GDP and Nature

Writing in the New York Times, Eric Zencey, a professor of historical and political studies describes how the gross domestic product or GDP distorts our understanding of the economy:

If you let the sun dry your clothes, the service is free and doesn’t show up in our domestic product; if you throw your laundry in the dryer, you burn fossil fuel, increase your carbon footprint, make the economy more unsustainable — and give G.D.P. a bit of a bump.

Only God can make a tree, but it doesn't have value in GDP until someone cuts it down. If I cut down a tree or destroy an entire mountain and burn it for heat, GDP is increased. But if I make my home more energy efficient, and don't have to burn that wood or that coal, the savings don't show up in GDP—at least not directly.
Instead, the savings are likely to show up indirectly. I can either spend the savings on other goods and services, or put more money in my bank account. The fallacy that reducing spending on energy reduces economic value is related to the shortcomings of using GDP to measure economic value:

This points to the larger, deeper flaw in using a measurement of national income as an indicator of economic well-being. In summing all economic activity in the economy, gross domestic product makes no distinction between items that are costs and items that are benefits. If you get into a fender-bender and have your car fixed, G.D.P. goes up.

This of course is nonsensical. If a corporation had an asset damaged, it would be expected to write down the asset value on its balance sheet. But a nation can cut down forests or dynamite mountains out of existence and see its GDP go up.
As I noted recently, some critics of energy conservation have fallen prey to the fallacy that if I spend less on energy I must be worse off, when the opposite could be true. The measure of my well being is not what I spend, but the value I receive. An economic measure that fails to recognize that a tree has value before it is cut down is clearly flawed. But GDP, as presently constituted, is more likely to measure value if something is burned in the process.

GDP and Well Being

The New York Times Magazine has an interesting account of attempts to replace (or at least supplement) GDP with measures that more completely capture well being, including measures of social and environmental capital. Economist Joseph Stiglitz offers a car metaphor:

Suppose you’re driving, Stiglitz told me. You would like to know how the vehicle is functioning, but when you check the dashboard there is only one gauge. (It’s a peculiar car.) That single dial conveys one piece of important information: how fast you’re moving. It’s not a bad comparison to the current G.D.P., but it doesn’t tell you many other things: How much fuel do you have left? How far can you go? How many miles have you gone already? So what you want is a car, or a country, with a big dashboard — but not so big that you can’t take in all of its information.

I wrote about the shortcomings of GDP last summer:

Only God can make a tree, but it doesn't have value in GDP until someone cuts it down. If I cut down a tree or destroy an entire mountain and burn it for heat, GDP is increased. But if I make my home more energy efficient, and don't have to burn that wood or that coal, the savings don't show up in GDP—at least not directly.

As I wrote in February, GDP growth has outstripped energy consumption since WW II. Energy intensity, the amount of energy input required to support a dollar of economic output, has fallen by half since 1949.

Way Too Big to Fail

When they say too big to fail, they're not kidding. The federal government today announced a bailout of Citigroup, including $20 billion in direct investment (on top of $25 billion) and $306 billion in loan guarantees. For those keeping score, the federal intervention in Citigroup alone totals 2.5 percent of U.S. GDP.
How did this happen? Good question. The New York Times offers a revealing look at how basic management oversight failed at Citi:

In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.
There, Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.
Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.
For months, Mr. Maheras’s reassurances to others at Citigroup had quieted internal concerns about the bank’s vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup’s huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.
Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.

I don't know how much these gentlemen were paid last year for their role in destroying the world financial system. I would guess that their compensation packages rewarded them for taking on such scary levels of risk without regard for the consequences.
The idea that that markets would keep everyone honest without the need for internal or external oversight has certainly been discredited. Last month, Alan Greenspan himself acknowledged that his benign view of magically self-correcting financial markets was wrong:

I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms," Mr. Greenspan said.

As for how to keep this from happening again, I find myself returning to the principle Floyd Norris proposed two months ago in his column in the New York Times:

Allow me to propose a simple principle that the next president and Congress could follow as they devise a new financial regulatory regime to replace the one that failed so badly: If an activity is important enough to justify a government nationalization to prevent a default, it is important enough to be regulated.

Stiffening Spines on the Bailout

If banks want the government to bail them out, they will probably have to put something on the table. The New York Times reports that Senate Democrats are not rolling over when it comes to Henry Paulson's plan to assume almost total authority to spend or invest $700 billion in taxpayer funds:

The Senate Democrats' proposals includes two bold provisions. One would grant the Treasury "contingent shares" of stock in any financial institution that wants to sell bad debt to the government; the other would grant bankruptcy judges the authority to modify the terms of primary mortgages, a step aimed at helping homeowners at risk of foreclosure.

Senator Chris Dodd has put forward a proposal that fills in some of the accountability left out of Paulson's plan, and would give the federal government a stake in any company it provides capital to:

(c) LIMITATION ON AUTHORITY.—
(1) IN GENERAL.—The Secretary may not purchase, or make any commitment to purchase, any troubled asset unless the Secretary receives contingent shares in the financial institution from which such assets are to be purchased equal in value to the purchase price of the assets to be purchased.

This is just what happened with AIG. You want our capital? Fine, we own you. As the Times reports, this is how Sweden bailed its banking industry in 1992:

But Sweden took a very different course than the one now being proposed by the United States Treasury. And Swedish officials say there are lessons from their own nightmare that Washington may be missing.
Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.
That strategy kept banks on the hook and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

If the prospect of turning over the equivalent of five percent of GDP to one man wasn't hard enough to swallow, Republican recalcitrance is stiffening Democratic spines. Democrats don't want to be left holding the bag if GOP lawmakers don't line up behind the bailout. ABC News reports that Republicans won't line up without John McCain:

ABC News' George Stephanopoulos reports: If Republican presidential candidate Sen. John McCain doesn't vote for the Bush administration's $700 billion economic bailout plan, some Republican and Democratic congressional leaders tell ABC News the plan won't pass. "If McCain doesn't come out for this, it's over," a Top House Republican tells ABC News.

McCain's position isn't made easier by the disclosure that his campaign manager's firm was paid $15,000 a month through last month by Freddie Mac. The New York Times reports that Davis's firm (he owns an equity stake) "had been kept on the payroll because of his close ties to Mr. McCain."
The Hill reports that even Newt Gingrich is blasting the bailout:

Gingrich said he came out against Paulson's plan after looking at the absence of specifics and the focus the plan puts on giving such an enormous amount of money to the federal bureaucracy. "I thought if [Russian Prime Minister Vladimir] Putin had written that, I’d understand it," Gingrich said.

If Bush, Paulson and Bernanke want the money, they are going to have to put some oversight and some upside on the table.