The National Bureau of Economic Research today announced that its Business Cycle Dating Committee had officially determined a peak in economic activity at December 2007, which signals the start of the recession. I am a member of the committee. Though I speak only for myself, not the committee, I offer my views on two questions of possible interest:

(1) Who needs the NBER Business Cycle Dating Committee (BCDC) anyway?

(2) Why did we pick December 2007 as the starting month of the recession?

(1) We sometimes hear the question "Who needs the NBER Committee anyway?" This question most often comes in one of two forms:

(1a) Everyone in the real world has known that the economy has been in a serious recession for some time. In past cycles, media reports have sometimes taken the line "Ivy Tower Eggheads Finally Figure Out What Everybody Else Has Known All Along." The implicit critique is that the committee takes too long after the event -- typically almost a year -- to make its declaration. One short answer is that our job is to be definitive, not fast. GDP and other government statistics are often revised after the fact, for example. We don't want to have to revise our dating of the peaks and troughs later, in part because it would sow confusion among those who rely on them (from econometric researchers to political speechwriters). We leave it to others -- pundits, forecasters, consulting companies, financial newsletters, and so on -- to try to get there first. We deliberately get there last.

(1b) The other form taken by the question "Who needs the NBER committee?" runs as follows: "The rule of thumb is simple: two consecutive negative quarters of GDP growth. Why complicate things?" The Frequently Asked Questions segment of the BCDC announcement answers this in detail. For now, observe simply that questions (1a) and (1b) are inconsistent with each other. As of December 1, 2008, the US economy has not yet experienced two consecutive negative quarters. So an argument that we should wait for two consecutive quarters (critique 1b) is the opposite of the critique that we should have acknowledged a recession before now (critique 1a).

(2) The more important question is: Why did we pick December 2007 as the start of the recession? As is the case surprisingly often, different economic indicators give very different answers to the date of the peak.

Of the monthly indicators to which the BCDC gives primary attention, the most important is jobs, more specifically Payroll Employment (from the Labor Department's Bureau of Labor Statistics). It peaked in December 2007, and has been declining ever since. My personal favorite indicator is Total Hours Worked (which is closely related, because it is number of people employed times the average number of hours per worker). Hours Worked also peaked in December, as shown in the graph below.

Of the quarterly indicators, the most important is aggregate economic activity, more specifically, Output. The Commerce Department's Bureau of Economic Analysis computes two measures of output: Gross Domestic Product (GDP) and Gross National Income (GNI). The two should be the same in theory, but differ in practice due to measurement errors. GDP receives far more public attention, but in fact has no claim to be a more accurate measure of output than does National Income. The statistics currently available show that GNI peaked in Quarter 3 of 2007, whereas GDP peaked in Quarter 2 of 2008. A simple-minded average of the two peak dates would seem to point to midnight of New Year's Eve, December 2007, as the peak. Another (comparably unsatisfactory) way of forcing the output data to cough up a precise month is to look at Personal Income, which is available monthly. The BCDC's computed measure of real personal income less transfers peaked in December 2007.

It would be wrong to claim that all roads arrive at the same destination, December 2007. Other indicators point to other dates, some earlier, some later. If we are very lucky, revisions that the BEA makes in July 2009 will help resolve the discrepancy between the GDP and GDI measures somewhere in the middle. But perhaps the best characterization of the output measures is that they show a rough plateau from the fall of 2007 to the summer of 2008. That the employment statistics speak more clearly allows them to have the predominant say.

Over the last 24 hours, President-Elect Obama has announced his new economic team. What do they all have in common?

Retreads from the Clinton Administration? Rubin protéeacute;géeacute;s? No, not all.

Friends of mine? Well, yes. As it happens, they have been friends, for 12-to-30 years. (god forgive me. There is no greater turnoff in a column than an author who thinks it's "all about me." On the other hand, this isn't a column. It's just my personal blog. So what the hell.)

Yesterday, President-elect Obama formally introduced Larry Summers as his choice for Chair of the National Economic Council and Tim Geithner as his choice for Treasury Secretary. Both excellent choices.

At the same time, he introduced Prof. Christina Romer as his choice for Chair of the Council of Economic Advisers. Christie was my colleague for 20 years in the Economics Department at the University of California, Berkeley; she and her husband David Romer form a team who were my favorite daily lunch companions during that period. Although this is her first policy job, she is another excellent choice. She, together with Fed Chairman Ben Bernanke, have the added bonus of being among the world's top experts in the monetary history of the Great Depression, an expertise that is of unexpected benefit at the current juncture.

Today, Obama also announced Peter Orszag as his choice for Director of the Office of Management and Budget. In 1996, when I arrived at the Council of Economic Advisers, Peter was a Senior Staff Economist at CEA, working on international economics. Even then his extraordinary abilities had made him indispensable to top officials. He was the sort of person who rises very quickly in a merit-oriented government: not just extraordinarily smart, but able to get lots of things done very quickly and very well. When Peter returned from a quick spell at the London School of Economics (finishing his doctoral degree), he moved to a key position on the National Economic Council staff. More recently, he has been director of the Congressional Budget Office. This position at the Capitol Hill end of Pennsylvania Avenue is the counterpart to the OMB Director job at the White House; thus Orszag will "hit the ground running" with respect to the budget, in the same way that Geithner will with respect to the financial crisis.

Irrelevant gossip: At the height of the East Asia crisis in 1998, I hosted a party in honor of Peter Orszag. The party is mentioned in Paul Blustein's The Chastening (which remains the book that gives the best blow-by-blow account of the East Asia crisis), because Joe Stiglitz took Stanley Fischer outside on the doorstep to voice in person the critiques of the IMF's management of the crisis that he had been making in public. The reason they went outside was so that Larry Summers, who was managing the crisis from the Treasury, could not hear them inside.

No, the reason that Obama chose this team is that they are The Best and Brightest and The Least Arrogant. As he says, the American people want effectiveness.

The phrase "The Best and the Brightest" comes readily to mind because their IQs are off the chart. After 8 years of the current President and his appointees, I hope that the American public, despite its understandable anti-elitist bias, understands that intelligence and ability do actually matter.

But IQ in an academic sense, by itself, is a very incomplete qualification for higher office. Many university professors are famous for being as bad at social skills, personnel management, openness, and humility as they are smart – all abilities which are just as important in policy making. Indeed, the phrase The Best and the Brightest comes from the famous book by David Halberstam, where the phrase is meant ironically since the Kennedy brain trust screwed up so badly in Vietnam. The McNamaras were arrogant in the same sense as Cheney and Rumsfeld: when reality diverted from their pre-conceptions (whether in Asian wars or other policy areas), they stubbornly refused to process the discrepancy and to adjust course. But the Obama team is different. It is The Best, the Brightest, and the Least Arrogant. With one possible exception, these people have no ego, no rough edges. They are not close-minded or stubborn. They are not ideologues. They will scoop up facts and arguments, on all sides of a policy question, before making a decision; and even after a decision has been made, they will monitor new information as the situation develops and adjust course when necessary. These traits, more than anything, has been missing from government in recent years.

Many will object to this description with the observation that Larry Summers is famous for being arrogant. Summers' arrogance is a little overdone, compared to some others I could name. But it is true that Larry's personality is not ideally suited for the traditional job description of the Chair of the National Economic Council, which is to be an honest broker (in the classic phrase of Roger Porter's early description of the proto-position). The NEC manages the decision-making process in the White House. It must make sure that every agency feels that its views have been heard and fairly represented to the president. ("Agencies" here means not just cabinet departments like Treasury, State, Commerce, Labor, Agriculture, HHS, etc., but also White House agencies such as CEA, OMB, NSC, etc.) It is evident that Larry was given the title of NEC Director so that he could have the status of Principal, which means he gets a seat at the table in cabinet-level meetings, as opposed to having to sit in the row behind, where the top aides sit. I am sure that Obama realizes that Larry is not perfectly suited to the honest-broker role. (The same was true of Larry Lindsay, who was fired from the NEC Director position by George W. Bush not just because he correctly forecast that the cost of the Iraq war would be higher than the official line. He did not have a lot of interest in running the policy process, and was rather more interested in expressing his own views to the President, as compared to his more bureaucratically inclined successors.)

Not to worry. The Wall Street Journal has evidently reported that the NEC will have Jason Furman as Deputy Director. Jason, who has been Obama's Economic Policy Director during the national campaign, could not possibly be better suited to the job of running the policy process as an honest broker. He is a young version of the others: brilliant, tireless, non-ideological; no ego, no rough edges, a team player. I know. He worked for the CEA in 1996 and 1997.

The Best, The Brightest and the Least Arrogant. Current conditions are so bad it would be foolish to make an optimistic prediction about economic performance over the coming years. But I will make the prediction that this team will function like clock-work, and give the country the most capable economic policy making it has had in many a decade.

News services reported today that Tim Geithner, currently President of the Federal Reserve Bank of New York, was President-elect Obama’s choice to be Secretary of the Treasury. The markets reacted very positively to the news. This presumably captures both relief that some policy uncertainty has been resolved at this critical juncture and approval that Geithner is the man chosen. I share the pleasure at this appointment.

Tim Geithner is refreshingly straightforward and personable, and doesn’t “stand on ceremony.” At the same time, he is cool and unflappable. By coincidence, the Economic Advisory Panel to the NY Fed President, of which I am a member, met today. Unusually, Geithner excused himself at two points in the four-hour meeting to take short phone calls. Given the timing, it seems very likely that one of the phone calls was Senator Obama offering him the Treasury position. These Panel meetings are off the record, but I think I am not betraying any confidences to report that Geithner betrayed no sign to us of what had just happened. No change in demeanor, no change in the substantive flow of the discussion. This is a guy who does not lose his cool. Just what the country needs.

Everyone speculating on President-Elect Obama's most likely choice for Secretary of the Treasury has the same two names: Larry Summers and Tim Geithner. I have known them for a long time, and worked with both in the Clinton Administration. Either one would be excellent. Geithner is now way ahead in the Intrade odds: 45% to 27% as of November 14. But my guess is that Obama will go with Summers. For one thing, Geithner is needed at the New York Fed, where he has been one of the key players managing the financial crisis.

They are both said to have baggage that might disqualify them. I disagree. Some say Geithner is tarred by association with the Bush Administration, because he has been working with it on the financial crisis. But his position is non partisan, and some continuity managing this crisis is desirable. More to the point, it was in the Clinton Administration —under Larry Summers – that Geithner rose from obscurity to prominence. Some say that Obama should not choose either of them, precisely because they are associated with the Clinton Administration and he campaigned for change. But that is the most absurd argument of all. We need somebody experienced in this job. The sort of competence these two showed at the 1993-2001 Treasury, especially at crisis management, and the track record of that Administration, is what we want to change to, not what we want to change from. All the economic indicators improved during the Clinton Administration, as surely as they have worsened since then: employment, growth, inflation, budget balance, poverty, and so on.

Most sensationally, Summers is said to be tainted by his time as President of Harvard. Too much has already been said about this. But I will make just a couple of observations. First, although Summers may not be Mr. Personality, and he will never be elected to high office nor chosen to head offices for women's rights or the environment, he has all the most important qualities for the Treasury job. Despite a tendency to say what he thinks, I don't think he committed any true faux pas or became involved in any mini-scandals during 8 years in the government — no easy feat. (The closest he came to a faux pas, or what counts for one in the media, was a statement that the argument for abolishing the estate tax was based on greed rather than efficiency — a statement that he quickly retracted without bothering to try to explain what he had meant, having already by then become familiar with the rules of political brouhahas.) In his time in Washington, he learned how to get along with politicians across the spectrum, from socialists to the far right. It's true that he wasn't able subsequently to get along with the full range of faculty in the Harvard English Department, but that is a tougher task.

Finally, I continue to be surprised at how the press describes Summers' ill-fated and ill-considered (but "off the record") remarks regarding explanations for the lack of women in academic science departments. He is most often reported as having suggested that women generally have less aptitude for science than men. I link to the text here, and urge readers to make up their minds for themselves. But I don't read his speculation about the various hypotheses quite the way many people have assumed. To me the outrageous line in the remarks was, rather, the suggestion "that no economist who had gone to work at the President's Council of Economic Advisers for two years had done highly important academic work after they returned"!

Three areas that our new President will have to address during his term in office are the recession, energy and the environment, and the long-run fiscal outlook. The recession is the most urgent. But the long-run fiscal outlook will be the most difficult. Social Security and Medicare would have made addressing the long-run fiscal outlook difficult in any case. (Did you know that the first baby-boomers are starting to draw Social Security this year?) The Bush tax cuts of 2001 and 2003 made it worse. The rapid spending increases of the last eight years made it still worse. The financial crisis and recession are now making it still worse. To be clear, fiscal stimulus today is appropriate, given the weak economy. The trick is to combine it with the minimum damage to future budgets.

I offer some recommendations to the new President regarding tax policy that address all three areas simultaneously:

1. Make clear the intent to let the Bush tax-cuts-for-the-rich expire in 2011 as scheduled. No, the Republicans can't legitimately claim that this would be a tax increase, because their budget projections (remember, the projections that said we were going to have a budget surplus by 2011) have always built in the assumption that these tax cuts would expire. This plan will help maintain some semblance of long-term fiscal responsibility and therefore help keep long-term interest rates low, which one hopes will have the Rubinomic extra benefit of promoting investment.
2. Give the 90% or 95% of American workers who don't make the highest incomes a tax cut now, as Barack Obama talked about in the campaign. This is good for incentives, good for distribution, and good for boosting demand which is what we need in the short run.
3. 3. Take steps to raise future tax rates on fossil fuels, including gasoline. This would accomplish lots of objectives:
   1. raise much-needed revenue in the future (or else help finance those reductions in tax rates on lower-income workers),
   2. enhance national security by reducing dependence on imported oil
   3. improve the trade balance
   4. reduce emissions of greenhouse gases, particularly in the future by sending the right price signal today
   5. reduce local air pollution, traffic congestion, and traffic accidents.

In the past, such tax proposals have always been considered political suicide. But here are two ideas to reduce political resistance: (i) put a floor under domestic prices of fossil fuels at current levels, by making up any future falls in world energy prices by means of taxes; (ii) respond to any future major national security setback, if it were to occur (god forbid), by asking Americans to do their part toward sacrifice in the form of energy conservation. Since the responses tried by the Bush Administration to the tragedy of 9/11 didn't work very well (invading an irrelevant country and telling Americans to go shopping), the public may be open to an intelligent response next time.

Is the United States in recession? If one looked solely at the adverse shocks that have hit the economy over the last year, one would infer an unusually high probability of a recession. If one consulted some of the most import economic measures over the last year, one would say we clearly entered a recession last January. If one gauged the popular mood, one would hear, "Of course we are in recession!"

The one criterion that has been missing is the one criterion that people most commonly have in their minds as the definition of a recession: two consecutive quarters of negative growth. This morning, October 30, the Commerce Department released the preliminary estimate of GDP in the 3^rd quarter. It showed a decline. The decline was small: just 0.3 per cent at an annual rate, and it is only quarter. But at this point there can be little doubt that we are really truly in recession.

The adverse shocks include the most severe housing bust in more than 70 years, an oil shock as big as those of the 1970s, the greatest financial crisis since the Great Depression, and the worst fiscal outlook ever. Any one of these developments would normally be enough to send an economy into recession. Leading economists from Martin Feldstein to Larry Summers have since the start of the year been warning that the downturn has arrived.

And sure enough, many of the most reliable statistical indicators have suggested all year that we are in recession.

The most important statistical criterion besides GDP is employment. Jobs peaked in December 2007 and have declined steadily ever since. The cumulative loss is 760 thousand (or 0.55%) as of September. My personal favorite among indicators is Total Hours Worked in the economy, because it combines both employment (number of people working) and average length of workweek (are they working 40 hours a week? Overtime? Part-time?). Total Hours Worked shows a similar pattern as employment, but with an even steeper decline since December: 1.4%. (The Bureau of Labor Statistics is the agency that releases these numbers, on the first Friday of the subsequent month.)

The index Leading Economic Indicators, which is designed to try to warn of turning points in advance, turned down more than a year ago. Not only that, but also the index of Coincident Economic Indicators, which is supposed to move contemporaneously with the real economy, appears clearly to indicate that a recession started toward the end of 2007.

Housing prices as of August are down 27%, relative to their peak in July 2006 (Case-Shiller composite of 20 cities). Consumer confidence, an important determinant of household spending, fell to an all-time low in September, according to the October 28 release from the Conference Board. The version collected by the University of Michigan is also looking quite bleak. Retail sales are down, especially autos. The trend in industrial production has been downward for a year, and accelerated in August and September. Corporate profits are down.

But it is still not yet officially a recession! Why not? The most important criterion for dating business cycles is real growth. The rate of change of real GDP, surprisingly, was above zero in the first quarter of 2008, and was even moderately strong in the second quarter: 2.8%. (The revised "final" estimate of GDP in the fourth quarter of 2007 did turn out to be below zero, but just barely.) It is quite a mystery why output pointed up during the first half of the year, while everything else pointed down. Clearly the demand for US goods received some boost in the 2nd quarter from tax rebates and exports, both of which are expected to diminish subsequently.

But perhaps there is some measurement problem with GDP. Gross National Income (GNI) has as much claim to measure growth as Gross National Product does. In theory the two are supposed to be virtually the same: the value of goods and services sold is conceptually the same as the value of income earned. Real GNI did in fact turn down in the 4th quarter of 2007 and the first quarter of 2008, though it rebounded in the third quarter as real output did. Real personal income – one of the indicators that the NBER Business Cycle Dating Committee looks at – has been declining almost throughout the year.

The weight of evidence is overwhelming: we are currently in recession.

Did it start at the end of 2007, when employment and the other indicators peaked? Or was the stimulus from the government and from exports enough to hold off the turning point, and did the recession thus only start towards the end of the summer, when the financial crisis intensified very sharply? I am afraid that we need to wait for some more data and some more (regularly scheduled) revisions before we will know.

Why has the yen strengthened so much the week, even though the Japanese stock market has plummeted? The financial media have largely got this one right: the answer is unwinding of the carry trade, and the associated flight to quality, which means flight to yen and dollar (cash and treasury bills).

This was to be expected. It is an unseemly tooting of ones' own horn, but –

Earlier this year I wrote in an article in the Milken Institute Review (vol. 10, no. 1, pages 38-45)

"The traditional pattern is most clear with the carry from the yen to the euro: it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro."

("Getting Carried Away: How the Carry Trade and Its Potential Unwinding Can Explain Movements in International Financial Markets.")

Although the phrase "carry trade" became widely popular in the context of currency speculation, where scholars know it as the “forward discount bias,” its etymological root is in commodity speculation. The same phenomenon is observable in housing, equities, commercial bonds, and emerging markets: when money is easy and nobody is worried about risk (2002-2005), the search for yield sends the excess liquidity surging out of the low-interest currencies, and into all other assets. When the process reverses, investors pull out of the risky assets and retreat back to the safe haven of the low-interest-rate currencies. Over the last six months, the reversal of this broadly-defined carry trade hit equities and bonds first, and then commodities (having hit housing earlier, of course). This month it is finally hitting the high-interest-rate currencies.

The first thing to say about the calls for a "new Bretton Woods" is that they overreach, in the sense that it is very unlikely that any changes in the structure of the international monetary or financial system will or should, at this point in history, come out of multilateral discussions that are big enough to merit comparison with the first Bretton Woods. Certainly we are not talking about fixing exchange rates, as the 1944 meeting did.

Detour for an anecdote. In mid-1998, when the crisis that originated in Southeast Asia had reached its one-year anniversary without abating, President Bill Clinton decided to give two important speeches. He wanted to call for a new Bretton Woods. His economic advisers (including both at Treasury and in the White House) advised him against this, on the grounds that one should not call for something as portentous as a new Bretton Woods when one was not likely to have proposals substantive enough to merit the name. Soon after the (successful) speeches, British PM Tony Blair called for a new Bretton Woods. Clinton asked his advisers, "How come Blair got to call for a new Bretton Woods when you wouldn't let me do it?" Our answer was along the lines, "Blair's Treasury Secretary, Gordon Brown, doe s not necessarily have his interests aligned with his boss, in the way that Bob Rubin does. So Brown had less incentive to stop Blair from saying something foolish." The big irony of the story is that Brown today is himself leading the move for a "new Bretton Woods."

Nevertheless, it is worth taking the opportunity to consider what changes - whether more ambitious or less — might be made at the multilateral level to improve the functioning of the system.

Changes in government policy at the national level have already been radical in many countries, compared to anything that would have been imagined a short time ago:

• central banks' extension of credit to institutions and under terms not contemplated in the past,
• governments' buying up bad assets and taking over troubled banks and financial institutions (or engineering their transformation),
• agencies guaranteeing deposits (without limit) and money market funds, and so on.

Some of these steps can be done at the purely domestic level (US takeover of Fannie Mae and Freddie Mac); others require cooperation between a small number of countries (rescue of Fortis by Benelux countries); but others arguably require multilateral agreement, and thus are candidates for a modest "Bretton Woods."

• The International Monetary Fund has been given the task of outlining what a new Bretton Woods would look like - appropriate since the IMF is one of the original Bretton Woods institutions (along with the World Bank).
  • An Early Warning system is almost certain to be high on its list. But it already developed early warning indicators, after the East Asia crisis of 1997-98, and they haven't been much help.
  • Now that the financial crisis is spreading to small economies like Iceland, transition economies in easternmost Europe, and poor countries like Pakistan, the IMF country rescue programs will get back in the saddle.
    • This time around, however, the Fund has more competition (including from the ECB, the Gulf countries, China, and Sovereign Wealth Funds), and partly for that reason will probably demand less conditionality from the borrowing countries.
      • Bill Rhodes has proposed that the Fund facilitate expansion of currency swap arrangements, to allow emerging markets to have the same access that has been made available to developing countries; and that it should try to resurrect a lending facility known as Contingent Credit Lines.
      • The Fund would have to turn to newly-wealthy countries like China to help finance such new facilities and programs.
      • Michael Bordo and Harold James have suggested that the Fund could manage reserve assets of the new surplus countries; but it is not clear why the latter should want it to.
    • There has been a loose one-year campaign to suggest guidelines for the operations of Sovereign Wealth Funds themselves. But benefits of the SWFs may be more widely appreciated now, in the context of the current crisis than previously.
    • The IMF, just as all the multilateral economic institutions, has moved far too slowly to give added representation to the newly important developing countries such as China, Brazil, Korea, India and Mexico - representation at least in proportion to their economic role, to say nothing of population.
      • A big part of the problem is that larger quotas and voting shares for these countries would have to come to a substantial extent out of Europe's share.
      • In a fair world, Europe would also give up its stranglehold on the Managing Directorship (especially after the performance of the last two incumbents); and the same goes for the U.S and the World Bank presidency.
  • The IMF, just as all the multilateral economic institutions, has moved far too slowly to give added representation to the newly important developing countries such as China, Brazil, Korea, India and Mexico - representation at least in proportion to their economic role, to say nothing of population.
    • A big part of the problem is that larger quotas and voting shares for these countries would have to come to a substantial extent out of Europe's share.
    • In a fair world, Europe would also give up its stranglehold on the Managing Directorship (especially after the performance of the last two incumbents); and the same goes for the U.S and the World Bank presidency.
  • The G-8 has been increasingly handicapped in recent years by virtue of its obsolete membership.
    • How can they discuss global current account imbalances or the need for exchange rate adjustments without China and Saudi Arabia at the table? It looked like the G-20 would supplant the G-7.
    • The G-7 still retains some relevance, in its role as self-appointed steering committee for world governance. After all, this financial crisis did not start in the developing countries, as it did those of 1982, 1997 and 2001.
    • But they will still have to start inviting China, Saudi Arabia, and any other country that they expect to help finance any of its plans.
  • The most probable substantive outcome from talk of the need for a bold new multilateral initiative is that there could be a "Basel III" to replace the "Basel II" agreement.
    It would make capital requirements on banks countercyclical, rather than what has turned out to be procyclical, i.e., destabilizing, under Basel II. (Ironically economists at the BIS in Basel probably deserve credit for being the observers, in addition to Charles Goodhart, who most accurately warned of the procyclicality before the crisis.)
    • A Basel III could also replace the option of self-regulation of banks (under which they could choose their own Value At Risk models) with external regulation.
    • International guidelines for guaranteeing deposits (possibly reinstating a ceiling, such as $100,000, after the crisis has passed) should perhaps be coordinated, to avoid flight of the sort that Ireland's European partners experienced.
  • Other possibilities:
    • A more ambitious reform would be to try to agree on guidelines to extend prudential regulation from international banks to non-bank financial institutions, since the latter were such a serious part of the problem in 2008 that many either failed or were bailed out, against all expectations.
    • More radically, regulation of this sort not just agreed multilaterally but carried out multilaterally, rather than at the national level, by the BIS (which now includes major emerging market countries) or a new agency.
    • The IMF, Financial Stability Forum, and other institutions will vie to lead the effort.
    • Other radical proposals:
      • A securities transactions tax, harmonized internationally, to raise revenue in a way that satisfies the public's understandable feeling that the financial sector, which created this financial crisis, should not benefit from the solution.
      • Regulation of certain derivatives, such as Credit Default Swaps.
      • But there is a danger that derivatives regulation could do more harm than good, e.g., a ban on futures markets or short-selling.
    • At the other end of the spectrum, one should consider the possibility that doing nothing might in the end be better than undertaking fundamental reforms in the international financial system.

I wish to add my heart-felt approval to many others, regarding the awarding of the Nobel Prize in Economics to Paul Krugman. For those readers of the New York Times who can only think of him as a columnist, let me assure you that long before he ever wrote a newspaper opinion piece, Krugman had become the leading international economist of my generation. I leave it to others to explain the work on trade theory that earned the ultimate accolade. I will only say that (together with Elhanan Helpman) Krugman took traditional trade theory – which ever since David Ricardo had assumed perfect competition, constant returns to scale, and unchanging technology – and made it more realistic by assuming imperfect competition, increasing returns to scale, and endogenous technology.

Paul was my classmate in graduate school at MIT in the mid-1970s. In 1974 I departed my idyllic undergraduate institution for life in the big city (academically speaking). My college mentor had given me some final words of advice: not to waste much time worrying about how a position near the top of my undergraduate class would translate to the MIT Economics Department, where all the students had been at the top of their class. He said, "My impression is that within a few months of starting the graduate program, the students sort out for themselves who is the top student, the second student, and so on, and then they don’t worry about it from then on." As it turned out, it only took two weeks for us to figure out that Paul was the star of the class. This was clear, not so much from grades on problem sets, but from the intense discussion among classmates that is the core of a good graduate program.

When it came time to write a class skit at the annual MIT Christmas party, we did a parody of the Wizard of Oz. There was no question who should play the Wizard, who was a parody of Paul Samuelson: our own Paul. Here are some of his lines, from 34 years ago:

"Though I made a lot of money
No one thought my jokes were funny
'Til I won the Nobel Prize..."

"So you see you can be winners
even though you are just beginners
When you win your Nobel Prize."

Congratulations, Paul. We always knew you would do it!

I propose that the Congressional leadership re-introduce the Trouble Asset Relief Program accompanied by a major new policy: a small tax on securities market transactions. This will accomplish the political goal of aiming a silver bullet into the heart of the (understandable) popular outrage that blocked passage of the TARP bill on Monday. It will simultaneously accomplish the fiscal goal of raising revenue, which the federal government sorely needed even before the bailout arose and will need even more if the taxpayer is to be protected against subsidization of the financial sector.

A tax on securities market transactions might sound like a wild populist policy that would damage the functioning of the economy. But in fact it is far more sensible than such populist measures as banning short sales which have already been tried to no effect.

Proposals along these lines have a distinguished pedigree. Best-known was the Tobin tax proposal, by Nobel Prize winner James Tobin which was specifically aimed at volatility in foreign exchange markets. More relevant to what I am proposing are two articles by the pre-Treasury Larry Summers: “A Few Good Taxes” and “When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax” (1989).   Add another Nobel Prize Winner, Joe Stiglitz.

There is extensive experience with securities transaction taxes, especially in other countries, and there have been quite a few studies of their effects. On the one hand, often the motivation for such proposals is to reduce short-term speculative turnover (a tax of 0.1% means nothing to a long-term investor, but is a strong disincentive to those who trade hold their positions for only minutes or hours), with the idea that this will reduce volatility. On the other hand, often the defenders of unfettered financial markets argue that such a tax will reduce liquidity and thus hurt the customers who depend on the market. The historical experience with small taxes seems to be that there is no discernible effect on volatility. In some cases the volume of trading within the country is affected. But what the tax does usually do is raise a lot of money.

The UK has long had a securities transactions tax known as a stamp duty on the order of 0.3%.  Sweden introduced a 0.50 per cent tax on the purchase and sale of equities in 1984, and kept it until 1991.  (Froot and Campbell, studied these two examples in a 1994 book that I edited.)   India introduced a securities transactions tax in 2004 and Japan, Korea, Taiwan and Hong Kong did so earlier; in these cases there were not significant reductions in either price volatility or market turnover.  Other countries that have had financial turnover taxes of at least 0.10% include Australia, Austria, Finland, Germany, Malaysia, and Singapore.  In addition there are other countrires that have smaller trading fees.

Even the United States imposes an SEC fee of .0033%.  Thus our virginity is already lost.

An important potential drawback if the US were to impose a more substantial transactions tax alone, is that it might drive financial business offshore.   There is an answer to this point.  As noted, lot of countries already have such transactions taxes. Furthermore, lots would love to cooperate with the United States in an international program to harmonize such taxes internationally. This is precisely the sort of thing that many abroad have always asked Americans to participate in, but that we have not hitherto wanted to do.

The level and longevity of the tax could be adjusted over time to achieve the goal of Section 134 the TARP bill: that the taxpayer recoup the costs of the bailout. A 2004 study by the Congressional Research Service reported that an 0.5% tax on stock transfers could raise $65 billion a year. (Others have produced higher revenue estimates.) A tax extended to bonds and derivatives (especially derivatives!) would of course raise more.   Remember that one does not compare this annual revenue to the $700 billion headline cost of the bailout;  rather one compares the present discounted value of the annual flow to whatever of the $700 billion is left over after the government (we hope) collects something on the troubled loans and also recoups something on the warrants obtained from the banks.

The tax might on the margin contribute to a shrinking of the size of the financial sector; but this shrinking needs to happen anyway, as Ken Rogoff has pointed out. And most important politically, it would give expression in a non-damaging way to the blood lust that the public feels toward Wall Street, a venting that needs to take place if the bailout bill is going to be approved.