Perhaps that will occur when income taxes are hiked above 50 per cent. Or maybe when hospital budgets are cut, or military spending slashed. Either way, the potential list is long. While that might cause political instability (which, of course, would be bad for bond markets) it might trigger a renewed, vitriolic round of bank-bashing – particularly if voters in 2011 or 2012 know that 2010 was a year when banks paid out more, massive bonuses.

No wonder that some financial officials and politicians are frantically pleading with bankers behind closed doors to show more restraint in their current bonus round. “Don’t the bankers realise what could be coming?” I heard one senior western finance official tell a room full of bankers this week, as he argued – with passion and a sense of desperation – that it would be a mistake for banks to pay big bonuses.

But even if one firm’s management accepted the logic of this claim, there would be a collective action problem. People would want to go work at the firms that were still paying out the big bonuses. Under the circumstances “frantically pleading” couldn’t possibly work, you would need to actually force them to stop, perhaps through the kind of bonus windfall tax proposed by Martin Wolf.

David Brooks has a good column today arguing that Timothy Geithner’s approach to the financial crisis has been vindicated and that actually one of the most roundly criticized aspects of the Obama administration’s approach has worked out well.

He makes strong points, but I would have tempered this a bit. Brooks writes that it “now seems clear that nationalization would have been an unnecessary mistake — potentially expensive and dangerously disruptive.” But he also notes:

In the next few months, Geithner will be confronted with a cross-cutting set of pressures. First, the need to reduce the deficits, which is uppermost on his mind. Second, the rising populism in Congress, which has to be battled sometimes and appeased sometimes by an administration that hopes to get things passed. Third, intense public cynicism about government, which means that every debate is washed in negativity.

Most important, there’s the jobs situation. If job growth returns, that will be a sign that the recovery is normal and Geithner and the administration can return to a more moderate path. If employment does not rebound or the economy double dips, that will be a sign of systemic problems. Geithner and his colleagues will probably adopt a much more activist posture and have to throw their lot in with the left.

I think these challenges underscore the fact that even though Geithner’s approach worked a lot better than his critics were inclined to say*, they also haven’t worked all that well. The unemployment rate is much better than people feared it would have been without a financial rescue, but it remains unacceptably high. And the problematic political situation seems to me to be largely a direct result of the government’s failure to capture a larger share of the financial upside associated with post-TARP large financial services firms. The way the Chrysler/GM bailouts were structured, if either firms becomes wildly successful in the future, the US taxpayer will get a very handsome payout. But the services rendered to Goldman Sachs and JP Morgan and the rest were not similarly oriented. The TARP money was “paid back” but the taxpayer hasn’t gotten anything resembling a fair share of the upside. This has created a situation in which it’s very difficult for the government to take further steps in really any direction.

* Also note that one reason Geithnerism has worked out better-than-expected was that he actually wound up abandoning his much-criticized PPIP scheme.

From Glenn Beck to the Tea Parties, much of the energy in the post-Bush G.O.P. is with people who have grasped, albeit sometimes in inchoate ways, that big government and big business are increasingly on one team, and the champions of free markets and limited government are on the other. But they don’t know what to do about it, and what they do seem to know — cutting taxes, and letting the rest take care of itself — is often non-responsive, not only to the problems the country faces, but to the problems they themselves have diagnosed.

Speaking as an Obama administration apologist, I’m glad to see the incoherence noted. But it’s also worth saying that incoherence strikes me as incredibly appealing. The main issue here is, I think, the incredibly unpopular TARP “bailout” bill. I believe that absent the bailout, we’d be looking at even higher unemployment today. But it was and remains incredibly unpopular and has done a lot to sour the public on the idea of activist government. It also raises, I believe, serious questions of moral hazard and social justice. These issues would best be addressed by more stringent regulation and higher taxes on high-income individuals that are used to fund more and better public services. And that’s what the administration is proposing.

But conservative populists, by insisting that the real answer is basically to go back in time and not do the bailout have created a win-win-win situation for themselves. In the congressional debate over financial regulation, conservatives have proven themselves to be slavishly loyal to the interests of large financial firms. And in the congressional debate over taxing the wealthy to expand access to health care, conservatives have proven themselves to be slavishly loyal to the interests of rich financiers. But via their meaningless denunciations of bailouts, they’ve positioned themselves as on the side of anti-banker public opinion. And yet precisely because this rhetoric is so non-credible, they continue to receive generous financial support from big finance and from big business in general. Meanwhile, the public largely holds Barack Obama responsible for public policy even though it’s possible for congressional minorities to thwart his agenda. Thus he so far bears the brunt of public distaste not only for the bailout, but also for congress’ unwillingness to enact his own regulatory agenda.

Moving to a less-incoherent posture would have some real benefits, but also disrupt the current sweet deal.

A lot of the coverage of the new SIGTARP report on the handling of the AIG payouts—and, indeed, the report itself to an extent—seems a bit misleading.

Stepping back, this all began when banks made various risky loans. In order to reduce the risks, they essentially bought insurance from AIG. But AIG itself didn’t manage its own risk-profile well. So when the loans started going bad, it turned out that AIG couldn’t cover its contracts. Consequently, AIG’s poor risk-management was going to undermine the risk-management at every firm that managed risk through contracts with AIG. That would have led to a wave of bank failures. So the government stepped in and took over AIG. At which point it paid out the contracts in full.

The accusation of the report is basically that the government could and should have gotten a better deal than that for taxpayers. Paying out 80 cents on the dollar or whatever. But one big question is how would that have worked. If AIG were a firm going bankrupt, what you would do is call everyone up and say “uh…we screwed up…we can pay everyone 80% of what we owe you or else we can declare bankruptcy and you guys can roll the dice and see what you get in the end.” That’s a good strategy. But once AIG had been taken over by the government, the government couldn’t really threaten to default on AIG’s contracts. The government could have threatened to use its regulatory authority in a punitive way unless AIG counterparties agreed to a quasi-voluntary haircut. I can see the case for doing that, but I can also see the case for not doing it.

The crux of the matter is that once AIG goes from being an on-the-verge-of-bankruptcy company to a government-owned company, there’s really no more leverage that’s 100 percent legitimate. You could have said, pre-takeover, “hey guys, we’ll take over AIG but only if you all promise to take a haircut on your obligations.” But then you’re setting up a game of chicken. Are you really going to cause an economy-killing wave of bank failures unless the banksters agree to take a haircut? Well, no you’re not. So even when you seem to have leverage you actually don’t.

What’s really wanted here is for the United States to be a different kind of country with a more public-spirited business class wherein the bank executives could be persuaded to “do the right thing” in light of all the crap that taxpayers were doing on their behalf. But we live in the United States of America.

Fundamentally, though, as with a lot of this stuff I think what’s being implicated is much less America’s financial crisis emergency response policies than our background conditions of social justice. The very rich people in the top 0.5 percent of the income distribution who’ve garnered such a large share of the economic gains of the past thirty years should pay higher taxes, and in return there should be more and better public services. The Federal Reserve shouldn’t be so complacent about ten percent unemployment.

But suppose we buy into the more common negative current view of finance. There is still a big open question. Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. It’s reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth. Despite any role of finance in the current recession, are the market naysayers really ready to argue that worldwide wealth would be higher today if financial markets and financial institutions didn’t develop as they did?

A banker in Frankfurt put this same point to me, apparently believing it’s a brilliant argumentative trump card. In reality, it’s a bit nuts—it’s relying on a post-1980 boom that didn’t happen. The United States didn’t start growing faster in 1980:

The claim you’re supposed to make on behalf of the post-1980 US economy isn’t that it’s grown faster (it hasn’t!) but that it’s been less variable than was growth in the early postwar decades. That’s why the term “Great Moderation” was termed. Except in the wake of the current bust, it’s clear that no such decrease in variation was actually achieved. Growth has been the same as it was before, and yet median income growth has been substantially slower. In Europe and Japan growth post-1980 has been much worse than growth was in the previous decades.

The place where growth really has been much better since 1980 than it was before is China. This is not a fact to be neglected. Chinese growth has been very rapid, and very consistently maintained. And a very large number of people live in China, people who started this process being very poor. The past 30 years’ worth of economic growth in China have done an enormous amount to improve human welfare.

But the cause of this turnaround pretty clearly wasn’t financial deregulation in the developed world. It was policy shifts in China—the process, commenced by Deng Xiaoping, of moving away from central planning and joining the global economy. This doesn’t strike me as even remotely debatable. When we look at impressive growth over the past 30 years were looking at policy shifts in China, the success of container shipping, and to an extent shifts in developed world trade policy.

I'm putting my money into American real estate! (cc photo by chi king)

But why weren’t there enough good, traditional places to invest that money? And by “traditional” I mean people who want to build factories or expand call centers or start up biotech ventures. That is, businesses that provide goods and services to meet demand from consumers and corporations. The supply side of the economy may have been going great guns, but the demand side wasn’t keeping up. This is why some people think it’s better to talk about this phenomenon as an “investment drought.”

Kevin offers an explanation for this that relates to the maldistribution of income in the United States. But isn’t the real issue here that the good investment opportunities were all in China?

That’s what was screwy about the global economy of the 2000s. For each and every one of those years, everyone believed that the short- and medium-term growth prospects in China were better than the prospects in the United States. And yet on net investment funds were flowing from China to the United States. Similarly, Americans had much more consumer goods than Chinese people, yet it was Americans borrowing money to finance present consumption. Borrowing it from China! That’s why Bernanke called it a savings glut.

But in a larger sense, this reflects the failing of the international financial architecture. The IMF wasn’t just created as a stimulus program for the makers of giant puppets—the architects of the postwar economic order thought the globe would be wracked by periodic crises without something to play its role. Nevertheless after the way the IMF handled things in the 1990s, Asian countries resolved to never again rely on the IMF and to instead start stockpiling dollars. But this effort to develop a workaround created a ton of problems. Bypassing the organization turns out to be a poor substitute for actually addressing the problems with it.

I pointed out yesterday that even conservatives like Ben Bernanke agree on the need for congress to pass some form of “resolution authority” regulation, empowering the government to deal with failing financial institutions that aren’t covered by the FDIC process. That’s clearly a necessary step to dealing with the “too big to fail” issue, and some people even think it’s sufficient.

And then there’s Edward Yingling, the banksters’ top lobbyist, who’s against the idea on the grounds that it “could make it unnecessarily more expensive for them to do business during less turbulent times.” As Pat Garofalo observes “as for ‘unnecessary’ expenditures, I’d like to ask Yingling what he thinks of the $700 billion spent to pull the banking system back from the brink.”

But, look, this is just zealous advocacy on Yingling’s part. It’s clearly preferable for large financial firms that they be allowed to exist in a way that ensures the taxpayers have no choice but to cover their losses in the case of screwups. Anyone with any sense would jump at the chance to privatize profits and socialize losses. It’d just be insane of congress to let them keep getting away with it. Y

Liberals will probably find a fair amount to disagree with in these remarks from Ben Bernanke, especially the lead elements that involve vague assertions about the “economic benefit of multi-function, international (financial) firms.” That said, there’s no reason whatsoever to disagree with this:

Both in answering the question and in his prepared text, Mr. Bernanke again beseeched Congress to act soon to give regulators “resolution authority” to cope with the imminent collapse of a big financial firm other than a bank, and to address other vulnerabilities in the regulatory regime exposed during the crisis.

There’s plenty of room for disagreement as to whether an approach to “too big to fail” that’s centered on this resolution authority point is sufficient. But I think everyone can agree that it’s necessary. And unlike other elements of regulatory reform, this is something that at least might come into play during the current crisis if things get worse. I see no reason why congress couldn’t or shouldn’t move quickly on this point irrespective of controversy over the rest.

Martin Wolf’s ideas for financial regulation:

First, create a set of laws and institutions that make it possible to bankrupt any and all institutions, even in a crisis. Second, make financial institutions safer, with much higher capital requirements, against all activities. Third, prevent off-balance-sheet activities. Fourth, impose dynamic provisioning. Fifth, require huge cushions of contingent capital. Finally, cease to favour debt-finance, throughout the economy.

Kevin Drum likes this a lot.

I’m not sure how much of this can stick in an industry where the product and the inputs (just money, really) can cross international borders so easily. Shut down some antics in London and they move to Zurich.

Relatedly, with a lot of regulatory ideas you need not only to write good rules down on a piece of paper in advance, you need to pull the trigger when the time comes. Say you resolve to “prevent off-balance-sheet activities” and write some rules. Then it’s 2017 and so-and-so at GiantBankCorp finds some kind of loophole. By 2019 everyone’s using this loophole. So some bureaucrat at Treasury says, “hey we should really rule that this amounts to an illegal off-balance-sheet activity and shut it down.” Next Tuesday there’s a story in Roll Call about how a group of GOP House members, joined by a bloc of moderate Democrats and even some liberals from the New York City area have written a letter to the Treasury Secretary warning that the proposed rule would reduce US financial services competitiveness. And you have to understand, this isn’t going to be a front page headline in Roll Call—this is 2019, not 2009, and the general public doesn’t care about banking regulation anymore—it’s buried in some backwater. The only people following the issue are financiers and lobbyist types. And, hey, the Secretary tells himself that the critics aren’t even wrong. Closing the loophole won’t shut the activity down, it’ll just ensure that the loopholes are being exploited out of the London office. Who does that help? What could go wrong?

Good news for investors who like to lose all their money, “John Meriwether, the hedge fund manager and arbitrageur behind Long-Term Capital Management, is in the process of setting up a new hedge fund – his third.” What’s that, you ask, didn’t his first fund lose all its money? Why, yes. And didn’t the second fund fold because it lost a ton of money? Yes, quite so. So how will this new one be different? It won’t! It’s “expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.”

The way this works is that you identify arbitrage opportunities such that you make trades you’re overwhelmingly likely to make money on. But those opportunities only exist because the opportunities are very small. So to make them worth pursuing, you need to lever-up with huge amounts of debt. Which means that on the rare moments when the trades do go bad, everything falls apart: “The strategy typically has a high ‘blow-up’ risk because of the large amounts of leverage it uses to profit from often tiny pricing anomalies.”

As a friend puts it, this strategy is “literally the equivalent of putting a chip on 35 of the 36 roulette numbers and hoping for no zero/36.” But you’re doing it with borrowed money. I’m not a huge believer in human rationality, so I totally understand how this scam worked once. That he was able to get a second fund off the ground is pretty amazing. If he finds investors for a third spin around the wheel I’m going to propose confiscating all the rich peoples’ money and giving it to capuchin monkeys.

Economics of Contempt has an excellent post up noting that the Obama administration’s proposed regulatory reforms actually do quite a bit more to deal with the “too big to fail” problem than is generally acknowledged. In particular, along with various regulatory steps, they’re asking for specific “resolution authority” over so-called “Tier-1 Financial Holding Companies. This would create a non-bankruptcy approach to dealing with insolvent big financial firms, much as the FDIC process exists for conventional banks.

But he also notes a substantial flaw in the proposal:

I think the administration makes a big mistake by requiring a separate “systemic risk” determination in order to use the proposed resolution authority for Tier 1 FHCs. This introduces needless uncertainty. Remember, a financial company is a Tier 1 FHC, by definition, if “material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress.” An institution thus can’t even be a Tier 1 FHC in the first place if it doesn’t pose a systemic risk. Why require an additional, albeit slightly different, determination of “systemic risk” before the new resolution authority can be used? This will leave the market guessing as to which resolution regime — the Bankruptcy Code or the new resolution authority? — will be used to resolve a distressed Tier 1 FHC. Creditors, unsure which resolution regime will apply and thus how their claims will be treated, will be less likely extend credit at exactly the time we don’t want creditors to be pulling back from a Tier 1 FHC.

I would make the new resolution regime automatically applicable to Tier 1 FHCs. By requiring a second “systemic risk” determination, the administration is essentially saying that there are Tier 1 FHCs that can be resolved in an orderly fashion under the Bankruptcy Code as it’s currently written. You’d be hard-pressed to find any market participant who agrees with that statement (in fact, I don’t believe Tim Geithner honestly believes that statement). I continue to be confused by the insistence on a second “systemic risk” determination.

I think the real problem here isn’t that there’ll be uncertainty about whether or not the Bankruptcy Code will be used. The problem is that given policymakers clearly indicated (and correctly so) unwillingness to resolve big financial firms through bankruptcy, this seems to continue to hold the door open to future bailouts rather than actual use of the new resolution authority.

Either way, the proposal could be greatly improved by making this more automatic.

JP MorganChase HQ

Jim Henley makes a good point in response to Kevin Drum:

It isn’t possible to get the banksters “off the federal teat immediately” or otherwise. There is simply no guarantee we make today that can bind the politicians of tomorrow. That’s not even necessarily a nebulous “tomorrow” either. Nor can we guarantee that, when the time comes, it would even make sense for tomorrow’s politicians to honor today’s future refusal. We have to figure out how to organize a political economy predicated on massive if implicit subsidies to the finance industry and its owners and executives so as to minimize the harm they can do and so it works tolerably for the rest of us. Am I optimistic that we can do this? Not so much. But since we can’t cut ‘em off, all we can hope to do is keep ‘em in line.

Right. Banks are profiting massively from ultra-low interest rates, but making such rates available serves the general interest. Banks are also profiting massively from implicit federal government guarantees. But you can’t “take away” those guarantees—they’re basically intangible—and it’s not at all clear that doing so would be wise. So you’re left with the difficult task of prudential regulation and trying to shrink the largest players over time with special fees and higher capital requirements.

That said, I think this is primarily an issue of social justice rather than an issue of technocratic regulation. And the answer is higher taxes on extremely high-earning individuals. The evidence suggests that big shot financiers make up a huge proportion of the highest-earning Americans, leaving CEOs of non-financial firms in the dust. You need to tax these guys and use the money to finance more and better social services and jobs for the people who provide the social services.

Having administration officials go whine to Wall Street honchos isn’t going to achieve anything.

This seems like a mighty strange choice of words:

A big reason for Goldman Sachs’s blowout profits this year has been the willingness of its traders to take big risks — they have put more money on the line while other banks that suffered last year have reined in such moves. Executives say there are big strategic gaps opening up between banks on Wall Street that are taking on more risks, and those that are treading a safer path.

It’s not really a “risk,” though, is it when you’re operating with an implicit government guarantee to pull your ass out of the fire if your bets blow up. The federal government is taking a risk on these Goldman trades, they’ve just given Goldman the bulk of the upside.

It may come as a surprise that one of the most powerful forces driving the resurgence on Wall Street is not the banks but Washington. Many of the steps that policy makers took last year to stabilize the financial system — reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institutions’ debts — helped set the stage for this new era of Wall Street wealth.

Titans like Goldman Sachs and JPMorgan Chase are making fortunes in hot areas like trading stocks and bonds, rather than in the ho-hum business of lending people money. They also are profiting by taking risks that weaker rivals are unable or unwilling to shoulder — a benefit of less competition after the failure of some investment firms last year.

The Obama administration felt that nationalizing and recapitalizing banks directly would require congress to appropriate far more money than was possible. After all, if you think “bailouts” are unpopular now, just ask what it would look like if Obama wanted hundreds of billions more. Instead, they’ve used regulatory forebearance and other techniques to put banks in a position to recapitalize themselves through trading profits. And that’s what we’re seeing here. It’s an ugly, ugly business. They’re basically gambling on the taxpayers’ dime and operating with an implicit taxpayer guarantee to cover their losses if they blow up.

This, I think, is one of the main reasons you hear more about breaking banks up from people talking to newspapers than you do from policymakers. What, exactly, are Ben Bernanke and Tim Geithner supposed to do at this point?

Which is why, I think, the idea of enhanced capital ratios and special fees is actually a pretty good idea. Greenspan says “I don’t think merely raising the fees or capital on large institutions or taxing them is enough.” He thinks we need to actually break them up. But raising fees and capital requirements can be a way of doing this. The point would be to make the fees and requirements onerous enough that the managers of large financial institutions find it worthwhile to start finding ways to spin things off and shrink. That would produce the goal of smaller firms without having the Treasury Secretary personally step in and reorganize the commanding heights of the economy. The test is that if the fees are imposed and banks don’t start doing this, you need to come back and raise the fees. The fees need to be high enough to generate substantial fee-avoiding behavior, you can’t just say “well, we’ve got some extra revenue so it’s all good.”

But what if they lose? For all we know, they’re actually making really unsound bets. Imagine putting $1 down on a lottery where there are 100,000 possible outcomes. In 99,999 of those outcomes, you win $3. But if that 100th ball comes out, you lose $1 billion. That’s a terrible bet. But you could still put a nice long winning streak together making that bet. You could earn a lot of money. Now you’d never do it with your own money on the line. But suppose you could do it with your company’s money, and then pay yourself an annual bonus based on the profits, and know all along that if you ever wind up with the bad outcome that Uncle Sam is going to bail you out.

We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector.

As Ryan Avent points out, there’s a reasonable case to be made that this is actually the Wall Street compensation issue we should be worried about:

Officials in Washington scrutinising the pay packages of TARP recipients are primarily focused on the incentive effects of those pay structures—whether financial pay packages are inducing financial employees to take excessive risks. But the bigger incentive problem may be—almost certainly is—the drain of talent from other fields, into finance. If there were more evidence that this drain was producing significant net benefits for the economy, than there would be less cause to worry. To an increasing number of people, it looks as though the financial sector is recruiting the nation’s best brains and putting them to work endangering the global economy.

Imagine a world in which being the owner of one of these telephone psychic scam operations discovered that high-skill fake-psychics could produce more earnings than a low-skill fake-psychic. He might start recruiting more people from top schools. And other firms would notice that this one guy moving up the skill chain was producing benefits, and begin doing the same himself. Over time, competition between firms would drive compensation in the psychic sector up and a greater-and-greater share of the high-skill workforce would start draining out of other fields and into psychic work. This would, in turn, seem likely to create a less productive economy over time. Some people would be arguing that the high wages in the psychic sector are, as such, proof that the psychics are generating social value. But nobody looks at the actually existing psychic industry and infers from the fact that psychics are able to earn income that psychics possess real ability to forecast the future. Rather, we recall that as Larry Summers famously argued “there are idiots”.

I’ve seen a fair amount of commentary on the part of Ryan Lizza’s profile of the Obama economic team where Christina Romer recommends a $1.2 trillion stimulus proposal and they wind up with just a bit more than half of that out of deference to the tender sensibilities of the United States Senate. I’ve seen less commentary on this other part, where basically the same thing happen on financial system policy:

Romer believed that the banks wouldn’t lend again until they were well capitalized. For banks in severe stress, she favored creating a government-backed “bad bank” to take the toxic assets off the banks’ books and then recapitalize them with government funds—essentially a version of nationalization, and what the Swedish government had done during that nation’s financial crisis of the early nineties. This argument was quickly rendered moot because of the cost. There wasn’t much money left in the TARP kitty, and any chance of getting more from Congress had ended with that morning’s news: A.I.G., which had received a hundred and seventy billion dollars in federal money, had handed out multimillion-dollar bonuses to the executives responsible for the company’s demise. Axelrod said, “The one thing that was absolutely clear was, we were not in a position to go back to Congress.”

Axelrod’s argument seems absolutely sound. And Rahm Emannuel’s argument on the stimulus that congress wouldn’t appropriate $1.2 trillion also seems absolutely sound. But of course Romer’s arguments weren’t arguments about feasible legislative strategies. Of all the senior members of the Obama administration, Romer has by far the least experience with practical legislative politics and also has the job that’s the least concerned with practical legislative politics. And I think that it was in a lot of ways a masterstroke to appoint a very policy-focused academic with no practical legislative experience to the CEA job. When people work too long in Washington, their notions of what would be good policy in principle tend to become unduly corrupted by their knowledge of what’s possible in practice.

But what Lizza is telling us is that on the two biggest pieces of macroeconomic management, the Obama administration is pursuing policies that its in-house expert on macroeconomic crisis management believed were far too timid. He’s also telling us that this was done primarily not because people disagreed with her analysis, but because they felt it wasn’t possible, legislatively speaking, to do what was objectively necessary. It’s a bit of a scary situation.

The third decision the administration will be faced with is whether to launch a new stimulus package. Unemployment continues to creep up and is likely to soon hit the 10 percent tripwire. And while companies have reduced their payrolls, they are not growing on the top line, and the result is worsening job outlook. This is the most devastating result of the economic crisis that started with subprime mortgages and Wall Street arbitrage — persistently high unemployment.

From a strategic standpoint, it is that unemployment and how it is handled that will most likely determine the political fate of the administration. Joblessness is where economics and politics converge; while banking regulation and deficit reduction are certainly significant issues, no statistic is more vital in human or political terms than unemployment. And no decision is more critical for the president’s political future than how he moves to bring it back down — even if the fault rightly lies with the past administration’s neglect of the brewing financial storm.

Having chosen to spend what it takes to get us out of the recession, the president should not diverge from that basic direction at this point unless he wants to jeopardize essentially all the economic capital he has built up. In the polls, he’s losing steam as the one to handle the economy, but if he reasserts his positions and his policies, he can regain momentum, even in the face of higher unemployment.

I also agree with Ryan Avent that the theory that unemployment is caused by a boom/bust asymmetry seem to bolster rather than undermine the case for economic stimulus.

The question of policy design for a new stimulus package ought to be how do we design something that more directly targets the labor market rather than merely supporting GDP growth?