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Showing papers in "Cato Journal in 2009"


Posted Content
TL;DR: The role of monetary policy and asset prices in financial markets has been examined in the context of the current crisis as mentioned in this paper, with a focus on monetary policy but that does not mean regulatory measures are irrelevant in this context.
Abstract: Crisis: Time to Ponder on Traditional Wisdom Beyond dealing with the immediate problems, any crisis raises questions of why and how we got there and what lessons should be drawn to avoid a repetition of past developments--without laying the ground for a new disaster. This line of inquiry also applies to the current crisis in financial markets. Even during the heaviest turbulence a discussion has started on obvious deficits in the system of regulation and supervision and on badly needed improvements. In this article, I concentrate on monetary policy but that does not mean regulatory measures are irrelevant in this context, quite the opposite. For central banks the relation between monetary policy and asset prices has gained new interest and the dominant view has come under critique. The Consensus View There is a broad consensus around the world that central banks should maintain price stability--keeping inflation low and stable. This objective is reflected in the mandate given to the central banks in many countries. Price stability is normally specified in terms of stabilizing an index of consumer prices in one form or another. There are very good reasons for this practice. The purchasing power of money is undermined by an increase in consumer prices; a constant index of consumer prices maintains the real value of money over time. With stable prices, money serves society best as a unit of account, medium of exchange, and store of value. Any index of consumer prices covers only a segment of prices in an economy--although an important one. Prices of assets like real estate or equities are excluded by definition. Most of the time this omission is not seen as a problem, quite the opposite. Monetary policy can only control the development of goods prices over the medium to long term. But, in times of large movements of assets prices, the debate always starts on whether this concentration of monetary policy on consumer prices alone is appropriate or not. Asset price developments have an influence on spending decisions by companies and households. A rising value of one's house makes people richer and might encourage additional consumption. Higher stock prices reduce the cost of equity financing and might help increase investment. The opposite will happen with falling asset prices. This so-called wealth effect will finally, via changes in expenditures, have an influence on the development of consumer goods prices and should therefore be included in inflation and growth projections by central banks. The strategy of inflation targeting comprises this effect beyond which asset prices should not play a role in the conduct of monetary policy. On the role of asset prices there is wide consensus on the following principles: (1) central banks should not target asset prices; (2) central banks should not try to prick a bubble; and (3) central banks should follow a "mop up" strategy after the burst of a bubble, which means injecting enough liquidity to avoid a macroeconomic meltdown. The first two principles are uncontroversial. A central bank has no instruments to target successfully asset prices and creating a macroeconomic disaster by pricking a bubble would ruin the standing of a central bank. (The role of a central bank as a regulator and supervisor is a separate issue.) On the third principle, there is also broad agreement--once a bubble has burst the central bank has to take all necessary steps to avoid the propagation of the consequences of a collapse of asset prices. However, restricting the role of the central bank to a totally passive role in the period of the buildup of a bubble and practically preannouncing its role as the "savior" once the bubble bursts represents an asymmetric approach that risks creating moral hazard with actors driving the development of asset prices. What can be called the "Jackson Hole Consensus" (Greenspan 2002, Blinder and Reis 2005, Mishkin 2007) is exactly that. …

226 citations


Posted Content
TL;DR: In this article, the effect of corruption in the host country's corruption level on foreign direct investment (FDI) inflows has been investigated and no significant relationship has been found.
Abstract: The surge in foreign direct investment (FDI) flows during the 1990s has motivated a host of recent studies into their determinants. Recently, the level of corruption in the host country has been introduced as one factor among the determinants of FDI location. From a theoretical viewpoint, corruption—that is, paying bribes to corrupt government bureaucrats to get “favors” such as permits, investment licenses, tax assessments, and police protection—is generally viewed as an additional cost of doing business or a tax on profits. As a result, corruption can be expected to decrease the expected profitability of investment projects. Investors will therefore take the level of corruption in a host country into account in making decisions to invest abroad. The empirical literature on the effects of the host country’s corruption level on FDI inflows, however, has not found the commonly expected effects. Some empirical studies provide evidence of a negative link between corruption and FDI inflows, while others fail to find any significant relationship. Most existing studies use a cross-sectional rather than a panel data analysis to examine the effects of a complex phenomenon. Such a method cannot control for the unobserved country-specific effects

210 citations


Posted Content
TL;DR: In country after country, we see governments panicked into knee-jerk responses and throwing their policy manuals overboard: bailouts and nationalizations on an unprecedented scale, fiscal prudence thrown to the winds, and the return of no-holds-barred Keynesianism as discussed by the authors.
Abstract: There is no denying that the current financial crisis has delivered a major seismic shock to the policy landscape. In country after country, we see governments panicked into knee-jerk responses and throwing their policy manuals overboard: bailouts and nationalizations on an unprecedented scale, fiscal prudence thrown to the winds, and the return of no-holds-barred Keynesianism. Lurid stories of the excesses of “free” competition—of greedy bankers walking away with hundreds of millions whilst taxpayers bail their institutions out, of competitive pressure to pay stratospheric bonuses and the like—are grist to the mill of those who tell us that “free markets have failed” and that what we need now is bigger government. To quote just one writer out of many others saying much the same, “the pendulum will swing—and should swing—towards an enhanced role for government in saving the market system from its excesses and inadequacies” (Summers 2008). Free markets have been tried and failed, so the argument goes, now we need more regulation and more active macroeconomic management. 1

157 citations


Posted Content
TL;DR: Kaufman as discussed by the authors presented a paper on public regulation of depository institutions at a conference on Public Regulation of Depository Institutions, Koc University, Istanbul, Turkey in November 1995.
Abstract: George G. Kaufman is the John F. Smith Professor of Finance and Economics at Loyola University Chicago and a consultant at the Federal Reserve Bank of Chicago. This paper was initially prepared for presentat ion at a conference on Public Regulation of Depository Institutions, Koc University, Istanbul, Turkey in November 1995. The author thanks Douglas Evanoff (Federal Reserve Bank of Chicago) and an anonymous referee for helpful comments on earlier drafts.

156 citations


Posted Content
TL;DR: In this paper, the authors describe the factors that contributed to the financial market crisis of 2008 and propose policies that could have prevented the baleful effects that produced the crisis, and then propose policies to prevent the negative effects that led to the crisis.
Abstract: I begin by describing the factors that contributed to the financial market crisis of 2008. I end by proposing policies that could have prevented the baleful effects that produced the crisis. Factors Contributing to the Financial Crisis At least three factors exercised significant influences on the emergence of the global financial crisis. Factor One: Expansive Monetary Policy The basic groundwork to die disruption of credit flows can be traced to the asset price bubble of the housing price boom. It bas become a cliche to refer to an asset boom as a mania. The cliche, however, obscures why ordinary folk become avid buyers of whatever object has become the target of desire. An asset boom is propagated by an expansive monetary policy that lowers interest rates and induces borrowing beyond prudent bounds to acquire the asset. The Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25 basis point increase in August 2006. The rate cuts that began on August 10, 2007, and escalated in an unprecedented 75 basis point reduction on January 22, 2008, was announced at an unscheduled video conference meeting a week before a scheduled FOMC meeting. The rate increases in 2007 were too little and ended too soon. This was the monetary policy setting for the housing price boom. In the case of the housing price boom, the government played a role in stimulating demand for houses by proselytizing the benefits of home ownership for the well-being of individuals and families. Congress was also more than a bit player in this campaign. Fannie Mae and Freddie Mac were created as government-sponsored enterprises. Beginning in 1992 Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low- and moderate-income borrowers. In 1996, HUD, the department of Housing and Urban Development, gave Fannie and Freddie an explicit target: 42 percent of their mortgage financing had to go to borrowers with incomes below the median income in their area. The target increased to 50 percent in 2000 and 52 percent in 2005. For 1996, HUD required that 12 percent of all mortgage purchases by Fannie and Freddie had to be "special affordable" loans, typically to borrowers with incomes less than 60 percent of their area's median income. That number was increased to 20 percent in 2000 and 22 percent in 2005. The 2008 goal was to be 28 percent. Between 2000 and 2005 Freddie and Fannie met those goals every year, and funded hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans made to borrowers who bought houses with less than 10 percent down. Fannie and Freddie also purchased hundreds of billions of dollars worth of subprime securities for their own portfolios to make money and help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities. Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor people allowed Congress and the White House to subsidize low-income housing outside of the budget, at least in the short run. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis (Roberts 2008). Fannie and Freddie were active politically, extending campaign contributions to legislators. Factor Two: Flawed Financial Innovations A second factor that influenced the emergence of the credit crisis was the adoption of innovations in investment instruments such as securitization, derivatives, and auction-rate securities before markets became aware of the flaws in the design of these instruments. The basic flaw in each of them was the difficulty of determining their price. Securitization substituted the "originate to distribute securities" model of mortgage lending in lieu of the traditional "originate to hold mortgages" model. …

140 citations


Posted ContentDOI
TL;DR: Calomiris et al. as mentioned in this paper argued that the main story of the subprime crisis is not the government "errors of commission", but rather the huge risks and large losses that brought down the U.S. financial system.
Abstract: Financial innovations often respond to regulation by sidestepping regulatory restrictions that would otherwise limit activities in which people wish to engage. Securitization of loans (e.g., credit card receivables, or subprime residential mortgages) is often portrayed, correctly, as having arisen in part as a means of "arbitraging" regulatory capital requirements by booking assets off the balance sheets of regulated banks. Originators of the loans were able to maintain lower equity capital against those loans than they otherwise would have needed to maintain if the loans had been placed on their balance sheets. (1) Capital regulation of securitization invited this form of off-balance-sheet regulatory arbitrage, and did so quite consciously. Several of the capital requirement rules for the treatment of securitized assets originated by banks, and for the debts issued by those conduits and held or guaranteed by banks, were specifically and consciously designed to permit banks to allocate less capital against their risks if they had been held on their balance sheets (Calomiris 2008a). Critics of these capital regulations have rightly pointed to these capital requirements as having contributed to the subprime crisis by permitting banks to maintain insufficient amounts of equity capital per unit of risk undertaken in their subprime holdings. Investment banks were also permitted by capital regulations that were less strict than those applying to commercial banks to engage in subprime-related risk with insufficient budgeting of equity capital. Investment banks faced capital regulations under SEC guidelines that were similar to the more permissive Basel II rules that apply to commercial banks outside the United States. Because those capital regulations were less strict than capital regulations imposed on U.S. banks, investment banks were able to lever their positions snore than commercial banks. Investment banks' use of overnight repurchase agreements as their primary source of finance also permitted them to "ride the yield curve" when using debt to fund their risky asset positions; in that respect, collateralized repos appeared to offer a substitute for low-interest commercial bank deposits. (2) But as the collateral standing behind those repos declined in value and became risky, "haircuts" associated with repo collateral became less favorable, and investment banks were unable to roll over their repos positions, a liquidity risk that added to their vulnerability and made their equity capital positions even more insufficient as risk buffers. There is no doubt that the financial innovations associated with securitization and repo finance were at least in part motivated by regulatory arbitrage. Furthermore, there is no doubt that if on-balance-sheet commercial bank capital regulations had determined the amount of equity budgeted by all subprime mortgage originators, then the leverage ratios of the banking system would not have been as large, and the liquidity risk from repo funding would have been substantially less, both of which would have contributed to reducing the magnitude of the financial crisis. And yet, I do not agree with those who argue that the subprime crisis is mainly a story of government "errors of omission," which allowed banks to avoid regulatory discipline due to the insufficient application of existing on-balance-sheet commercial bank capital regulations to the risks undertaken by investment banks and off-balance-sheet conduits. The main story of the subprime crisis instead is one of government "errors of commission," which were far more important in generating the huge risks and large losses that brought down the U.S. financial system. What Went Wrong and Why? The subprime crisis reflected first and foremost the willingness of the managers of large financial institutions to take on risks by buying financial instruments that were improperly priced, which made the purchases of these instruments contrary to the interests of the shareholders of the institutions that invested in them. …

137 citations


Posted Content
TL;DR: An arrangement for measuring the condition of a receiver antenna at a base station, utilizing an antenna amplifier positioned in connection with an antenna apart from other base station equipments, e.g., at a mast.
Abstract: We are in the midst of a global financial crisis that is now weighing heavily on economies around the world. Although the outlook remains extremely uncertain, both the fragility of the financial system and the weakness in real activity seem likely to persist for a while. To promote maximum sustainable economic growth and price stability, the Federal Reserve has responded to this crisis by easing monetary policy markedly, and we have greatly expanded our liquidity facilities to keep credit flowing when private lenders have become reluctant or unable to do so. Other central banks have also cut policy rates significantly and expanded their lending. In addition, the federal government and governments around the world have taken extraordinary actions to strengthen financial systems to preserve the ability of households and businesses to borrow and spend. The current situation is so severe that it calls for careful review of how such a crisis evolved and how we can prevent a similar situation from happening again. This conference is a welcome step in that review, as it asks about the lessons we have learned, particularly for monetary policy, from the collapse of subprime lending and the preceding house-price bubble--developments that contributed importantly to the present financial crisis. I would like to reflect on some of what I, in my role as a monetary policymaker, have learned from recent developments in the housing sector and, more broadly, in financial markets as a whole. In doing so, I will revisit the remarks I made in 2006 in Frankfurt at a colloquium honoring Otmar Issing (Kohn 2006). There I argued that a central bank facing a possible asset bubble would have to surmount some high hurdles before it would be justified in tightening policy beyond what the outlook for output and inflation would require, after taking into account past and projected asset price developments. In the aftermath of the collapse of the housing market and in the midst of the ensuing financial and economic turmoil, does that conclusion still hold? More time and study will be needed before we can be confident about the lessons of the current crisis. But to foreshadow the remainder of these remarks, based on what we know today, I still have serious questions about whether trying to use monetary policy to check speculative activity on a regular, systematic basis would yield benefits that outweigh its costs. I hasten to add that it is evident from the current crisis that much has to change on the regulatory front. Governments around the world face the challenge of revamping the regulatory structure governing financial markets. And changes in this area, I believe, will prove to be the most necessary and effective at reducing the odds on another severe financial crisis. Today, however, I will focus on some of the lessons of the current crisis for monetary policy. Alternative Strategies for Addressing Asset Price Bubbles In my 2006 speech, I discussed two different strategies for monetary policy to deal with a possible asset price bubble--the "conventional strategy" and "extra action." A central bank following the conventional strategy does not attempt to use monetary policy to influence the speculative component of asset prices, on the assumption that it has little ability to do so and that any attempt will only result in suboptimal economic performance in the medium run. Instead, the central bank responds to asset price movements, whether driven by fundamentals or not, only to the degree that those movements have implications for future output and inflation. This conventional strategy conforms to the Federal Reserve's dual mandate under the law and it has been our policy strategy; it also has been consistent with the practices of most inflation-targeting central banks. However, some observers have argued for a more activist policy than this one. Specifically, they have urged central banks, upon perceiving the development of an asset bubble, to take extra action by tightening policy beyond what the conventional strategy would suggest, with the hope of limiting the size of the bubble and thus the fallout from its deflation. …

82 citations


Posted Content
TL;DR: Zimbabwe experienced the first hyperinflation of the 21st century and the world's 30th in 2007-08 as discussed by the authors, which is the only reliable record of the second highest inflation in world history.
Abstract: Zimbabwe experienced the first hyperinflation of the 21st century. (1) The government terminated the reporting of official inflation statistics, however, prior to the final explosive months of Zimbabwe's hyperinflation. We demonstrate that standard economic theory can be applied to overcome this apparent insurmountable data problem. In consequence, we are able to produce the only reliable record of the second highest inflation in world history. The Rogues' Gallery Hyperinflations have never occurred when a commodity served as money or when paper money was convertible into a commodity. The curse of hyperinflation has only reared its ugly head when the supply of money had no natural constraints and was governed by a discretionary paper money standard. The first hyperinflation was recorded during the French Revolution, when the monthly inflation rate peaked at 143 percent in December 1795 (Bernholz 2003: 67). More than a century elapsed before another hyperinflation occurred. Not coincidentally, the intervening period represented the heyday of the gold standard. The 20th century witnessed 28 hyperinflations (Bernholz 2003: 8). Most were associated with the monetary chaos that followed the two World Wars and the collapse of communism. Zimbabwe's hyperinflation of 2007-08 represents the first episode in the 21st century and the world's 30th hyperinflation. Most hyperinflations (17) occurred in Eastern Europe and Central Asia, with Latin America accounting for 5 and Western Europe for 4. While Southeast Asia and Africa accounted for 2 hyperinflations each, the United States has avoided hyperinflation. It came close, however, during the Revolutionary War, when the revolutionary government churned out paper continentals to pay bills. The monthly inflation rate reached a peak of 47 percent in November 1779 (Bernholz 2003: 48). A second close encounter occurred during the Civil War, when the Union government printed greenbacks to finance the war effort. Inflation peaked at a monthly rate of 40 percent in March 1864 (Bernholz 2003: 107). Zimbabwe first breached the hyperinflation benchmark in March 2007 (Table 1). After falling below the 50 percent threshold in July, August, and September 2007, inflation soared, peaking at an astounding monthly rate of 79.6 billion percent in mid-November 2008. At that point, as one of us anticipated, people simply refused to use the Zimbabwe dollar (Hanke 2008: 9), and the hyperinflation came to an abrupt halt. As incredible as Zimbabwe's November 2008 inflation rate was, it failed to push Zimbabwe to the top of the world's hyperinflation league table. That spot is held by Hungary (Table 2). Zimbabwe's Data Void Even though the Reserve Bank of Zimbabwe produced an ever-increasing torrent of money, and with it ever more inflation, it was unable, or unwilling, to report any meaningful economic data during most of 2008. Indeed, the last Reserve Bank balance sheet and money supply data produced in 2008 were for March (Reserve Bank of Zimbabwe 2008a). As for the 2008 inflation data, the last available figures were for July, and these were not released until October (Reserve Bank of Zimbabwe 2008b). This data void hid Zimbabwe's hyperinflation experience under a shroud of secrecy: Our problem was to lift that shroud by measuring inflation after July 2008, when conventional inflation measures were not available. PPP to the Rescue Does economic theory provide any insights that might assist in solving our problem? The principle of purchasing power parity (PPP) should be able to come to our rescue. PPP states that the ratio of the price levels between two countries is equal to the exchange rate between their currencies. Changes in the exchange rate and the ratio of the price levels move in lock step with one another, with the linkage between the exchange rate and price level maintained by price arbitrage. …

80 citations


Book ChapterDOI
TL;DR: The U.S. housing bubble and the fallout from its bursting are not the results of a laissez-faire monetary and financial system as mentioned in this paper, but the result of poorly chosen public policies that distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions.
Abstract: The U.S. housing bubble and the fallout from its bursting are not the results of a laissez-faire monetary and financial system. They happened in an unanchored government fiat monetary system with a restricted financial system. What Happened and Why? Our current financial turmoil began with unusual monetary policy moves by the Federal Reserve System and novel federal regulatory interventions. These poorly chosen public policies distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions. There is no doubt that private miscalculation and imprudence have made matters worse for more than a few institutions. Such mistakes help to explain which particular firms have run into the most trouble. But to explain industry-wide errors we need to identify price and incentive distortions capable of having industry-wide effects. Here I will make two main points. First, the Federal Reserve's expansionary monetary policy supplied the means for unsustainable housing prices and unsustainable mortgage financing. Elsewhere (White 2008) I have discussed the growth in regulatory mandates and subsidies that exaggerated the demand for riskier mortgages, most importantly the implicit guarantees to Fannie Mae and Freddie Mac that combined with HUD's imposition of "affordable housing" mandates on Fannie and Freddie to accelerate the creation of a market for securitized subprime mortgages. (1) Second, the Federal Reserve has undertaken self-initiated new lending roles that constitute a shadow bailout program more than twice the size of the Treasury's $700 billion bailout program. There is unfortunately little evidence that the Fed's new lending has helped to resolve our financial problems, rather than to delay their resolution. The Credit Supply Bubble Some authors, considering the relationship of Federal Reserve policy to asset bubbles, ask only: Should the Fed actively burst a growing bubble? If so, how? As posed, their questions suggest that asset bubbles arise independent of monetary policy, and the only Fed role to be discussed is that of bubble-buster. A more important pair of questions is: Does Fed policy as currently conducted tend to inflate assets bubbles? If so, how can we reformulate policy to avoid that tendency? Call our objective a non-bubble-prone or "non-effervescent" monetary policy. The economics profession has not reached a consensus on what the optimally non-effervescent monetary policy is, but it is now widely agreed that it isn't holding interest rates too low for too long. It should also now be clear that a Fed policy that deliberately ignores asset prices, as though consumer prices alone were a sufficient indicator of excessive Fed expansion, is also not the way to avoid inflating asset bubbles. In the recession of 2001, the Federal Reserve System under Chairman Alan Greenspan began aggressively expanding the U.S. money supply. Year-over-year growth in the M2 monetary aggregate rose briefly above 10 percent, and remained above 8 percent entering the second half of 2003. The expansion was accompanied by the Fed's repeatedly lowering its target for the federal funds (interbank overnight) interest rate. The Fed funds rate began 2001 at 6.25 percent and ended the year at 1.75 percent. The Greenspan Fed reduced the rate further in 2002 and 2003, pushing it in mid-2003 a record low of 1 percent, where it stayed for a year. The real Fed funds rate was negative--meaning that nominal rates were lower than the contemporary rate of inflation--for an unprecedented two and a half years. A borrower during that period who simply purchased and held vacant land, the price of which (net of taxes) merely kept up with inflation, was profiting in proportion to what he borrowed. How do we judge whether the Fed expanded more than it should have? One venerable (albeit no longer popular) norm for making fiat central bank policy as neutral as possible toward the financial market is to aim for stability (zero growth) in the volume of nominal expenditure. …

66 citations


Journal ArticleDOI
TL;DR: In this article, the authors make a distinction between a central planner's ability to increase a particular output by devoting more resources to its production and his ability to solve the economic problem, where most evaluations of foreign aid go awry.
Abstract: Under normal conditions, devoting more resources to X'S production produces more X. This follows from the nature of the physical world, which positively relates quantities of outputs to quantities of inputs used in their production. In principles of economics classes, it is common to highlight that this relationship has nothing to do with the economic problem. The economic problem asks how to produce X in the least-cost way, whether to produce more or less X, and indeed, whether to produce any X at all given the alternative uses of the inputs required to produce it. Solving the economic problem determines whether a country's economy develops. It is strange, then, that professional economists have had trouble distinguishing the positive relationship between inputs and outputs from solving the economic problem when it comes to evaluating foreign aid. (1) The purpose of this article is to make this distinction, and in doing so to clarify what aid can and cannot do. Foreign aid's advocates claim aid has been successful. Aids critics claim aid has failed. We explain why both camps are correct. Aid can, and in a few cases has, increased a particular output by devoting more resources to its production. In this sense, aid has occasionally had limited success. However, aid cannot, and has not, contributed to the solution of economic problems and therefore economic growth. In this much more important sense, aid has failed. Flashbacks from Econ 101 Economic progress requires economic efficiency: resource allocations that maximize resources' value to society. Economic efficiency improves when economic actors move resources from less-valued uses to more-valued ones. Economic actors tend to move resources in this way when they make their decisions in an institutional environment defined by private property rights? In this institutional environment, market prices emerge that communicate information to entrepreneurs about how to use resources in ways that enhance wealth, and entrepreneurs have incentives to act on this information (see Mises 1920, Hayek 1945, Kirzner 1978, Coyne and Leeson 2004). Central planning, which attempts to allocate resources without private property and market prices, cannot allocate resources efficiently because central planners can't learn about resource allocations that maximize resources' value (Mises 1920, Hayek 1945). (3) Since central planning cannot promote economic efficiency, it cannot promote economic progress. Nevertheless, like anyone else, central planners can increase a given output by devoting more resources to its production. There is nothing surprising about this fact. The nature of the physical world, including the positive relationship between inputs and outputs, is as true for central planners as for anyone else. The distinction between a central planner's ability to increase a particular output by devoting more resources to its production and his ability to solve the economic problem is where most evaluations of foreign aid go awry. An example from the real world illustrates the relationship, or rather lack of relationship, between increasing a predetermined output by devoting more resources to its production and solving the economic problem. Before its collapse, the Soviet Union devoted substantial resources to training scientists and engineers. Because of these expenditures, during the 1980s the Soviet Union had 10-30 percent more scientists and engineers than the United States (Dezhina and Graham 1999). Occasionally, people pretend this fact illuminates the relative efficiency of these countries' contrasting economic systems. It does no such thing. If the United States had devoted as many resources to training scientists and engineers as the Soviet Union, it could have produced as many scientists and engineers, and perhaps many more. However, the United States allowed private citizens to determine resource allocations in a way the Soviet Union did not. …

46 citations


Posted Content
TL;DR: Gorton et al. as mentioned in this paper argue that monetary policy has played a pivotal role in the financial crisis and financial crisis, and that the crisis is the product of a "perfect storm" of misguided policy.
Abstract: We remain in an economic crisis and financial crisis, one that Gary Gorton has named "The Panic of 2007" (Gorton 2008). The thesis of this article is that monetary policy has played a pivotal role. Under Alan Greenspan and now Ben Bernanke, the Fed has conducted monetary policy so as to foster moral hazard among investors, notably in housing (O'Driscoll 2008a). More generally, the crisis is the product of a "perfect storm" of misguided policy. Policies to encourage affordable housing fostered the growth of subprime lending and complex financial products to finance that lending. Regardless of the desirability of the social goal, the financial superstructure depended on housing prices never falling. Housing prices do fall sometimes, and did so decisively beginning in 2007 (Gorton 2008: 50). It is largely a myth that unregulated financial capitalism failed and new regulation is needed. Aside from health care, financial services is the most heavily regulated industry in the economy. No part of it completely escaped regulation and most parts were heavily regulated, typically with multiple government agencies overseeing the activities of financial services firms. The last legislative deregulation occurred in 1999 during the Clinton administration. The most significant change it wrought was to permit commercial and investment banks to combine into universal banks. (In reality, the statute legalized and regularized activities already in place.) All such entities (e.g., Citigroup and JPMorgan Chase) have survived the debacle. Stand-alone investment banks, the legacy of Glass-Steagall, have fared much worse. Of the five major investment banks operating at the beginning of 2008, Merrill Lynch merged with a commercial bank, Bank of America; the Fed financed and arranged for the shotgun marriage of Bear Stearns with JPMorgan Chase; Lehman failed; and Goldman Sachs and Morgan Stanley each sought protection by transforming themselves into bank holding companies. Born in one crisis, Glass-Steagall's 75-year-old separation of commercial and investment banking was undone by another. In 2004, by unanimous vote among the commissioners, the SEC changed the net capital rules designed to protect brokerage accounts at investment firms. The SEC wanted to apply international standards for commercial banks to investment banks. There is still controversy over whether the commissioners intended to improve regulatory oversight, or ease capital standards. Investment banks certainly leveraged up after the change, as did commercial banks under the Basel capital standards. The attempt to establish risk-based capital standards has been a failure, as many (including the present author) predicted they would be when proposed. It is unclear whether a failed attempt at regulation should be termed deregulation. In any case, the SEC commissioners acted within their authority under existing law. Regulation of financial services certainly failed, but not for lack of quantity (Dorn 2008). Former congressman John LaFalce described the performance of financial services regulators as competition in laxity. Those advocating enhanced regulation in response to the current crisis must explain why the system will work better in the future. Financial services regulation pretty much functioned as Public Choice would have predicted: agencies were largely captured by the industries they regulate. Buiter (2008: 102) defines capture and provides citations on the literature: "Capture occurs when bureaucrats, regulators, judges or politicians instead of serving the public interest as they are mandated to do, end up acting systematically to favor specific vested interests--often the very interests they were supposed to control or restrain in the public interest." To suppose it could be otherwise would be to adopt "a romantic and illusory" theory of politics (Buchanan 1999: 46). It is unclear how adding more regulation would change that outcome. …

Posted Content
TL;DR: In this paper, the authors discuss how the United States got into the financial crisis and some needed changes to reduce the risk of future crises, including closing down of Fannie Mae and Freddie Mac.
Abstract: I am going to make several unrelated points, and then I am going to discuss how we got into this financial crisis and some needed changes to reduce the risk of future crises. Some Observations First, we should close down as promptly as possible Fannie Mae and Freddie Mac. There never was a reason for those two institutions, other than to avoid the congressional budget process. The benefit that people got from Fannie and Freddie came from the subsidy to the mortgage interest rate. Congress could have passed that subsidy over and over again. They avoided passing it by taking the program off budget. That led to a benefit to members of Congress who participated in the profits of Fannie Mae and Freddie Mac. It is an example of bad government policy. Second, looking ahead, the debt of the United States as a share of GDP is going to go from 40 percent to at least 60 percent. If you look at Japan, Italy, or Belgium, that doesn't seem like a startling number. The difference is that much of that debt is owed to foreigners. Looking ahead, get used to the idea that we're going to have to export more and probably see consumption grow at a slower rate. After years of rising expenditure on consumption in the United States, we are going to have to learn to tighten our belts a bit. That's not going to be an easy thing to do politically; woe to the president who presides over that period. Third, I get a lot of questions from the press every day, and one of the questions these days is deflation. The last time somebody asked me that question--it must have been the 15th time I'd heard it--I said that was one of the most stupid question I'd heard in 40 years of dealing with the press. It's time that the people who talk about deflation went back to school and learned about the difference between maintained rates of change and one-time changes in level. The so-called deflation that we're going to have is the decline in oil and food prices that are the reverse of the increase in oil and food prices. Those are changes in the level of prices, but not in the sustained rate of change of prices. Deflation properly understood refers only to a sustained decline in the rate of change of prices. Incidentally, in Federal Reserve history, there are six or seven periods in which we had deflation. Only one of them was a disaster: the Great Depression. It was a disaster because while the deflation was going on, money growth was falling, so that the expectation was that deflation would continue. In the others cases of deflation, if you look at the footprints of those recoveries you wouldn't be able to distinguish them from any other recovery. Fourth, is the bankruptcy law. There's a lot of pressure to change the bankruptcy law to adjust to the current circumstance. If we do that, the simple fact is, we won't have a bankruptcy law. The benefit of the bankruptcy law is it gives people some ideas as to what they can expect under troublesome circumstances. If we change it in relation to those circumstances, we violate the rule of law. Finally, I believe that the Congress and the administration are working on the wrong problem. You can solve the mortgage problem by solving the housing problem. But you can't solve the housing problem by adjusting the mortgage market. Let me expand on that a little bit. A major problem that the economy faces in the housing and mortgage market is that the price decline in houses stimulates defaults. And the expected decline for 2009, which the market puts at 11 percent, means there are going to be many, many more defaults as the price of houses falls even further below the mortgage value. You want to solve that problem. The difficulty is that if policymakers seek to benefit people by reducing the value of their mortgage, or the interest rate on their mortgage, then other people will be encouraged to come and ask for help. To solve the problem caused by declining house prices, and the future problem of the mortgage market, there needs to be an increase in the demand for houses. …

Journal Article
TL;DR: Bauer was one of the earliest opponents of the overpopulation thesis, recognizing that the poor like the rich should have the right to choose the number of children they have, that many developing countries are underpopulated, and that population growth will anyhow slow down once they become richer as discussed by the authors.
Abstract: Peter Bauer was one of the greatest development economists in history. He was an advocate of property rights protection and free trade before these ideas became commonplace. He appreciated before others did the crucial roles of entrepreneurship and trade in development. He was also one of the earliest opponents of the overpopulation thesis, recognizing that the poor like the rich should have the right to choose the number of children they have, that many developing countries are underpopulated, and that population growth will anyhow slow down once they become richer. Baner's writings are remarkable for their deep humanity and commitment to the welfare of the people in the developing world, but without the fake sanctimony that characterizes much of the modern rhetoric. The Foreign Aid Debacle Bauer is perhaps best known as a persistent and articulate critic of foreign aid. At least since 1972, he saw it as not only failing to speed up, but actually hurting economic development. He started his criticism when foreign aid to the developing world was only getting underway, and never wavered. He defined foreign aid as "a transfer of resources from the taxpayer of a donor country to the government of a recipient country" (Bauer 1975: 396). Needless to say, this did not endear him to the aid establishment. Indeed, 30 years ago, just as today, a critic of foreign aid was ridiculed for being inhumane and insensitive to the plight of the poor. Bauer's 1972 book was savaged by the surly (now Sir) Nicholas Stern, who wrote, "Dissent on Development is not a valuable contribution to the study of development" (Stern 1974: 209). Stem's case for aid was simple: People in the rich countries are much richer than people in the poor ones, and therefore foreign aid is their moral obligation. This observation was supplemented with a sprinkling of success stories and a criticism of Bauer for excessive reliance on examples. Little has changed in 30 years. In retrospect, Bauer looks both prescient and courageous. And prescient he was. Countless empirical studies have failed to find beneficial effects of official foreign aid. The consensus that aid has failed is nearly universal among those who look at the data. Perhaps the most important recent statements of this conclusion are William Easterly's accounts of both the history and the evidence on foreign aid (Easterly 2003, 2006, 2009). The failure of foreign aid is all the more remarkable once we remember that, in the last quarter century, the world has experienced an enormous spurt of economic growth and social development. I have elsewhere (Shleifer 2009) called this period "The Age of Milton Friedman" and documented its enormous accomplishments. Starting from East Asia, and concluding most recently with India and China, nearly all the countries in Asia (where much of the world's population lives) have experienced rapid economic and social progress. The collapse of communism started the period of economic transition in Eastern Europe and the former Soviet Union, which, while difficult at the start, within a few years has brought rapid economic growth in the whole region. Even the current economic crisis will slow down, but is highly unlikely to reverse, these achievements. Economic success has not been as conspicuous in Latin America and Africa. Even those regions, however, judging by many indicators of human development, such as health, education, and poverty reduction, have seen substantial progress. Economic growth has been accompanied by improvements in the quality of life for billions of people. Extreme poverty is declining at staggering rates. Life expectancy has grown tremendously around the world. Literacy and education have improved rapidly. Starting in the mid 1970s, when Bauer began to criticize foreign aid, the world has experienced unbelievable growth in democracy and human rights. The sources of economic progress are becoming increasingly apparent. …

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TL;DR: In this paper, the authors argue that the reasons for extreme social turbulence are related to the regulatory and institutional rigidities that still prevail in Greece's economy, despite the strong growth that it enjoyed until recently.
Abstract: Last December, downtown Athens experienced three nights of street battles, arson, and looting that became headlines in the international press. We argue that the reasons for this extreme social turbulence are related to the regulatory and institutional rigidities that still prevail in Greece’s economy, despite the strong growth that it enjoyed until recently. Furthermore, we describe the pattern of state intervention, institutional sclerosis, and high administrative costs that secure and allocate “rents” to interest groups that obstruct all efforts to reduce these rents and to open up the economy. 1 In particular, we argue that these numerous rent-seeking groups curtail competition in the product and services markets, increase red tape and administrative burdens, and actively seek to establish opacity in all administrative and legal processes in order to form an environment in which they will be able to increase the rents they extract. At the same time, they actively strive to ensure that the rule of law fails to such an extent that the society will not be able to hold them

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TL;DR: The current global financial crisis is the worst economic crisis since the Great Depression, with no end in sight as discussed by the authors, and much political finger pointing has occurred, with most of those fingers pointed at supposedly greedy bankers, investors, and hedge-fund managers as well as the financial deregulation of recent decades.
Abstract: The current global financial crisis is the worst economic crisis since the Great Depression, with no end in sight. Already, much political finger pointing has occurred, with most of those fingers pointed at supposedly greedy bankers, investors, and hedge-fund managers as well as the financial deregulation of recent decades. Governments everywhere are rushing to enact new regulatory protections to prevent another crisis of this magnitude. Yet if history is any guide, these new regulations will set up the global economy for yet another financial crisis, perhaps worse than the present one, or create regulatory straitjackets that will greatly impede economic growth. This article will first explore the interactions between finance and human nature, for public policymaking--enacting laws and adopting regulations--that ignores or misinterprets those interactions, is doomed to fail. Indeed, policymaking that responds to symptoms and consequences of perceived problems, rather than forthrightly addressing the underlying causes of real problems, will introduce greater fragility into the financial system. After drawing observations from an analysis of interactions between finance and human behavior, I will then examine 11 underlying public-policy causes of the financial crisis and offer recommendations for addressing those causes, or at least ameliorating their deleterious effects. Interactions between Finance and Human Nature The current financial crisis represents a collision between finance and human nature. The consequences of this collision are as a predictable as the consequences of a collision between human nature and the physics of the real world. Unfortunately, politicians either seem oblivious to or deliberately ignore the interactions between finance and human nature when enacting laws and regulations affecting financial activities. Behavioral economics seeks to explain the role of human behavior in economic decisionmaking. That is, certain aspects of human nature, of how human beings approach financial decisionmaking, are extremely critical in understanding the underlying causes of the current financial crisis. Misunderstanding how humans approach financial decisionmaking leads to policymaking that creates a frequently refreshed hothouse environment in which financial crises flower every decade or so. To put this point another way, most people make financial decisions that seem rational to them at the time even though the aggregate effect over time of thousands or millions of similar decisions may have disastrous macroeconomic or social consequences. In particular, if people, as individuals or as managers of organizations, make decisions that appear to them to be in their self-interest under the laws and regulations in effect at that time ("the rules of the game"), but the product of those decisions, when viewed after the fact, is not desirable, then clearly the rules of the game had a negative impact on that decisionmaking. Hence, bad rules produce bad outcomes. The following is a discussion of five aspects of human behavior that relate to finance and therefore must be taken into account when establishing the rules of the game as they apply to financial transactions and outcomes. Alter the rules of any game--baseball, football, basketball, or finance--and the players will alter the way they play the game. Key to improving the game is to give players an incentive to act in their own self-interest while also maximizing the outcome of the game for all concerned. Arbitraging the Rules of the Game in an Attempt to Gain an Advantage Trying to arbitrage the rules of the game--interpreting the rules in a manner that seems to favor the decisionmaker--is a very understandable human trait. After all, successful, lawful arbitrages reduce costs, which in turn increases the profits, or capital, created by the transaction. Lawfully arbitraging the Internal Revenue Code and other tax laws is so widespread, and readily accepted, that insufficient thought is given to the distorting effect on economic decisionmaking of those arbitraging activities. …

Posted Content
TL;DR: In the era that has come to be known as the "great moderation" (dating from the mid-1980s), the Federal Reserve's policy committee (the Federal Open Market Committee or FOMC) pursued what has to be called a "learning-by-doing" strategy as discussed by the authors.
Abstract: In the era that has come to be known as the "Great Moderation" (dating from the mid-1980s), the Federal Reserve's policy committee (the Federal Open Market Committee or FOMC) pursued what has to be called a "learning-by-doing" strategy The data that counted as relevant feedback--the unemployment rate and the inflation rate--seemed all along to be suggesting that the Fed was doing the right things Even when the Fed lowered the Fed funds target to 1 percent in June 2003 and held it there for nearly a year, the economy appeared to be on an even keel and US interest rates were in line with those in other countries The historically low interest rates were attributed not to excessive monetary ease in the United States but to a worldwide increase in savings But then came the two-year-long ratcheting up of the Fed funds target from 1 percent on June 20, 2004 to 525 percent on June 29, 2006, to stave off inflation The FOMC reversed course, in response to softening labor markets and increasingly troubled credit markets, and began an even steeper ratcheting down on September 18, 2006, so that by April 30, 2007, the Fed funds target was at 2 percent Subprime mortgages revealed themselves as being particularly troublesome, after which it became increasingly clear that the cumulative effects of deep-rooted financial innovations in mortgage markets had been leveraged into an unsustainable boom The bust involved problems of illiquidity and insolvency for the whole financial sector The full-blown financial crisis that is still unfolding provides ample evidence that the underlying weakness in credit markets had been developing for a number of years and that the learning part of the learning-by-doing policy formulation had been seriously degraded--most dramatically by the financial innovations in the business of mortgage lending and mortgage holding The initial response by Washington was not surprising The goal was to cobble together some bold sequence of stopgap measures to keep the crisis--whatever its ultimate causes--from feeding on itself We should have serious doubts, however, that Congress, whose legislative acts have made the financial sector (and particularly the secondary mortgage markets) so crisis-prone, is somehow able to deal effectively with the crisis's self-aggravating potential There are also doubts that even the self-aggravating aspects of the crisis can be effectively countered by legislators who have no understanding--or, worse, a profound misunderstanding--of the nature of the problem Claims that jumbo-sized bailouts will deal with the debilitating uncertainties in the financial sector ring hollow in view of the open-ended uncertainties about just how the bailouts will be financed and just how they will be administered Claims that just "doing something" may counter the fear factor and cure the economy's financial-sector woes (as if "we have nothing to fear but fear itself') are to be dismissed out of hand In fact, the uncertainties about the timing, size, and particulars of the government's next "do-something" measure can only intensify the real fears that are immobilizing credit markets A meaningful response to our financial crisis will require a full understanding of the nature of the crisis and a willingness to follow through with institutional reforms An essential part of those reforms should be based on a complete rethinking of the Federal Reserve's learning-by-doing strategy The key issues here are (1) the Fed's ability--or inability--to pick the right interest rate target and (2) the appropriateness of relying on the unemployment rate and the inflation rate as the dominant indicators of the macroeconomic health of the economy The unemployment rate did not break out of the conventionally accepted 5-6 percent full employment band until August 2008 and the (year-over-year) inflation rate has stayed in the low-to-mid single digits In ordinary times--or, at least, in times past--an unemployment and inflation scorecard like the one that characterized the Great Moderation could be displayed by the Federal Reserve with great pride …

Journal Article
TL;DR: The U.S. economy had experienced 24 consecutive quarters of positive GDP growth, at an average annual rate of 2.73 percent as mentioned in this paper, and the S&P 500 Index stood at roughly 1,500, having rebounded over 600 points from its low point in 2003.
Abstract: At the end of September 2007, the U.S. economy had experienced 24 consecutive quarters of positive GDP growth, at an average annual rate of 2.73 percent. The S&P 500 Index stood at roughly 1,500, having rebounded over 600 points from its low point in 2003. Unemployment was below 5 percent, and inflation was low and stable. Roughly 12 months later, in September 2008, U.S. Treasury Secretary Henry Paulson announced a major new intervention in the U.S. economy. Under the bailout plan, as explained at the time, the Treasury proposed holding reverse auctions in which it would buy the troubled assets of domestic financial institutions. (1) Further, as the plan developed, Treasury proposed using taxpayer funds to purchase equity positions in the country's largest banks. These policies aimed to stabilize financial markets, avoid bank failures, and prevent a credit freeze (see Paulson 2008). In the weeks and months after Paulson announced the bailout, enormous changes occurred in the U.S. economy and in the global financial system. Stock prices fell sharply, housing prices continued the decline they had begun in late 2006, and the real economy contracted markedly. The House of Representatives initially voted down the bailout bill, but Congress approved an expanded version less than a week later. The Federal Reserve and other central banks pursued a range of rescue efforts, including interest rate cuts, expansions of deposit insurance, and the purchase of equity positions in banks. In this article, I provide a preliminary assessment of the causes of the financial crisis and of the most dramatic aspect of the government's response--the Treasury bailout of Wall Street banks. My overall conclusion is that, instead of bailing out banks, U.S. policymakers should have allowed the standard process of bankruptcy to operate. (2) This approach would not have avoided all costs of the crisis, but it would plausibly have moderated those costs relative to a bailout. Even more, the bankruptcy approach would have reduced rather than enhanced the likelihood of future crises. Going forward, U.S. policymakers should abandon the goal of expanded homeownership. Redistribution, if desirable, should take the form of cash transfers rather than interventions in the mortgage market. Even more, the U.S. should stop bailing out private risk-takers to avoid creating moral hazards. The article proceeds as follows. First, I characterize the behavior of the U.S. economy over the past several years. Next, I consider which government polices, private actions, and outside events were responsible for the crisis. Finally, I examine the bailout plan that the U.S. Treasury adopted in response to the crisis. What Happened? I begin by examining the recent behavior of the U.S. economy. (3) This sets the stage for interpretation of both the financial crisis and the bailout. Figure 1 shows the level of real GDP over the past five years. GDP increased consistently and strongly until the end of 2006, and then again during the middle of 2007. GDP fell in the final quarter of 2007, rose modestly during the first half of 2008, and then declined again in the third quarter of 2008. Thus, GDP grew on average over the first three quarters of 2008, but at a rate considerably below the postwar average (1.05 percent vs. 3.27 percent at an annual rate). [FIGURE 1 OMITTED] Figures 2-4 present data on industrial production, real retail sales, and employment. For industrial production, growth was robust for several years but flattened in the second half of 2007 and turned negative by the second quarter of 2008. A similar pattern holds for retail sales, except that the flattening occurred in the final quarter of 2007 and negative growth began in December 2007. For employment, the flattening also occurred in the final quarter of 2007 and negative growth began in December 2007. The overall picture is thus consistent across indicators. …

MonographDOI
TL;DR: The Asian financial crisis 10 years later: What Lessons Have We Learned? Anwar Ibrahim 6.5 as discussed by the authors The Asian Financial Crisis 10 Years Later: What lessons have we Learned?
Abstract: 1. Introduction Richard Carney PART I: OVERVIEW 2. From Miracle to Misadventure: The Political Economy of the 1997-98 Crises John Ravenhill 3. Causes of the 1997-1998 East Asian Crises and Obstacles to Implementing Lessons Jomo Kwame Sundaram PART II: LESSONS LEARNED AND NOT LEARNED 4. Indonesian Financial Crisis Ten Years After: An Insider's View Soedradjad Djiwandono 5. The Asian Financial Crisis 10 Years Later: What Lessons Have We Learned? Anwar Ibrahim 6. Ten Years from the Financial Crisis: Managing the Challenges Posed by Capital Flows Khor Hoe Ee and Kit Wei Zheng 7. The Asian Financial Crisis Ten Years Later - Lessons Learnt: The Private Sector Perspective Manu Bhaskaran 8. Politics, Policy, and Corporate Accountability Peter Gourevitch PART III: PREPARATIONS FOR FUTURE PROBLEMS 9. The Asian Financial Crisis Revisited: Lessons, Responses and New Challenges Masahiro Kawai and Pradumna B. Rana 10. Ten Years After the Asian Crisis: Is the IMF Ready for "Next Time"? Stephen Grenville 11. The Post-Asia-Crisis System of Global Financial Regulation And Why Developing Countries Should Be Worried About It Robert Wade PART IV: CONCLUSIONS 12. Conclusions Hubert Neiss

Posted Content
TL;DR: For example, the authors found that the U.S. federal government expenditures and tax revenues have a positive causal relationship, and that if tax revenues are increased, spending will increase; if tax revenue are lowered, the beast is starved; and if tax decreases may lessen the perceived cost of government spending, increasing the quantity demanded.
Abstract: [My opponent] tells us that first we've got to reduce spending before we can reduce taxes. Well, if you've got a kid that's extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker. --Ronald Reagan (1980) The attractiveness of financing spending by debt issue to the elected politicians should be obvious. Borrowing allows spending to be made that will yield immediate political payoffs without the incurring of any immediate political cost. --James Buchanan (1984) What is the intertemporal relationship between U.S. federal government expenditures and revenues? Do variations in revenues cause variations in expenditures (tax-spend) or is causation the other way round (spend-tax)? Alternatively, is causation bidirectional or nonexistent? Understanding the "revenue-expenditure nexus" has important implications for the political economy of fiscal policies. For example, if causation is in the tax-spend direction, then there are at least two interpretations. First, there is the conventional tax-spend hypothesis associated with Milton Friedman (1978): Government wants to and will spend whatever is made available. If tax revenues are increased, spending will increase; if tax revenues are lowered, the beast is starved. Revenues have a positive causal relationship to expenditures. This view has led various proponents of limited government to encourage tax cuts that are not conditional on offsetting spending cuts. The ultimate goal is for eventual spending cuts as a result of "starving the beast." (1) On the other hand, a negative causal relationship from revenues to expenditures may exist due to fiscal illusion (Wagner 1976, Buchanan and Wagner 1977). Niskanen (1978, 2002, 2006) finds a negative correlation between federal expenditures and tax receipts. He states, "The most direct interpretation [is] a demand curve [where] federal spending is a negative function of the tax price" (Niskanen 2002: 184). A tax increase may make taxpayers hostile toward government spending as they are forced to directly reckon with its costs. (2) Likewise, tax decreases may lessen the perceived cost of government spending, increasing the quantity demanded. For proponents of limited government, understanding which of these relationships best explains reality is critical in terms of policy. Believers in conventional tax-spend or "'starve the beast" may applaud the type of tax cuts associated with Ronald Reagan and George W. Bush because, despite the lack of simultaneous spending cuts, lower taxes are expected to constrain future spending. Alternatively, believers in fiscal illusion may view such tax cuts as counterproductive because they perversely encourage even greater spending by decreasing its perceived (by the electorate) price. Fiscal illusionists may instead encourage tax increases (especially during times of budget deficits) because they force the public to confront the costs of excessive spending, hopefully decreasing their tolerance for it. Ultimately, which relationship best describes the revenue-expenditure nexus is an empirical question and several recent studies using U.S. federal time series data provide evidence for the conventional (Friedman-type) tax-spend hypothesis. Examples include Bohn (1991), Mounts and Sowell (1997), Koren and Stiassny (1998), Garcia and Henin (1999), and Chang, Liu, and Candill (2002). However, Baghestani and McNown (1994) find that there is no relationship between revenues and expenditures, and Ross and Payne (1998) provide evidence favoring the spend-tax hypothesis. Payne (2003) provides an excellent survey of the literature for the United States and other nations. All of the recent studies follow the example set early on by Miller and Russek (1989) in estimating error-correction models that allow for long-run fiscal synchronization (cointegration). Recent U. …

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TL;DR: The Cato Institute is the ideal place to draw lessons from the subprime crisis as mentioned in this paper, where the authors focus on the interaction of public policies with free markets and limited government, and the role of the public policy framework for dealing with institutional failure in financial markets.
Abstract: The Cato Institute is the ideal place to draw lessons from the subprime crisis. The organization’s mission focuses on the interaction of public policies with free markets and limited government. Even the most ardent believer in free markets must fully understand that individual liberty implies neither the nonexistence nor the indifference of government to economic affairs. Individuals live in freedom and peace when public policies are crafted in accordance with wellestablished rules and implemented with an eye toward effectiveness, not expansion. In the halls of government, we need sobriety and vigilance rather than apathy or empire building. The playing out of the subprime crisis has revealed a weakness in our public policy framework for dealing with institutional failure in financial markets that invites a continued expansion of government into areas that should be the domain of private citizens and institutions. In particular, policymakers have been unwilling to let financial institutions that made unwise decisions bear fully the negative consequences of those decisions. Procedures exist to provide liquidity to solvent but illiquid institutions, and other procedures exist to liquidate insolvent institutions. But as the subprime crisis emerged, the government failed to adhere to a consistent policy for dealing with

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TL;DR: The U.S. and China are two of the dominant economies in the world today and the nature of their relationship has far-reaching implications for the smooth functioning of the global trade and financial systems.
Abstract: The U.S. and China are two of the dominant economies in the world today and the nature of their relationship has far-reaching implications for the smooth functioning of the global trade and financial systems. These two economies are becoming increasingly integrated with each other through the flows of goods, financial capital, and people. These rising linkages of course now stretch far beyond just trade and finance, to a variety of geopolitical and global security issues. Getting this relationship right is therefore of considerable importance. The global financial crisis has brought this relationship under the spotlight of international attention. Indeed, the United States and China together epitomize the sources and dangers of global macroeconomic imbalances. U.S. regulatory and macroeconomic policies may well bear a lion’s share of the blame for the current crisis. But there is a deep irony in the fact that Chinese virtue—its high national saving rate—and its policy of tightly managing the external value of its currency abetted U.S. profligacy by providing cheap goods and cheap financing for those goods, setting the stage for a cataclysmic crisis rather than a bubble. The consequences of those policies are now rebounding on the Chinese economy itself.


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TL;DR: The Ricardian theory of economic progress has been challenged by economic historians and development economists as discussed by the authors, who argue that it cannot explain why economic progress in some countries is not due to a lack of resources or technology, but a failure to exploit the resources and technology available.
Abstract: The most basic challenge for economics is to understand the nature and causes of economic progress. But what exactly is to be explained? What are the facts? One very striking fact is historical--the rapid acceleration in the rate of economic progress since the early 1800s. Another is geographical the huge differences in levels of economic progress in different parts of the world today. The questions virtually ask themselves. Why did economic progress accelerate? Why is it not universal? On the whole, these two questions have been addressed by two different specialized fields within economics. Economic history has addressed the question of change over time, and development economics has addressed the question of contemporary differences across countries. The theory that until recently guided work in both fields--the Ricardian theory--measures economic progress in terms of the quantity of output produced by the economy. It sees the economy as a kind of machine that transforms inputs (labor, natural resources, capital) into output: the amount of inputs and the technology of the machine determine the quantity of output. If output increases more rapidly, it is either because of larger amounts of inputs or because of better technology. If output is low in some countries, it is because inputs or technology are lacking. Since Solow (1957) showed that increases in physical inputs explain only a small part of observed changes or differences in output, Ricardian theory has focused primarily on the nonphysical in explaining growth--on technological change and on increases in human capital in the form of skills and knowledge (Lucas 2002, Galor 2005). The Deficiencies of the Ricardian Theory The Ricardian theory of growth has been found wanting both by economic historians and by development economists. The problem for economic historians is that the Ricardian theory offers no explanation for why the accumulation of human capital and technological progress accelerated in the West in the early 1820s. There have been attempts at purely Ricardian explanations: Pomeranz (2000) has suggested that it was the discovery of new resources in the Americas and in England's coalfields that did the trick; Clark (2007a), that human evolution in England came to favor human capital accumulation and technological progress. However, both of these explanations have been challenged on the facts, and neither has achieved wide acceptante (Broadberry 2007, Broadberry and Gupta 2006). The problem for development economies, a more practical field, is that the Ricardian theory has proven itself to be a treacherous guide to policy. For decades after World War II, development economists advocated a series of dirigiste policies for the less developed countries (LDCs) aimed at making up perceived deficiencies in resources and technology: physical capital, technology, and human capital all had their day. The results, to put it mildly, were disappointing: Lal (2000) and Easterly (2001, 2006) have documented the sorry record. The failings of the Ricardian theory have caused economists to look further afield for explanations of growth and development. In particular, many have come to challenge a fundamental assumption of the Ricardian theory--that an economy's potential, defined by its resources and technology, is fully realized. To development economists in particular this assumption has seemed increasingly farfetched: surely, the problem of the LDC economies is not a lack of potential but an inability to achieve that potential (see de Soto 2000, Parente and Prescott 2000, and Guest 2004). The obstacle to their development is not a lack of resources or technology, but a failure to exploit the resources and technology available. In development economies and in economic history, attention has therefore shifted to how and to what degree economies succeed in realizing their potential. Grantham (1999) has labeled this approach--more in the spirit of Adam Smith than of David Ricardo--Smithian. …

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TL;DR: The assumption underlying government alternative energy programs, including the ethanol program, is that voluntary market action is insufficient to develop new energy sources and therefore, government has to step in to induce the technological development the market fails to create as mentioned in this paper.
Abstract: Over the last 35 years, the U.S. government has embarked on several major projects to spur the commercial development of energy technologies intended to substitute for conventional energy resources, especially fossil fuels. Those efforts began with the 1973 energy crisis when President Nixon became the first U.S. leader to announce a plan for energy autarky. Presidents Ford and Carter followed Nixon’s “Project Independence” with similar pledges. But beginning with Ford’s 1975 energy act, plans for energy independence were tied directly to the development of new, alternative energy technologies. Under President Carter in particular, the federal government embarked on highly publicized, heavily funded efforts at developing new technologies with specific timetables for commercial entry and, in a few cases, a timetable for mass market substitution. Current mandates for ethanol and other biofuels fit this latter objective. The presumption underlying government alternative energy programs, including the ethanol program, is that voluntary market action is insufficient to develop new energy sources. Therefore, government has to step in to induce the technological development the market fails to create. Only through government intervention, according to this logic, can the market failure be corrected and the

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TL;DR: In this paper, Niskanen et al. found that reductions in federal revenues constrain neither the growth of peacetime federal spending nor the growth in nondefense discretionary spending.
Abstract: In recent years, some fiscal conservatives have argued that reducing tax revenues and increasing budget deficits is an effective strategy for limiting federal spending This strategy is commonly known as "starve the beast" Niskanen (2006) convincingly demonstrates that reductions in federal revenue do not limit the growth of federal expenditures Instead, he finds statistically significant evidence that revenue reductions actually stimulate the growth of federal spending However, proponents of starve the beast argue that low federal revenues might be able to limit the growth of certain components of the budget, such as nondefense discretionary spending Similarly, others argue that federal revenue reductions might be more effective at limiting expenditure growth during times of peace However, my analysis strengthens Niskanen's original research by finding that his results are consistent across time Furthermore, I find that reductions in federal revenues constrain neither the growth of peacetime federal spending nor the growth of nondefense discretionary spending Background Starve the beast argues that reducing tax revenues is an effective strategy for reducing, or at least limiting, government expenditures Specifically, proponents of starve the beast argue that low revenues, and the resulting deficits, will give elected officials the incentive to cut spending While a number of conservative activists have frequently used starve the beast as a justification for tax reductions, this theory has received support from some economists The most influential academic proponent of starve the beast is Milton Friedman Friedman (2003) argued that, if taxes are cut, "the resulting deficits will be an effective restraint on the spending propensities of the executive branch and the legislature" Other leading economists who have voiced support for starve the beast include Harvard University's Robert Barro (2001) who argued, "Tax cuts remove tax revenues from Washington and keep Congress from spending them" The first mention of starve the beast as it relates to the federal budget was in a 1985 Wall Street Journal article where an unnamed White House official felt that the Reagan administration had not done enough to cut spending: "We did not starve the beast," the official said (Blustein 1985) However, the ideas behind starve the beast have had some currency in mainstream political discourse since the late 1970s For instance, columnist George Will (1978) supported the enactment of the Kemp Roth tax reduction bill in 1978 because he thought "it would restrain the predictable growth of government that is financed by windfall revenues" Similarly, during the 1980 presidential debates Ronald Reagan argued that tax reductions would stop spending growth saying, "If you've got a kid that's extravagant, you can lecture him all you want to about his extravagance Or you can cut his allowance and achieve the same end much quicker" (Mallaby 2006) Much of the analysis of starve the beast has been largely anecdotal Some observers have argued that budget deficits in the 1980s helped President Reagan reduce the growth of nondefense discretionary spending Additionally, during the early years of the Clinton administration, some analysts argued that the Reagan-era deficits hindered President Clinton's efforts to increase expenditures on various programs (Edsall 1993) Furthermore, some observers have argued that the income tax rate reductions that President Bush signed in 2001 were an effort to put Congress in a "spending straightjacket" (Kinsley 2004) As such, even though starve the beast has provided a justification for those who wish to promote tax cuts, that theory has been subject to relatively little empirical scrutiny However, in 2006, William Niskanen, a former member of President Reagan's Council of Economic Advisers, ran a regression where he analyzed federal spending as a percentage of GDP from 1981 to 2005 …

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TL;DR: For instance, the authors argues that the U.S. government incentivizes and even mandates racial discrimination by creating or maintaining official race-based definitions of out-groups and differential outcomes based on race.
Abstract: Economics tells us that racial discrimination is expensive. Yet social psychology suggests that humans nonetheless tend to mistrust those whom they identify as outsiders. As a result, governments can exacerbate this mistrust and thereby encourage costly discrimination by creating or maintaining official race-based definitions of out-groups and differential outcomes based on race. This article reviews evidence from economic and legal history to argue that not only did U.S. governments incentivize and even mandate racial discrimination, but these acts tended to reinforce racial mistrust as time went by. Segregation became more strict, not less, from the end of Reconstruction until the mid-20th century, largely because of growing and self-perpetuating state action. Discrimination created its own constituency. Some skeptics of the civil rights movement have viewed racial discrimination as an essentially private matter that did not warrant the extensive state intervention. This view is untenable. Although certain measures passed in the name of black civil rights still raise serious legal issues in light of strict constitutional construction, the civil rights movement also dismantled a wide variety of even more troubling measures. Most of these can be characterized as straightforward impediments to the freedoms of movement, trade, and association. Although, if given a free market and a neutral state, economic incentives will tend to work against racial discrimination, American history has never witnessed a neutral state. Instead, and until the mid-20th century, the market incentives that might have worked against discrimination were repeatedly frustrated. Recent historical scholarship, notably from left-leaning scholars, has done much to show the depth and surprising recentness of state support for discrimination. As a result, even those not ideologically on the left can rethink the civil rights movement as a complex set of tradeoffs that moved the United States from one type of interventionism to another, much more benign one. On the whole, state intervention into the lives of ordinary citizens shrank in this area of life, rather than grew. Although libertarian and conservative intellectuals of that era viewed certain developments, notably the Civil Rights Act of 1964, with great alarm, this alarm was badly misplaced. Discrimination and the State Opposing racism isn't a difficult call. Economists tell us that discrimination is inefficient (Becker 1971). Worse, racism is a collectivist idea that doesn't sit well with other deeply seated American values. Recent American history has seen the rollback of discriminatory practices to a degree that might have been hard for previous generations to imagine. Yet some questions remain: Wasn't racial discrimination basically a private affair? Did we really have to enact federal laws and regulations to end it? Many of these laws dictate how people run their businesses and associations, and these restrictions are problematic to say the least. Even if we do find discrimination wrong, isn't it a private wrong? Why wasn't private moral force enough? Such questions, while serious, can be difficult to ask. Many on the American left have dismissed libertarianism as an unserious political movement or even as a form of crypto-racism precisely because it raises them. Admittedly, many of the characteristically libertarian concerns about property rights, employment at will, and the freedom of contract have often been echoed by individuals and groups of questionable character. Yet this is no reason to reject these concerns out of hand, and it is worth continuing to consider the problem of discrimination in ways that do not simply concede the necessity of coercion in combating it. One answer is that even until relatively recently, the state itself mandated and incentivized discrimination. In recent years, a growing revisionist literature, often sympathetic to the political left, has exposed this tendency even in popular initiatives like the New Deal (Quadagno 1994, Brown 1999). …

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TL;DR: This paper examined the effect of government consumption on economic growth in 23 Latin American countries over the years 1974-2003 and found that increases in government consumption lead to unambiguous decreases in economic growth.
Abstract: This article examines the effect of government consumption on economic growth in 23 Latin American countries over the years 1974-2003. Employing the Armey Curve, we show that the typical Latin American government is spending beyond the optimal point. Using panel data mad a Fixed effects (FE) model, we find that increases in government consumption lead to unambiguous decreases in economic growth. An Overview An important policy goal of governments is to improve the economic well-being of their citizens. However, as can be seen in Figure 1, Latin America's share in world output (GDP) dropped significantly during the 1980s. This decade has been called the "lost decade" for Latin America, with per capita real income actually shrinking from 1980 to 1989. While the Latin America region has suffered from lack of economic growth, other regions of the world have experienced economic growth, especially during the last 20 years. Figure 2 depicts the growth of East Asia's share of world economic output and contrasts it to that of Latin America's. From 1970 to 2005, Latin America's share of world output grew from 6.09 percent to 6.35 percent (an increase of 4.3 percent) while East Asia's share, for the same period, went from 16.26 percent to 22.46 percent (an increase of 38.13 percent). The comparative exercise suggests that even after the implementation of more free-market economic policies during the late 1980s and 1990s, Latin America economic growth has been suboptimal. It could be argued that this is one of the reasons several countries of the region have recently veered toward less capitalist economic systems. (1) [FIGURE 1 OMITTED] One of the fastest-growing economies in the world, China, is eating away an important source of Latin American economic growth with an upward shift in the exports of manufactured goods, especially in textile and other tradable goods. China has 'already surpassed Latin America and the Caribbean in global exports. Figure 3 documents the growing importance of exports in China's GDP relative to Latin America's export/GDP share. In 1970, Latin America and China both had an export/GDP share of about 1.9 percent, but by 9.004, China's share had risen to 28.48 percent while Latin America's share was 18.02 percent. (2) Such a trend is expected to continue unless effective economic reforms are put in place. [FIGURE 2 OMITTED] Along with sluggish economic growth, the Latin America region suffers from a severe inequality of income distribution both within and between countries. Figure 4 displays significant variation in annual real GDP per capita in the region ranging from $480 for Haiti to over $18,000 for the Bahamas in 2006. Economists and other social scientists have tried to figure out the causes of disparities in living standards and the lack of economic growth. Some experts have suggested that corruption, excessive debt, political instability, low investment in human capital, and emigration account for low levels of economic prosperity in Latin America (3) Others have attributed the suboptimal economic growth to exchange-rate volatility (Hausmann, Panizza, and Rigobon 2006; Kaminsky and Reinhart 1998); bad monetary policy (Wallich 1985); insufficient foreign direct investment (FDI) (Goldberg and Kolstad 1995); inequality (Birdsall and Londoso 1997); lack of economic freedom (Islam 1996; Farr, Lord, and Wolfenbarger 1998; Fraga 2004; Miles, Feulner, and O'Grady 2005); and lack of democracy (Barro 1996, Leblang 1997). [FIGURE 3 OMITTED] [FIGURE 4 OMITTED] Figure 5 presents the average real GDP per capita (RGDP) of the G-7 (group of seven industrialized nations of the world) and of the 23 Latin American countries included in this article for 2003. The more than 3 to 1 gap in income between the two sets of countries is evident. Figure 6 presents average government consumption (GC) as a share of real GDP for both blocks of countries for 2003. …

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TL;DR: The United States and many other countries are now experiencing the first major financial crisis in over 75 years, a condition that too many people have been quick to blame on an outbreak of greed that they claim is characteristic of capitalism as mentioned in this paper.
Abstract: The United States and many other countries are now experiencing the first major financial crisis in over 75 years, a condition that too many people have been quick to blame on an outbreak of greed that they claim is characteristic of capitalism. Blaming a financial crisis on greed, however, is like blaming airplane crashes on gravity. Greed and gravity are always with us, and capitalist markets usually channel self-interest into mutually beneficial behavior. On occasion, the public and private institutions that have the responsibility to monitor economic behavior fail to perform their roles before there are large losses to other parties. The Securities and Exchange Commission, for example, was slow to react to early information about the misleading accounting by the Enron Corporation and the massive Ponzi scheme by Bernard Madoff, and the private credit rating agencies are often among the last to recognize that they have substantially underestimated the risks of some securities. The current financial crisis, however, is primarily a consequence of public policies to promote home ownership that have long been supported by politicians of both parties combined with recent changes in the private market for mortgages, policies and market institutions that have led to massively unwise behavior but with little evidence of a knowing unethical exploitation of other people. Forms of Human Interaction An understanding of the market requires that we put it in context of other forms of human interaction. All forms of human interaction involve one or more of three types of relations: caring, exchange, mad threat. In a caring relation, one person does what another person wants (or needs) because he (she) cares for the other person. In an exchange relation, each person does what the other person wants. In a threat relation, one person threatens to do what the other person does not want unless the other person does what the threatening person wants. Caring A caring relation is inherently limited to one's family, friends, and others with whom one wants to maintain a close relation. In The Theory of Moral Sentiments., Adam Smith rejected the idea that man was capable of forming moral judgments beyond a limited sphere of activity centered on his own self-interest, stating: The administration of the great system of the universe ... the care of the universal happiness of all rational and sensible beings, is the business of God and not of man. To man is allotted a much humbler department, but one much more suitable to the weakness of his powers, and to the narrowness of his comprehension--the care of his own happiness, of that of his family, his friends, his country [Smith (1759) 1976: 386]. Similarly, the late Paul Heyne, who may have been the most thoughtful contemporary writer about the relation between theology and economics, concluded that the New Testament ethics of face-to-face relationships have almost nothing to contribute to understanding how large-scale social systems are or should be organized. And he extensively documented the inconsistency and foolishness of contemporary theologians and others that have judged commercial society by the morality of face-to-face relationships (Heyne 2008). All the same, even children learn quickly that there is also some role for both exchange and threat in interactions in which caring is the distinctive relation. Neither families nor friendships are likely to survive without some consensual exchange or with more than a minimum amount of threat. Exchange The market, of course, is the interaction in which consensual exchange is the distinctive relation. This makes it possible to have economic transactions with almost countless people that one does not know and for whom one has no special caring. This makes it possible to have a much finer division of labor than is possible within a family, among friends, or within a firm, and the combination of increased trade and comparative advantage leads to a higher level of output and income for most everyone. …

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TL;DR: The current financial crisis undoubtedly will inspire a great deal of research in the years ahead, and it may take some time before anything like a professional consensus emerges on causes and consequences.
Abstract: The current financial crisis undoubtedly will inspire a great deal of research in the years ahead, and it may take some time before anything like a professional consensus emerges on causes and consequences After all, it took several decades to document the causes of the Great Depression, and recent research continues to provide new perspectives (1) Nonetheless, I believe the central questions that are likely to occupy researchers are plainly in view, and some tentative lessons have emerged already And in any event, legislators are not likely to await the fruits of future scholarship I will divide my discussion into two parts, reflecting two distinct time periods--the boom in housing and housing finance and the subsequent turmoil in financial markets--and then conclude with some thoughts about what lies ahead The Boom in Housing Finance The expansion in mortgage lending that preceded the recent turmoil in financial markets is best viewed as a component of the long boom in housing activity that began in the mid-1990s and peaked in late 2005 and early 2006 Hard work will be required to estimate the quantitative contribution of various causal factors to the rise in subprime mortgage lending and the increase in subprime losses In the meantime, the list of plausible suspects is reasonably clear First, real per capita income grew more rapidly in the decade after 1995 than in the decade before Second, real interest rates were relatively low over this period, especially after the recession earlier this decade Low real interest rates in part reflected large capital inflows, but the Federal Open Market Committee kept the federal funds target rate low in 2003, and raised rates only gradually starting in mid-2004 Some economists have argued that tighter monetary policy during that period would have led to better outcomes by preventing core inflation from rising While I find this view plausible, I believe further research will be required to substantiate this hypothesis The third contributing factor was the technologically driven wave of innovation in retail credit delivery that allowed lenders to make finer distinctions between borrowers This lowered borrowing costs for many borrowers and expanded the availability of credit to borrowers formerly viewed as unworthy of credit (2) As in any industry undergoing significant innovation--credit cards in the 1990s are a good example--natural evolution can involve overshooting and retrenchment Fourth, the regulatory and supervisory regime surrounding US housing finance probably contributed to the boom in housing and housing finance Here, several factors deserve mention Supervisory agencies, like borrowers, lenders, and investors, assigned a low probability to the possibility of an adverse housing demand shift of the magnitude and geographic extent that we have seen Private sector incentives to foresee and protect against such shocks were to some extent dampened by the presence of the federal financial safety net, including the inferred prospect of support for Fannie Mae and Freddie Mac The safety net probably also played a role in banks' involvement in the securitization process Banks' use of off-balance sheet arrangements and provision of backup lines of credit created state-contingent exposures for the banking system that by design were most likely to be realized in generally bad states of the world, when the safety-net protection of the formal banking sector would be most valuable Official policies aimed at increasing home ownership also provided at least some positive inducement to risk-taking in housing finance In addition, the unscrupulous and fraudulent practices of some mortgage brokers outside of the banking sector may have contributed to the problem Although the housing boom will, as I said, inspire a great deal of research in the years ahead, some lessons have emerged already and have motivated corrective action, both by market participants and policymakers …

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TL;DR: For example, this article pointed out that even the firmly rooted structure of this process, the majority of which is some 240 years old, and the solidarity exuded by “dyed in the wool” Republicans and Democrats, has been transformed into what often appears to be a chaotic frenzy.
Abstract: Once every four years, it has become an American ritual to have the opportunity to make history and change a major part of the world by electing or reelecting a president. Certainly, presidential election years feature not only the symbolic exercising of a fundamental American right, but also the fruits and labors of an extraordinarily complex political process. However, even the firmly rooted structure of this process, the majority of which is some 240 years old, and the solidarity exuded by “dyed in the wool” Republicans and Democrats, has been transformed into what often appears to be a chaotic frenzy. Clouding the matter even further, recent advancements in information technology have increased mass media attention surrounding campaigns. The publicizing of debates, primaries, polls, and political mudslinging is now embedded in the political system and can be transmitted around the world in the blink of an eye. Unquestionably, the process of electing a president has long involved campaigns, primaries and caucuses, debates, polls, and pundits. Yet, in a modern way, our political preoccupation often appears unnecessarily self‐created, mundane, phlegmatic, and to some extent capricious. The impetus of election-year popularity and commercialization are intertwined with an established ritual so profoundly rooted in American history. Indeed, as the modern process unwinds and more often than not meanders, recent history has revealed that, deep‐