS-based non-synthetic CDOs which preceded it.

Think about it this way: both CDOs and synthetic CDOs resulted in losses for investors on the long side. But In the world of CDOs, demand for paper ended up creating a disastrous building boom which diverted resources from more productive activity, skewed local tax revenues, and created the precondition for the wave of foreclosures which is likely to continue for the foreseeable future.

In the world of synthetic CDOs, by contrast, demand for paper just ended up making a bunch of shorts extremely rich: all the other real-world repercussions of the CDO market were actually avoided.

I’m not saying that the world of synthetic CDOs was a good thing. In fact, I’ve explained why I think that it was harmful. But the point that investors started moving from CDOs to synthetic CDOs marked the point at which the housing bubble stopped growing: the move played a significant role in ending the real-world housing insanity. If banks could create synthetic CDOs out of thin air, they no longer needed to encourage subprime originators in the Inland Empire to give $600,000 mortgages to itinerant strawberry pickers, just to keep their channels full.

When talking about credit default swaps, the material out of which synthetic CDOs are made, people often get very upset that you can have more CDS outstanding on a certain name than there is of the underlying instrument. But just think how much better off we would be if the amount of real-money subprime lending had never boomed at all, and if all the financial speculation on subprime mortgages had been confined to synthetic CDOs, all of which referenced a relatively small handful of subprime deals. We wouldn’t have had nearly as much of a housing boom, we wouldn’t be stuck with crumbling suburbs, we wouldn’t have a foreclosure crisis, and we would have invested our money in much more productive things than real estate for most of the last decade.

Of course, it would have been much harder to find people like John Paulson to take the short side of those trades: you needed a bubble to attract the hedge funds who fueled the synthetic CDO boom. But I still think it’s reasonable to consider synthetic CDOs to be less harmful, at the margin, than their real-money counterparts.

All that said, synthetic CDOs did make it much easier for banks, in particular, to take on enormous amounts of highly-leveraged exposure to the subprime market, by holding on to unfunded super-senior tranches. That was a particular problem in the case of Citigroup. When the likes of Citi and Merrill Lynch got out of the moving business and started going into the storage business, they were creating a lot of systemic risk where none had previously existed — and the rise of synthetic CDOs made it much easier for them to do so. As I say, synthetic CDOs were indeed harmful. But were they more harmful than normal CDOs? I’m far from convinced.

Nicola Gennaioli, Andrei Shleifer, and Robert Vishny have a great new paper out entitled “Financial Innovation and Financial Fragility”.* It doesn’t break a lot of new conceptual ground, but it’s very thought-provoking, and it helps to codify in a formal way the serious problems with financial innovation. Their conclusion is spot-on, I think:

Recent policy proposals, while desirable in terms of their intent to control leverage and fire sales, do not go nearly far enough. It is not just the leverage, but the scale of financial innovation and of creation of new claims itself, that might require regulatory attention.

The idea here is that financial innovation is, by its nature, inherently and predictably dangerous. If something’s innovative, it’s new. And if something’s new, it’s untested. Meanwhile, a very large part of what we consider “financial innovation” consists of “improving” on existing securities, usually by creating a source of new supply for in-demand securities while also providing some kind of pick-up in yield.

Eventually, a test comes along: the world behaves in a way that no one had expected, and the new securities prove to be less attractive than the traditional securities they replaced. When that happens, demand for them plunges, their price falls dramatically, and enormous losses ensue. This narrative has been played out many times — look at CMOs and junk bonds in the 1980s, or CDOs and money-market accounts more recently. Or look back on eight centuries of financial folly, for that matter.

In order to make the model in this paper work, you just need to make a couple of very reasonable assumptions. First of all, there’s the assumption that investors aren’t perfectly rational; instead, they use what’s known as “local thinking”, and don’t consider every possible eventuality when buying securities. Secondly, there’s the assumption (which isn’t even necessary, it just makes the results stronger) that investors prefer safety over risk. The authors dryly note that it would be possible to model such an assumption by considering “investors who have lexicographic preferences with respect to particular characteristics of investments (e.g., AAA ratings)”. Quite.

The results are predictable. First, you get far too many of the new securities:

When some risks are neglected, securities are over-issued relative to what would be possible under rational expectations. The reason is that neglected risks need not be laid off on intermediaries or other parties when manufacturing new securities. Investors thus end up bearing risk without recognizing that they are doing so.

And second, you get a spike in tail risk:

Markets in new securities are fragile. A small piece of data that brings to investors’ minds the previously unattended risks catches them by surprise, causes them to drastically revise their valuations of new securities, and to sell them in the market. The problem is more severe precisely because new securities have been over-issued.

Finally, if you add leverage to this toxic mix, that only serves to make everything a great deal worse.

More generally, a lot of what’s going on here is that banks are creating “private money”, and that while economists have generally considered that to be a good thing, “security issuance can be excessive and lead to fragility and welfare losses, even in the absence of leverage and fire sales”. Private money, it turns out, is a bit like public money, but not nearly as robust: think of it as a hundred-dollar bill which, unbeknownst to the holder, can occasionally simply self-destruct.

There’s implicit support in this paper for government attempts to intervene in the market during a crisis: under the model, it’s entirely possible that “investors’ valuation of the claim is low not because it is unappealing per se, but because it is not the claim they wanted to hold”. In that situation, intermediaries — banks — can step in to arbitrage the difference, but they often don’t have nearly enough money to do so. If the government steps in with extra liquidity to buy up the now-undervalued securities, that can help to avert a systemic meltdown.

Left to its own devices, a market with financial innovations is very likely to end up harming investors, while still making lots of money for the innovators:

In our model, innovation benefits intermediaries who earn large profits selling securities, but hurts investors, who are lured into an inefficient risk allocation and suffer from ex-post price drops… Investors’ losses from risk misallocation may be so large as to eliminate the social value of innovation altogether.

Realistically, I see very little chance that any financial regulatory reform will do anything to prevent or even slow down the pace of financial innovation. But maybe, if enough investors read and fully grok papers like this, they’ll learn to stay away from securities they don’t fully understand, or which are so new as to be untested in the real world. But I’m not holding my breath.

*Yes, I read this paper the journalistic way, ignoring the mathematics. But dude, it’s Andrei Shleifer. Surely we can trust his math.

(HT: guan)

Update: The paper also sparks some counterintuitive ideas about the utility of synthetic CDOs.

Update 2: Glenn Yago, author of a new book on the wonders of financial innovation, makes a couple of good points in the comments. The model, he says, is “unable to distinguish between the good, bad and ugly of financial innovation” — which is true. He also suggests that there are fundamental reasons why CLOs haven’t performed nearly as badly as CDOs, which is probably also true, with hindsight, although I’m not sure that the structures are so different that the outperformance would have been particularly predictable ex ante. Not all financial innovations blow up in every crisis, after all, but financial innovations do blow up. Glenn goes on to use credit ratings in support of his argument, which is kinda funny, I think.

Fundamentally, Glenn seems to be saying that if you “consider capital structure, overleverage, and impacts of regulatory arbitrage”, then you’ll somehow be able to weed out the bad financial innovations, and leave yourself with only the good ones. I’d be more willing to believe him if he didn’t go on to laud the wonders of leveraged loans, which are definitely more leveraged than the super-senior tranches of synthetic CDOs.

Clay Shirky is talking about media, but might as well be talking about finance:

Complex societies collapse because, when some stress comes, those societies have become too inflexible to respond. In retrospect, this can seem mystifying. Why didn’t these societies just re-tool in less complex ways? The answer Tainter gives is the simplest one: When societies fail to respond to reduced circumstances through orderly downsizing, it isn’t because they don’t want to, it’s because they can’t.

In such systems, there is no way to make things a little bit simpler – the whole edifice becomes a huge, interlocking system not readily amenable to change. Tainter doesn’t regard the sudden decoherence of these societies as either a tragedy or a mistake—”[U]nder a situation of declining marginal returns collapse may be the most appropriate response”, to use his pitiless phrase. Furthermore, even when moderate adjustments could be made, they tend to be resisted, because any simplification discomfits elites.

Meanwhile, Steve Waldman makes the case that banks are far too complex, these days, for notions of “capital” to mean anything any more. What we need, he says, is to get simpler: “we are doomed,” he says, “unless and until we simplify the structure of the banks.”

Which, if true, is to say that we are doomed. We have reached a level of institutional complexity which renders radical simplification impossible, short of outright collapse. We can see this even in relatively simple structures like that of U.S. financial regulators: such things are much easier to create than to abolish, and so they tend to multiply. But it’s even more true of finance more generally. The world’s biggest banks must become much simpler; the world’s biggest banks won’t become much simpler. The conclusion is not a pretty one.

Justin Fox sums up the overwhelming majority of economics papers in one sentence:

The basic form of an academic economics paper is a couple of comprehensible paragraphs at the beginning and a couple of comprehensible paragraphs at the end, with a bunch of really-hard-to-follow math or statistical analysis in the middle.

What he doesn’t (need to) mention is the way that journalists, myself included, read economics papers: we generally have no ability or inclination to try to understand the details of the formulae and regression analyses, so we confine ourselves to reading the stuff in English, and work on the general assumption that the mathematics is reasonably solid.

The problem of course is that we really have no basis for making that general assumption: we make it not because we think it’s particularly justified or justifiable, but because we don’t have any choice. What’s more, because we’re always interested in what’s new, and because we have easy access to the internet and little access to expensive journals, we gravitate to preprints at sites like SSRN, rather than papers which have gone through peer review.

I worry about this. The blogosphere is full of interesting debates between people who understand and respond to what everybody else is saying. But the minute that economic papers get cited, the degree of understanding plunges, and most bloggers and journalists are cowed by all those equations into simply assuming that it all stands up somehow.

There’s no easy way around this problem, but at the very least it should probably be much more out there in the open than it is. No one likes admitting ignorance, but the blogosphere would be a better place, I think, if we all did so more regularly, especially when it comes to the nuts and bolts of economic analysis.

On the other hand, maybe the general assumption is justified. Any economists care to weigh in on the frequency with which important problems in an economics paper are buried in the math?

Update: An Econ grad student writes to Andrew Sullivan:

[U]nderstanding the math lets you realize how narrow the analysis is and how stylized the world depicted by the model has to be for its conclusions to follow. As descriptions of the world, they’re metaphors; but without the math it’s hard to show someone where the metaphor holds and where it’s just an analogy not to be taken literally.

Update 2: Robert Waldmann writes:

The sloppy translation of “Pareto efficient” to “efficient” has caused huge damage…

However, things are much much worse than you imagine. It is not rare for the plain English parts of articles published in top journals to contradict the statistical analysis presented in the body of the paper. I absolutely assure you that it is not rare for the abstract introduction and conclusion to state that a hypothesis has not been rejected when the empirical results include rejection of that hypothesis.

Update 3: Mike Mandel says that “the real joker in the deck is not the mathematics, but the data.  Or more precisely, the lack of good economic and financial data in many areas.” Although it’s unclear whether this results in incorrect papers, or just in the absence of good and important ones.

How come Netflix has a market capitalization of $4 billion, on 2009 net income of just $116 million? That’s about $325 per subscriber, even as each subscriber generates on average about $145 in revenue and $10 in net income per year.

Ethan Epstein makes a pretty compelling case that Netflix’s business model is threatened by problems at the US Postal Service: a rise in postal rates would be bad, and the abandonment of Saturday delivery would be much worse.

But the fact is that the economics of Netflix have always been unique and hard to put into old-fashioned business models, and I think they’ve done quite a good job of reinventing the whole way that we pay for consuming movies. By turning it from a cost-per-movie into a cost-per-month, they can somehow charge more money but cause less pain while doing so.

I’m aware that I’m extrapolating wildly from my personal experience here, but in the olden days I hated paying late fees on rented movies, and as a result was an eager and early adopter of Netflix. But pretty much since day one, I’ve paid more money to Netflix in any given month than I ever would have paid in movie-rental fees, including late fees. I just don’t watch that many movies, and the occasional $10 late fee is still much less than the regular $20 or so I pay Netflix. And while Netflix has done a good job of reducing its rates noticeably: my plan has dropped from $23.84 in 2004 to $18.50 now, including tax, that’s still more than I’d ever be likely to pay a video-rental store.

Indeed, I still occasionally get DVDs from my local rental store, because of the way that serious-and-earnest Netflix DVDs tend to pile up unwatched when the whole reason for wanting to relax with a movie in the first place is because you’re frazzled and just want to kick back with something funny or brainless. The Netflix tail is long, but when you have no more than three movies out at a time, your choice is actually much more constrained than at the video store. And similarly with the streaming stuff: it’s great in theory, but in practice it’s going to take me a long while to work out how to hook it up to my video projector.

Yet despite all of that, I’ve been a loyal Netflix customer for nine years now, and I’m likely to continue to pay them their $18.50 a month pretty much indefinitely, bearing them none of the ill will that I used to have towards surly clerks charging me late fees for scratched DVDs. There’s just so much less pain involved, when you pay for access to movies rather than for the movies themselves.

Still, $4 billion seems pretty crazy to me. Netflix is just a middleman, a delivery company. Shouldn’t that be a commodity, rather than something trading on a p/e in the mid-30s?

The smartest reaction so far to the Kinsley-Krugman hyperinflation debate comes from Ryan Avent:

The pain of hyperinflation is every bit as bad as and worse than the pain of tax increases, or spending cuts, or default. No politician would risk it, and even if the politicians were willing to, America’s independent Fed wouldn’t let them.

The truth about hyperinflation is that it isn’t so much an economic phenomenon as a political one; it corresponds to the complete breakdown of a country’s political institutions…

To get from America’s current situation to one in which hyperinflation is a realistic possibility, one must pass through an intervening step in which America’s political institutions utterly collapse. And I submit that if Mr Kinsley has reason to believe that such a collapse is imminent, he should be writing columns warning about that rather than the economic messes which might follow.

It’s also worth expanding on what Ryan’s hinting at in his reference to “America’s independent Fed” — and that’s a neat little rhetorical sleight-of-hand on the part of Kinsley. Consider:

The Federal Reserve is independent, but Congress and the White House have ways to pressure the Fed. Actually, just spending all this money we don’t have is one good way.

Compared with raising taxes or cutting spending, just letting inflation do the dirty work sounds easy. It will be a terrible temptation, and Obama’s historic reputation (not to mention the welfare of the nation) will depend on whether he succumbs. Or so I fear.

Kinsley continues:

Hyperinflation is the result of explicit policy choices by public officials… There are reasons to worry that our political leaders may opt for inflation even if there is no economic evidence of it happening naturally.

The logic here is that simply running large fiscal deficits is an “explicit policy choice” by officials who “opt for inflation”. Just by spending money, the government is pressuring the Fed to, um, what, exactly? Keep interest rates too low? Print money?

It’s true that the Fed isn’t looking particularly independent these days, but that’s largely because inflation isn’t a problem, and therefore the Fed is rightly concentrating on the second part of its dual mandate, which is reducing unemployment through loose monetary policy. Fiscal policy and monetary policy should both be pulling in the same direction right now — which is the direction of trying to extricate the country from the deepest recession in living memory.

It’s also hard to see the dynamics by which hyperinflation — or even plain old ordinary high inflation, for that matter — could emerge. If there’s a panicked run away from the dollar and dollar-denominated assets, that would hurt both the stock market and the bond market, hitting wealth hard. It would also send the cost of imports up. But the US doesn’t import so much that import-price inflation would pass through into domestic hyperinflation. And with the markets in turmoil, weak unions, and unemployment surely rising, I don’t think that workers would be in any position to ask for double-digit wage increases on an annual basis. In any case, to have any hyperinflation you need a maniac helming the printing press, and Ben Bernanke is not a maniac. Yes, he’s expanded the money supply significantly, but only when disinflation was the greatest risk facing the economy. It’s almost impossible to imagine the Fed continuing to print money once consumer prices start rising sharply on Main Street — and, frankly, it’s hard to imagine the Obama administration putting pressure on the Fed to do so.

As Krugman notes, it’s instructive to take a hard look at Japan, which ran enormous deficits for many years and which still has no sign of any inflation any time soon. Deficits, in and of themselves, do not cause inflation. And while Kinsley is right that there’s no obvious way out of America’s current fiscal problems, he’s wrong that politicians can simply choose inflation as an option. Just as the Treasury secretary does not control the value of the dollar, the president does not control the trajectory of consumer prices. So in order for his fears about hyperinflation to be remotely justified, Kinsley first has to explain how the Fed is going to transmogrify into the Reserve Bank of Zimbabwe. And he hasn’t come close to doing that.

There’s a nice empirical post-script to the debate over the economic effects of classifying the Spotted Owl as an endangered species. Freakonomics cites a study putting the effect at $46 billion, but others, including John Berry, who wrote a story on the subject for the Washington Post, think it’s much closer to zero.

And now it seems the Berry side of the argument has some good Freakonomics-style panel OLS regression analysis of the microeconomy of the Pacific Northwest to back up its side of the argument. A new paper by Annabel Kirschner finds that unemployment in the region didn’t go up when the timber industry improved, and it didn’t go down when the timber industry declined — not after you adjust for much more obvious things like the presence of minorities in the area.

From the abstract:

The controversy that ensued with this listing quickly became framed as one of jobs versus the environment, a contention that often characterizes conservation efforts. This contention is closely tied to export-based economic theory which assumes that a rural area’s natural resource commodity base is the most important factor in economic development and community well-being. However, other factors could impact well-being… Industrial restructuring and the presence of minorities are the only significant explanatory variables for poverty. The presence of minorities is the only significant variable for unemployment rates.

That’s industrial restructuring in the timber industry as a whole that we’re talking about here, not the effects of the Spotted Owl decision specifically. Employment in the timber industry in the region generally was in terminal decline whether or not the Spotted Owl was made an endangered species, and the decision to list the owl had zero visible effect either way.

Just don’t expect this particular paper to make it into the next edition of Freakonomics.

The ultimatum game has shown repeatedly that people aren’t profit maximizers if they think that the profit-maximizing outcome is fundamentally unfair. And it turns out that the same is true of mortgage companies. Here’s Dean Jens, telling the story of a short sale of a house with two liens:

The total debt was on the order of $350,000 — I don’t remember the exact figure — and he and the seller had agreed to a price of $253,000. The primary lien-holder had signed off on an agreement allowing the second lien-holder to receive $11,500, while the second lien-holder had agreed to accept 5% of the sale price. 5% of $253,000 is $12,650, so they were a bit stuck.

The climax came when the buyer was in an office with his real-estate agent, on a speaker-phone conference call with lower-level employees of both lenders, neither with the real authority to renegotiate either agreement. In lieu of being able to negotiate, they began yelling at each other for a protracted period of time, over which it occurred to them that there was nothing in the agreements stipulating a minimum dollar value that either bank would accept. Accordingly, they lowered the sale price to $230,000, of which 5% would be $11,500, and the buyer walked away $23,000 richer.

This is a classic zero-sum game. The first option is that the buyer is out $253,000, with $12,650 of that going to the second lien holder, and $240,350 going to the primary mortgage holder. The second option reduces the payment to the second lien holder by $1,150 to $11,500, and reduces the payment to the first lien holder by $21,850 to $218,500. In percentage terms, they’re both out an identical 9.1%, and in both cases the first lien holder gets exactly 19 times the sum going to the second lien holder.

So why would they choose the second option, when the buyer — the only winner in the deal — has no negotiating leverage at all? Just because the first option didn’t seem fair to the primary mortgage holder, for whatever reason. This is a short sale, and the second lien holder by rights should be getting nothing, and the first lien holder simply wasn’t willing to pay them more than $11,500 to go away.

Over the long term, such a tactic might actually make financial sense. If these two companies negotiate with each other a lot, then it’s in the interest of the first lien holder to shoot itself in the wallet occasionally, just to prove the point that when it sets a limit on how much it’s willing to pay the second lien holder, it’s going to stick to that limit, no matter what. But in the short term, it’s certainly nice to be in a position where a pair of squabbling mortgage companies decide on the spur of the moment to just give you $23,000.

Treasury had its second big blogger meeting today, where Tim Geithner and other Senior Administration Officials (sorry, ground rules) fielded questions from a group of bloggers* which tilted heavily towards the newsier end of the spectrum. The Center for American Progress was there in force, as were the Atlantic and the Huffington Post; the less corporate bloggers from last time round (David Merkel, Tyler Cowen, Yves Smith, Steve Waldman, John Jansen, Michael Panzer, Kid Dynamite) were absent this time.**

I can’t quote what anybody said, even anonymously, but I can tell you that the message from Treasury was that financial reform is not dead in the Senate, and that in fact on some matters, including derivatives reform, there’s real hope that the Senate can put something together that’s even stronger than what the House passed. I’ll believe it when I see it, but the general idea seems to be that so long as something gets out of committee, the final bill might actually have some teeth.

Have we reached the point at which we’ve wasted our crisis? The official Treasury talking point is that we haven’t, and that there’s a window of time through the end of this year in which there’s still some political urgency left; after that, passing something strong will get harder. Again, I think they’re just trying to make the best of a bad situation — that we’re still months away, in a best-case scenario, from a bill actually reaching the president’s desk, and that by then (fingers crossed) the crisis will be more of a distant memory than ever.

I did ask about credit default swaps, in the light of the latest moves by European governments to place blame derivatives and speculators for their debt woes, and got a pretty encouraging answer: it’s pretty clear that Treasury reckons debt woes should be addressed with fiscal measures, and doesn’t think much of banning naked CDS or anything like that.

HuffPo’s Shahien Nasiripour was on great form, and seemed to be much more on top of the Treasury brief than most of the officials we were talking to. He asked a great question about people walking away from their mortgages, and was told that no one in Treasury would ever officially countenance such behavior — but I did get the impression that the actual human beings there, in their personal capacity, might not necessarily agree with the official view. The answer was more “we’d never say that people should walk away” than “we don’t believe that people should ever walk away”.

There was also a little bit of talk about the higher capital requirements for bigger banks. That’s not part of the financial regulatory reform bill, because Treasury already has the authority to implement it unilaterally. The idea is that the exact requirements will be decided upon by the end of this year, in consultation with the G7, and that they will then be phased in over 2011 and 2012, coming into full force in 2013. There’s no real indication of where they’re going to be set, just that they’ll be more stringent than the requirements currently in place.

More generally, I came away with the impression that life at Treasury is not much fun, on a day-to-day basis, and that the stresses of trying to set economic policy in the face of strong opposition from both the banking lobby and the Republican party are wearing on the officials there. And I also came away with a photocopy of John Cassidy’s piece on Geithner in this week’s New Yorker: each of us got given it as some kind of Treasury party favor.

Josh Green has a big Geithner profile too, and now Treasury was inviting us bloggers in, and then there was that Vogue piece — there does seem to be some kind of PR offensive going on. But I’m not nearly enough of a Washington insider to hazard a guess as to who’s responsible, or why they might be doing it. But I’m sure it’s going to be a topic of conversation at the post-meeting dinner.

*Daniel Indiviglio, Megan McArdle, Matthew Yglesias, Patrick Garofalo, Amanda Terkel, John Aravosis, Faiz Shakir, John Amato, James Kwak, Duncan Black, Sam Stein, Shahien Nasiripour, Ryan Grim, David Kurtz, Tim Fernholz, and me.

**Update: It turns out that this was a deliberate policy: no one who came to the last meeting was invited to this one. James Kwak, Megan McArdle, and I all for various reasons couldn’t make the last one, so were invited to this one. But Treasury has a somewhat weird policy of “maximizing touch” and therefore not repeating any blogger.

Charles Forelle and Stephen Fidler have a really good front-page overview of the eurozone’s fiscal situation in the WSJ today. There’s not a lot of new news here, but as a lucid explanation of how we got to our present sorry state (and possible future even sorrier state), it’s vastly superior to sensationalist conspiracy theories about euro-shorting hedge funds.

So in the wake of the latest announcements from Greece promising fiscal rectitude in present and future — announcements which the market seems to like quite a lot — it’s worth bearing in mind two questions. The first, on which the market is currently fixated, is whether Greece can roll over its maturities in the next three months or so, tapping some combination of public bond markets, state-owned European banks, and EU loan guarantees. On that front, things are indeed looking pretty hopeful, partly thanks, as Sam Jones notes, to those very hedge funds which shorted Greece a few months ago, are making substantial profits by covering those shorts, and are now driving spreads tighter as opposed to wider.

The second question, which is much less tractable, is whether we can have any faith in eurozone government finances more generally, and this is where today’s WSJ article is so helpful, showing clearly that the truth has a tendency to come out very slowly and unpredictably, and that currency swaps through the like of Goldman Sachs are the least of the problem: governments hide much bigger debts by doing things like excluding defense expenditures or reclassifying subsidies as equity investments.

It’s worth remembering the famous convergence trade of the 1990s, whereby the wide spreads on what we now think of as PIGS debt all converged to something near zero as the euro approached: the idea was that simply adopting a single currency would mean an end to idiosyncratic credit risk between countries. In hindsight, that doesn’t make a lot of sense, since it was based on what Willem Buiter calls the “paper tiger” of the Maastricht treaty — the idea that somehow, after signing that piece of paper, sovereign governments would change the habits of decades or even centuries.

Of course it didn’t seem that way at the time. Because the PIGS were funding themselves in domestic currency, their credit risk pre-euro was very low, since they could and did always just print money to repay their debts. The result was high nominal interest rates to make up for high expected future inflation and/or currency depreciation. When those countries moved to the euro, the risks of inflation and currency depreciation were massively and credibly reduced — but no one seemed to worry overmuch about the fact that those risks didn’t simply disappear, they were just being transformed into medium-to-long-term credit risk.

Even at 400bp over German sovereign bonds, Greece’s nominal borrowing costs today are much lower than they were in the era of the drachma: the markets are requiring less compensation for Greek credit risk than they ever did for drachma depreciation risk. Maybe that’s because they have more faith in Greece’s fiscal rectitude today than they did in the early 1990s. And maybe that faith is well placed: the Greeks certainly seem pretty serious, these days, about cutting spending and increasing revenues. More serious than they ever were in the 90s.

But the fact is that the changes in nominal PIGS funding costs are not perfectly correlated with the fundamental faith that markets have in those countries’ fiscal sustainability, especially now that they’ve spent the past decade with no real control over monetary policy. So while the ouzo crisis might be waning, I’m sure that we’ll see more, similar, crises in future. Because southern Europeans can’t become Germans just by signing a treaty in Holland.

Free Exchange reprints this fantastic chart from the Economist:

The really fascinating charts, for me, are the second two. The one in the middle shows how consumption grew a little bit faster than income through the 70s, 80s, and 90s — but then the gap between the two completely spiralled out of control in the 2000s. There’s your credit boom and inevitable crunch right there.

And I can’t help but look at the payrolls chart in the light of the anti-immigration sentiments of Lou Dobbs and the like. It’s a lot easier to welcome foreigners to your shores when your payrolls are growing by 20% a decade than when they’re shrinking.

Incidentally, I think there’s a misprint in the graphic: the third chart shouldn’t have that asterisk, since the growth rate in that one is per decade, not per year. It seems silly to do it that way, I would have made all the growth rates annual, and maybe added a population-growth or bar to the final chart.

In 2001, after the 9/11 attacks, former U.S. President George W. Bush signed into law a $15 billion airline bailout, and I remember reading (I can’t find it now) a cogent argument that it really didn’t make much sense, since the airline business was reasonably competitive.

If any given airline was solvent, then throwing money at it would be unlikely to change the mathematics of any decision as to whether or not to invest money in new planes or flights. And throwing money at an insolvent airline just ends up bailing out creditors and shareholders, and makes it harder for younger, nimbler competitors to enter the market.

I was reminded of that argument when I saw Daniel Davies’s short post about how difficult it is for a government or central bank to get banks lending again:

Banks make loans and then work out how to fund them, they don’t raise deposits and then work out how to lend them. Therefore there basically is no “credit channel” of monetary policy; bank lending is exogenous (or rather, it’s exogenous to the monetary policy regime; it’s determined to a significant extent by overall macroeconomic conditions but not in a straightforward or easily analysable way).

This is a little bit of an oversimplification: if you read the BIS working paper that Davies is referring to here, it makes clear that monetary policy has little if any effect on bank lending if and only if the banking system is adequately capitalized. Monetary policy can have an effect on lending insofar as cutting interest rates helps to steepen the yield curve and thereby improve the financial health of the banking system, which generally borrows short and lends long.

But the central insight is undoubtedly true: the size of a bank’s deposit base is not a meaningful constraint on the amount of lending it does. And what’s more, if you have an adequately-capitalized bank, like say JP Morgan Chase, then throwing money at it either through fiscal policy (Troubled Asset Relief Program) or through monetary policy (cutting interest rates) is by no means guaranteed to change the amount of lending that the bank engages in.

If you want to get banks lending again, governments can try a bit of moral suasion, but ultimately it’s a decision that any bank is going to have to make on its own economic merits. And it’s likely, unfortunately, to take rather more time than most governments — and borrowers, for that matter — have patience for.

Oh, and one other thing: when the government guarantees loans, for instance through the Small Business Administration, that might do more to help increase lending — but only by transferring credit risk out of the banking sector and onto the taxpayer. And it might in fact just move lending activity into the small-business area from elsewhere in the bank, without increasing the total amount of credit that the bank makes available. It would be great to see some empirical studies on such matters.

One consequence of going on staff at Reuters last April is that I got a W2 this year for the first time in a decade, and I’m pretty impressed at how much money I managed to pay the government, without even trying, in 2009. I know that if I was paying the same kind of money in big quarterly checks, as I used to when I was freelancing, it would have hurt much more.

Eric Felten explains what’s going on here:

Policymakers have long understood that the less visible—or “salient,” to use the economist’s term of art—a tax is, the easier it is to raise. Which is why Milton Friedman, looking for ways the federal government could collect more money during World War II, recommended the creation of income tax withholding (an innovation he was not proud of).

I agree with Felten on the mechanism at play here, but I disagree that it’s a bad or invidious thing. In a world where people want to maximize their own happiness and minimize their own pain, it makes sense to automate and otherwise anesthetize as much as possible things like tax collection. If I’m happier paying more taxes less visibly, then isn’t that Pareto-optimal for all concerned?

Felten says that he would rather scrounge for change at a parking meter and at tollbooths, rather than pay painlessly with a cellphone or EZ-Pass, precisely because he wants to feel frustration and annoyance at paying those fees: “those are just the emotions I want to cultivate toward the entire enterprise,” he writes. Which, I suppose, is his right. But most of us — those of us who tend towards the sensible — are much more likely to want to minimize the frustration and annoyance in our lives.

This is one reason the Netflix business model is so elegant. I’m sure I pay Netflix much more money on an annual basis than I ever used to pay in DVD rental and late fees. But the frustration and annoyance involved in returning DVDs and paying late fees was enormous, and now all of that has gone away, and I’m happier.

And this is also a reason to love systems like the Oyster card, in London, where you merrily tap your way in and out of the subways and buses without spending much if any time worrying about how much it’s costing you. It’s a much more pleasurable way of getting around than the old system of buying tickets — and it also makes it easier for Transport For London to raise prices, if and when that becomes necessary. In general, the less visible any price rise is, the less pain it causes, and the happier everybody is.

There are limits, of course, to my happiness with such solutions. Sleazy companies like Vertrue, Ben Stein’s employer, who trick you into paying monthly fees on your credit card, are pretty evil — but mainly because you’re doing so unwillingly, and wouldn’t pay those fees at all if given a choice. Similarly for overdraft fees, monthly checking-account fees, and all the other ways that banks have of extracting money unwillingly from their depositors.

But when it’s a matter of degree rather than kind — when you’re willing to pay something, but would just rather not think about it when you do — then these kind of automated payments are a godsend, especially if you’re disciplined enough to manage your monthly cashflow and notice when it’s getting out of control. (Hint: look to see if the balance on your credit card is going up rather than down.) So let’s welcome easy ways of paying for parking, along with easy ways of paying taxes. They’re a lot less unpleasant than the alternatives.