In a speech he gave earlier this week, Federal Reserve Chairman Ben Bernanke said the following:

“In the current episode, in contrast to the 1930s, policymakers around the world worked assiduously to stabilize the financial system. … As a result, although the economic consequences of the financial crisis have been painfully severe, the world was spared an even worse cataclysm that could have rivaled or surpassed the Great Depression.”

For today I want to set aside whether Ben’s claim is right and simply ask what it means. In particular, I want to discuss whether the events that might have occurred without Fed and Treasury intervention - widespread failure of financial institutions – should be thought of as generating economic costs or merely as redistributing wealth.

To that end, here is a description of what occurred during the housing bubble and burst.  Market participants came to believe that housing prices were going to keep going up and up. Actors throughout the economy made decisions based on these beliefs, and the asset values on their balances sheets incorporated these beliefs.

Then one day everybody realized that fundamentals (land availability, construction costs, demographics) did not justify ever-increasing housing prices. And everyone recognized that assets backed by housing were about to be worth much less than everyone had previously believed.

At that point it was inevitable that all those assets backed by housing were going to decline in value. So the financial institutions that bet heavily on housing would suffer, and some would fail. Shareholders and creditors would lose a lot of money.

The crucial thing to note, however, is that so far in this story the declines in asset values have not caused any harm or loss of wealth other than that implied by the decline in housing prices. These losses are obviously bad for people who owned claims on housing, but the failures are not new or additional costs; they are just the reflections of a negative shock (the decline in housing values).

Further, if the surge in housing prices was a bubble, perhaps aided by ill-advised monetary and housing policies, then the decline toward fundamental values is good for economic efficiency. Specifically, the decline in housing prices suggests the economy should invest less in housing and more in factories and R&D.

So if this is the entire story, the failure of financial institutions is bad for their stakeholders, but not for anyone else. In wonko-speak, the failures per se are not an externality or inefficiency; they are the unavoidable undoing of a bubble. 

So why does Ben argue that we had to prevent the financial failures? His claim is that when financial institutions fail, it harms the non-financial part of the economy. The reasoning is that when a financial firm fails, no one else can easiliy step in and make the productive loans this firm might have made. Thus productive opportunities are lost throughout the economy.

Is this story interesting? Yes. Has it been verified beyond reasonable doubt? I do not think so, but reasonable people can disagree.

What should be indisputable, however, is that the mere fact that we would have witnessed widespread failure, bankruptcy, and lower wealth for those invested in housing does not by itself  justify intervention to prevent failures. An economically correct case for such intervention must argue that failures have negative externalities. I am far from convinced that would have been the case.

Here is the view of Congressman John J. Duncan, Jr. (Rep., TN):

Washington, DC — Mr. DUNCAN:  Madam Speaker, probably the most needless, useless agency in the entire Federal Government is the Air Marshal Service.

In the Homeland Security Appropriations bill we will take up next week, we will appropriate $860 million for this needless, useless agency. This money is a total waste: $860 million for people to sit on airplanes and simply fly back and forth, back and forth. What a cushy, easy job. …

We now have approximately 4,000 in the Federal Air Marshals Service, yet they have made an average of just 4.2 arrests a year since 2001. This comes out to an average of about one arrest a year per 1,000 employees.

Now, let me make that clear. Their thousands of employees are not making one arrest per year each. They are averaging slightly over four arrests each year by the entire agency. In other words, we are spending approximately $200 million per arrest. Let me repeat that: we are spending approximately $200 million per arrest.

I do not know if the Air Marshall service is a cost-effective way to reduce terrorism, but Rep. Duncan’s “math” proves nothing. If existence of the Marshalls means that no one even attempts to hijack a plane, then no arrests occur and the cost per arrest is infinity. Yet the program is 100% effective.

My hunch is that Air Marshalls are a reasonable method of reducing terrorism. Imagine they prevent one blown-up plane per year. Assuming 200 passengers and $5 million per lost life (roughly the standard estimate from economists), plus a $200 million plane, the avoided cost is at least $1.2 billion compared to a cost of $860 million.

One school of thought about current monetary policy holds that the Fed should start raising interest rates “soon ” (e.g., in a month or two) to avoid the posssibility that inflation pressures build faster than expected and get out of hand before the Fed can react. The other school of thought holds that the Fed should wait on interest rate increases for a while longer because the economy still has substantial slack, as evidenced by high unemployment rates and excess capacity (see discussion here).

The arguments on both sides are reasonable. I would not feel confident picking one approach over the other, even if I had access to all the available data and had spent long hours pondering the relative risks of the two choices.

But here is a different policy the Fed might choose: announce a path for future interest rates that involves small increases at regular intervals over, say, two years.  For example, the Fed might “commit” to raising the target federal funds rate by 25 basis points every three months. Over two years, this would raise the target rate to about 2.00 percent.

This approach “splits the baby” between the inflation hawks and the inflation doves. More importantly, it reduces uncertainty about monetary policy, assuming the Fed can credibly commit to this path of gradual increases.

The commitment issue is crucial; if inflation heats up faster than expected, or the economy languishes longer than expected, the Fed would be under significant pressure to abandon its pre-announced path for interest rates.

That is a valid concern, but I still think this approach is a reasonable middle ground that gives markets a sensible guidepost for future monetary policy.

I have just finished reading The Big Short, by Michael Lewis (author of Liar’s Poker, Moneyball, and The Blind Side).

Lewis’s main message is that Wall Street engaged in reckless and dishonest behavior by leveraging and mispresenting unimaginable amounts of risky, subprime debt.

Lewis’s analysis seems exactly right. And it makes me even more outraged that we bailed out the Wall Street financial institutions. If Lewis’s characterization is correct, these firms deserved to fail, from every perspective.

The counter-argument is that, however badly the Wall Street guys behaved, letting them fail would have devasted the economy, so we had to let them off the hook.

My best guess is that the damage to the rest of the economy from widespread failure would have been substantially less severe than asserted by defenders of the bailout.

But even if I am wrong, I am tempted to think that any chaos would been worth it to punish the arrogant, reckless, and greedy behavior that occurred.

I should add that I am delighted to defend enormous profits for Wall Street firms and lavish bonuses for their executives in good times, assuming they all get royally f—ed in bad times (as the characters in The Big Short might say). That is how capitalism is supposed to work. It might not be pretty, but I think it beats the alternative.

One of Mexico’s drug kingpins, Ismael Zambada (aka “El Mayo”), recently gave an extended interivew to Proceso, one of Mexico’s major news magazines (English summary here). The most interesting aspect for the legalization debate is this:

Zambada insisted … that the drug trade would continue unabated if he was arrested.

”When it comes to the capos, jailed, dead or extradited — their replacements are ready.”

Zambada’s statement is consistent with historical experience: law enforcement has captured or killed a long line of kingpins, with no descernible impact on the drug trade. Apparently the supply of people willing to take these risks is significant, given the enormous monetary incentives.

Roberton Williams and Roseann Altshuler, both of the Tax Policy Center, argue that the following statements about the U.S. tax system are myths:

1. The poorest and the richest Americans pay no taxes.

2. Americans are overtaxed.

3. Higher taxes could eliminate the federal deficit.

4. Most people’s tax returns are way too complicated.

5. You should aim for a big tax refund.

I accept their facts on these claims, but one could spin several quite differently. They find, for example, that about 25 percent of Americans pay no federal tax.  That seems like a big number to me! Likewise, U.S. taxes may be low relative to GDP, but they are more significant when measured per capita (see Greg Mankiw’s post). And the fact that some people can use a 1040-EZ does not prevent others from facing enormous complexity.

The most interesting fact concerns myth number 3:

A study we conducted at the Tax Policy Center found that Washington would have to raise taxes by almost 40 percent to reduce — not eliminate, just reduce — the deficit to 3 percent of our GDP, the 2015 goal the Obama administration set in its 2011 budget. That tax boost would mean the lowest income tax rate would jump from 10 to nearly 14 percent, and the top rate from 35 to 48 percent.

What if we raised taxes only on families with couples making more than $250,000 a year and on individuals making more than $200,000? The top two income tax rates would have to more than double, with the top rate hitting almost 77 percent, to get the deficit down to 3 percent of GDP. Such dramatic tax increases are politically untenable and still wouldn’t come close to eliminating the deficit.

In other words, our deficits are really big!

ObamaCare is modeled, approximately, on the health insurance plan adopted in Massachusetts in 2006. So it is useful to watch developments here as an advance view of how ObamaCare will operate:

Thousands of consumers are gaming Massachusetts’ 2006 health insurance law by buying insurance when they need to cover pricey medical care, such as fertility treatments and knee surgery, and then swiftly dropping coverage, a practice that insurance executives say is driving up costs for other people and small businesses.

In 2009 alone, 936 people signed up for coverage with Blue Cross and Blue Shield of Massachusetts for three months or less and ran up claims of more than $1,000 per month while in the plan. Their medical spending while insured was more than four times the average for consumers who buy coverage on their own and retain it in a normal fashion, according to data the state’s largest private insurer provided the Globe.

This is precisely the kind of strategic behavior that many critics of OamaCare fear; this one results from the ban on pre-existing conditions combined with community rating.

And this gaming is exactly the kind of “dynamic” effect that CBO’s cost estimates tend to miss. CBO engages in “static” scoring, which means it does not incorporate behavioral responses to the incentives created by a law. Its cost estimates are therefore almost certainly too low.

Note that static scoring is understandable; the correct assumptions to employ in dynamic scoring are not obvious, so dynamic scoring might be more open to political manipulation than static scoring.

But honest discussions should recognize that static scoring will typically underestimate a bill’s expenditure and overestimate its revenues. My colleauges Greg Mankiw and Matt Weinzierl have a nice paper on this issue.

With job openings scarce for young people, the number of unpaid internships has climbed in recent years, leading federal and state regulators to worry that more employers are illegally using such internships for free labor.

Convinced that many unpaid internships violate minimum wage laws, officials in Oregon, California and other states have begun investigations and fined employers.

Your first reaction to this story might be, “Well that’s just ridiculous: how can it make sense to prevent employers and interns from engaging in a mutually beneficial interaction?”

It does not. But that is exactly what minimum wages laws are meant to do: prevent a willing employer and employee from engaging in mutually beneficial interaction at a wage below the legal minimum.

So the logic of minimum wage laws implies that unpaid internships are a violation. One more reason to repeal such laws.

Paul’s op-ed in today’s NY Times is a useful starting point for discussing this topic.

Paul says that the Volcker plan – keeping banks small so they will not be too big to fail – is not going to stop financial crises because banking panics can and have occurred even when all banks were small, e.g., during the Great Depression. I agree.

Paul then argues for better regulation of bank balance sheets; that is, rules that prevent banks and other financial institutions from holding too many risky assets.

This view makes sense in principle. Deposit insurance and the implicit insurance emboddied in the Too-Big-to-Fail doctrine create strong incentives for financial institutions to assume too much risk, so regulation is needed to counter this tendency.

I am not persuaded, however, that more or better balance sheet regulation will work in practice. Financial institutions will try to innovate around the regulation, especially given the explicit and implicit insurance from government. This is what happened over the past decade.

Is there another alternative? Yes: eliminate the explicit (FDIC) and implicit (TBTF) insurance that generates the excess risk-taking in the first place.

The standard criticism of this approach is that before the U.S. adopted deposit insurance, created the Fed, and enshrined TBTF, banking panics were more frequent.

True.  But most panics in the pre-Fed, pre-Deposit inusrance era were not especially severe or associated with major recessions. Instead, most were short and geographically confined.

So maybe the banking panics that occur in the absence of government insurance are the lesser of the evils.

A reporter for an environmental web site recently asked me how the U.S. can become a leader in green energy; here is my response:

We should not try to become a leader in green energy.  Indeed, we should undue most existing policies that attempt to promote green energy.  Here’s why.

People give two main reason for reducing our use of fossil fuels: we do not want to have to buy oil from Middle Eastern countries, and we believe green energies produce less pollution or global warming than fossil fuel. Each of these arguments is misguided.

The energy independence argument is exaggerated because oil exporters cannot withhold it or use it as a “weapon” without hurting themselves (it is hard to eat oil). Plus, oil comes from many countries, and oil is only one fossil fuel.

The pollution/warming argument founders on the fact that green energies are much more expensive than fossil fuel. This means they use more resources, so even if they produce less pollution or warming, they are inferior unless the costs of pollution/warming are sufficiently great to offset the difference in private costs. This does not appear to be the case. Indeed, many green energies are more polluting or warming than fossil fuel (e.g., ethanol).

Even if we do want to discourage fossil fuels, moreover, the best method is to tax it. This raises the price and gives markets a clear incentive to consider other methods. Research subsidies, fuel effiiciency standards, and the like have poor track records at reducing the use of fossil fuel.

This discussion also relates to the Administration’s recent announcement of new fuel economy standards for cars and trucks. A higher gas tax would be far more effective.