Yesterday, I participated in a panel at the Cato Institute as part of its 26th Annual Monetary Conference, "Lessons from the Subprime Crisis."?? A dozen people spoke before I did, and none of them mentioned the words, "debt overhang," which was the main point of my remarks.?? That no one stole my thunder suggests to me that this??is an underappreciated reason why the bailout of financial and non-financial companies in financial distress??is such a thorny issue.

Debt overhang??is a situation in which a firm???s debt??is so large that in many possible future scenarios, earnings generated by new investment projects are entirely appropriated by existing debt holders.?? The implication is that even worthwhile projects (relatively safe ones with positive value added) will be hard to finance.?? New investors put in the money, but old investors get a big share of the proceeds.??

Your Sunday required reading this week comes from Professor Lasse Heje Pederson of NYU, courtesy of VoxEU, "Understanding Liquidity Risk and the Current Crisis."?? Jumping straight to the conclusions:

If the problem is a liquidity spiral, we must improve the funding liquidity of the main players in the market, namely the banks. Hence, banks must be recapitalised by raising new capital, diluting old equity, possibly reducing face value of old debt. This can be done with quick resolution bankruptcy for institutions with systemic risk, i.e. those causing liquidity spirals.

Further, we must improve funding markets and trust by broadening bank guarantees, opening the Fed's discount window broadly (giving collateralised funding with reasonable margins), and ensuring the Commercial Paper market function. Further, risk management must acknowledge systemic risk due to liquidity spirals and the regulations must consider the system as a whole, as opposed to each institution in isolation.

Continuing the series (with a one-letter modification), we have some unabashed appeals from state governments for an infusion of funds from the federal government, as reported in this article in The Washington Post:

"I believe that the crisis that is happening in the states needs to be elevated in the national discussion about restoring our economy," said California state Assembly Speaker Karen Bass (D). "California is the world's sixth-largest economy. And just as we cannot let the auto industry fail, we can't let the state of California fail."

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New York Gov. David A. Paterson (D) has urged federal assistance, telling Congress in recent remarks, "We are cutting all we can, and we will cut all that we are able to, but inevitably, the deficit is too voluminous for us to address."

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California Gov. Arnold Schwarzenegger (R) also demanded federal action, blaming the subprime mortgage crisis for the economic downturn. "Government is really at fault, and this is why government has to get us out of this mess now and figure out very quickly how to get us out of it," he said. "And I'm talking about Washington."

While the rhetoric is overblown, I do have some sympathy for the states in this case, more so than the financial or automotive sectors.

I suspect it will take months or even years for those on the political and ideological Right to map out a strategy to compete in national elections after two sound defeats in 2006 and 2008.??

The first step has been to assign blame for these defeats, to anyone who will listen.?? This op-ed by Governor Christie Todd Whitman in yesterday's Washington Post lays the blame on "social fundamentalists."?? I don't know how constructive that is -- each Party has??a base, and if you alienate the base, you have to make inroads substantially across the political center to make up for it.????The most liberal Republican he could have picked for his running mate would have been Whitman herself.?? I don't think that ticket would have run any better against Obama-Biden this year.

This is your Sunday required reading, two days early (or three days late).?? Michael Lewis gets to the bottom of it all.?? Here is one of many passages I particularly appreciated:

From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.???s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.???s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

Continuing the series, I could spend a lot of time trying to articulate why the Big Three automakers should stop receiving federal funds to resolve or reduce their financial troubles.?? But I wouldn't be able to say it any better than Declan McCullagh in his column yesterday.??

There are two misconceptions that are well addressed in the column.?? First, saying "the U.S. auto industry" is not the same as saying "The Big Three" automakers.?? As McCullagh points out, there are plenty of people employed in the U.S. auto industry who work for foreign car companies operating plants in the U.S.?? (My Subaru was team crafted in Indiana a decade ago.)?? Second, and more importantly, the absence of a bailout means bankruptcy, not the shuttering of factories.?? In bankruptcy, the company is reorganized.?? As McCullagh explains:

I agree with just about everything Robert Reich says in his post, "The Real Difference Between Bankruptcy and Bailout."?? We always suspected that it might be possible, we may have hoped, but now we have the demonstration.?? Sometimes, I think the political spectrum from Left to Right is curved, and that I am so far to the Right that I find myself closer in viewpoint to those far to the Left rather than in the middle of the spectrum.

Here's what Reich says about the conduct of the bailout thus far:

So why, exactly, is the Treasury substituting government bailouts for chapter 11? Even if you assume Wall Street's major banks and insurance giant AIG are so important to the national and global economy that they can't be allowed to fail, that doesn't mean they have to be bailed out. They could be reorganized under bankruptcy protection. True, their creditors, shareholders, and executives would take bigger hits than they're taking now that taxpayers are bailing them out. But they're the ones who took the risk. We didn't.

The Treasury seems to have lost sight of its real client. It's client is not the creditors, shareholders, or executives of any of these firms. Its sole client is the American people.

Dartmouth hosted another post-election panel yesterday, this one convened by President Jim Wright and consisting of a number of Dartmouth alumni who have engaged in public policy whether in office, in academia, or in the media.?? Here are some notes I took at the event:

1. Was this really the shattering of a glass ceiling??? If George H.W. Bush had won in 1992 and the field were wide open and the economy were in the toilet??in 1996, would Obama and the campaign that he ran in 2008 have also won in 1996??? I think so.?? What do you think?


2. Why do Democrats still have to answer Republican questions, even when they win the election??? George W. Bush loses the popular vote and governs like he won a mandate.?? Obama wins convincingly and he is somehow supposed to take it slow??? Not if he really does want to solidify a realignment.


3. What happens if these new voters from 2008 are unemployed in 2010 or 2012??? I'm guessing they will want change again.?? Obama has such a tough road ahead of him.


4. If the Obama administration is going well in 2012, would Obama drop Biden as a running mate to set up a chosen successor for 2016?


5. Will the Democrats ever nominate a white male for the top spot again?


6. When will the Republicans nominate someone for the top spot who is much younger than his Democratic opponent?

On Friday afternoon, the Rockefeller Center convened a panel of faculty to discuss the outcomes, consequences, and next steps after the 2008 elections.?? We tried something new: 10 faculty members speaking for about??5 minutes about their specific areas of expertise.??I spoke about fiscal policy (at about one hour and 5 minutes??into the video).????You can watch the YouTube video by following this link.

Continuing a series that began last week with health care reform, I suggest that another high priority for the Obama Administration is what is known as the Green Tax Swap -- an increase in the gas tax combined with a reduction in the payroll tax rate that fully offsets the revenue increase.?? (By gas, I mean all??fossil fuels used for any purpose, but others might restrict what is taxed only to gasoline.)?? What is the rationale for this?

Severely overcharging for his two cents' worth this week is Harold Meyerson in his column in The Washington Post, "A Real Realignment."

The first problem is the one we've seen quite a lot this week: it is not a realignment when one Presidential election departs from the recent past. It is a realignment when that Presidential election is followed by others that are similar enough so that we know the first was a turning point, not an aberration. The way to make that happen is for the Obama administration and the Democratically controlled Congress to provide the political leadership to make people want to return them to office in the next several elections.

The second and more important problem appears in the last paragraph. Just read it for yourself:

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Indeed, eight years after Karl Rove stormed into Washington proclaiming that he would create a 21st-century version of the Republican realignment that emerged from William McKinley's victory over William Jennings Bryan in 1896, today's emerging Republican minority looks confined to Bryan's base in America's rural backwaters. The future in American politics belongs to the party that can win a more racially diverse, better educated, more metropolitan electorate. It belongs to Barack Obama's Democrats.

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Since??higher education??is my industry, I thought I would take issue with the sentiments expressed by Molly Corbett Broad in today's article in the New York Times, "Tough Times Strain Colleges Rich and Poor."

With endowment values shrinking, variable-rate debt costs rising and states cutting their financing, colleges face challenges on multiple fronts, said Molly Corbett Broad, president of the American Council on Education.

???There???s no evidence of a complete meltdown,??? Ms. Broad said, ???but the problems are serious enough that higher education is going to need help from the government.???

I was not alone yesterday in thinking that Obama should push for some progress on health care reform immediately, but the sentiment wasn't universal.?? Here (via Mark Thoma) is what some of his advisers are saying:

"It would be very difficult to come in and say, 'That agenda I've been pursuing for a year and a half? Never mind it,' " Jared Bernstein of the liberal Economic Policy Institute said during an interview with The Times last week.

But Bernstein, a key Obama economic advisor, acknowledged that some economic issues may have to be addressed with greater urgency to provide a foundation for others.

"We can't tackle healthcare until we get the economy working," he said. "If the economy is weak, how can you make good on the promises you made?"

I read with some interest this piece by Jeff Sachs in Slate, "What Obama Needs To Do."?? I think there will be a lot of columns like this, so let me add to their number.?? The thrust of??Sachs' advice is this:

In sum, the recipes since 1981 of small government and small-bore solutions are pass?? and dangerous for our very survival in the United States and on this planet. While Reagan was crudely ideological, Clinton mildly reformist, and Bush simply crude in the application of these small-government doctrines, none of the recent approaches will do. It's time to stop talking about who can give away more to the public in rebates and start talking about investing in our future in a way that can save the poor, sustain the rest, and build a decent world for our children. Those are the real family values.

I mentioned yesterday that I voted for Senator McCain, not Senator Obama.?? If I could have split my vote, I would have given about 60% to McCain and 40% to Obama.?? I suspect that might wife would switch the percentages, and so between her vote for Obama and mine for McCain, the Samwick family's centrist tendencies were reflected pretty well.

My vote was determined more by my self-identication as a conservative??than my professional training as an economist.?? As a matter of principle, I never signed on to one of those "Economists for McCain" petitions despite a number of requests.?? It was McCain's failure to get serious about the budget deficit and other matters relevant for a fiscal conservative that limit??the??disappointment about the way the election turned out.?? That disappointment comes from my concerns about??judicial nominations,??free trade, and keeping the government's interference in the economy to a minimum in an Obama administration.

I'd like to pick up on Stan's two great posts from this weekend. It is election eve, and all the buzz this week will be about what it all means. In particular, if the polls should hold up and Senator Obama should win, does it mean that the country has aligned itself with the Democrats, who will control the White House, Senate, and House, with any degree of permanence?

The answer is "yes," from my perspective, only if President Obama is nearly flawless in his first two years.?? If he is, that means he will have overseen successful resolutions of the war in Iraq, the current financial meltdown, the coming recession, and enormous budget deficits.?? He will also have shown some progress on his health care reform and moves to curb greenhouse gas emissions. That he inherits all of these challenges??is not going to matter much to the American electorate in two years.

Of course, 2007 Q3 would have been even better.?? Paul Krugman reaches the right conclusion in his column today, but he's more than a day late and at least a dollar short.?? The part he gets right is this:

No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn???t spend.

Why is he more than a day late??? Because we should have begun planning the implementation back??in January, when the first so-called stimulus package was passed.

The Bureau of Economic Analysis released the advance estimate of third quarter GDP this morning.?? The headline is:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- decreased at an annual rate of 0.3 percent in the third quarter of 2008, (that is, from the second quarter to the third quarter), according to advance estimates released by the Bureau of Economic Analysis.?? In the second quarter, real GDP increased 2.8 percent.

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The decrease in real GDP in the third quarter primarily reflected negative contributions from personal consumption expenditures (PCE), residential fixed investment, and equipment and software
that were largely offset by positive contributions from federal government spending, exports, private inventory investment, nonresidential structures, and state and local government spending.?? Imports, which are a subtraction in the calculation of GDP, decreased.

I read this article in my local paper over the weekend (which had the much more appropriate headline, "A Bailout Bonanza").?? This is what government by panhandling looks like when all pretense that the??activity??is to be avoided is removed.?? Is there no use of future taxpayers' resources that is too wasteful for the government to pass up??? Bruce Bartlett's point that we have failed to articulate what makes the financial sector different is looking smarter and smarter as time goes by.

To make progress, perhaps a different approach is needed.?? How is this problem in the financial sector not different than problems we already know how to address??? From the home-repair-and-improvement category, I offer the following analogy:

The conduct of AIG in the wake of the government's loans to keep it afloat suggests a real problem with its bailout.?? At least with the bailout of banks, there is a presumption that "cash for trash" or preferred equity investments??make funds available to allow them to do new lending and contribute to economic activity.?? There doesn't seem to be any presumption of this happening with AIG.?? In this??Washington Post??article, "AIG Has Used Much of Its $123 Billion Bailout Loan,"??we learn:

AIG has borrowed $90.3 billion from the Federal Reserve's credit line as of yesterday, the bulk of it to pay off bad bets the company made in guaranteeing other firms' risky mortgage investments. That's up from roughly $83 billion AIG had borrowed a week ago, and the $68 billion level it reached a week before that. The news comes as the company's new chief executive warned Wednesday that the government's financial lifeline may not be enough to keep AIG afloat.

What is the new economic activity we are supposed to get from these loans and ownership of AIG??? What good thing will AIG now do??in the real economy because these loans have occurred??? Nothing.