Reviewing the Administration’s Financial Reform Proposals

Reviewing the Administration’s Financial Reform Proposals. By Douglas J. Elliott, Fellow, Economic Studies, Initiative on Business and Public Policy
The Brookings Institution, June 17, 2009

The Obama administration’s financial reform proposals to be announced today are virtually all sensible, necessary reforms. Unfortunately, some bolder steps have been left out, apparently due to the expectation of intense opposition from entrenched interests. The key proposals, as described in leaked “near-final draft” form are:

• A greater focus on systemic risks
• Higher capital and liquidity requirements for financial institutions, especially the largest
• Tougher regulation of systemically important financial institutions
• Expanded “resolution authority” for regulators to take over troubled financial institutions
• Modest consolidation of regulatory functions
• New regulations for securitizations and derivatives
• Stronger consumer protections led by a new Consumer Financial Protection Agency
• Greater international coordination

Systemic regulation

Regulation has largely focused on ensuring that each financial institution was sufficiently sound in its own right with less attention paid to how the dominos could fall if a major institution fails. Banks and other financial institutions are now so interconnected that problems at one can lead to problems at others which are then magnified throughout the entire system. The level of systemic risk before this crisis was much higher than had been appreciated, spurring the government into significantly more extreme responses than one would have expected to be necessary.

There is a dual response in the proposals to the need for more systemic oversight. First, Treasury will head a new Financial Services Oversight Council (FSOC) whose role will be to identify emerging risks to the system as well as coordinating regulatory activities in general. Second, the Fed will have regulatory power over individual systemically important financial institutions of all types, as discussed later.

This dual approach appears to be a political compromise. The administration’s initial impulse was apparently to give the Fed sole authority over systemic risk regulation, both at the systemwide level and in regard to individual systemically important financial institutions. There would have been the usual consultation with its peers, but nothing like a veto power wielded by the other regulators. However, Congress is not happy with the Fed at the moment. The Fed’s role in the bailouts, especially of AIG, has annoyed many in Congress. This has magnified concerns about the huge financial power of the Fed and its dramatically expanded role in the credit markets, where it operates with little Congressional oversight.

It makes sense to have a regulator responsible for watching over risks to the system as a whole, but there is a real limit to how effective it can be because it would be asked to do something extremely difficult. Ideally, the regulator would spot problems before they spawned bubbles whose bursting would cause great economic pain afterward. However, it is not necessarily easy to spot a bubble in advance, no matter how clear it seems in retrospect. Some things which may appear to be bubbles are not, but rather reflect true long-term changes in the economy. Other trends may be bubbles, but seem as if they were not. For example, what happens if commodity prices go up further and oil reaches $100 a barrel. Is that a commodity bubble or a natural response to tight energy supplies in a recovering world economy? Bubbles almost always start as a reasonable response to changing circumstances – the problem comes when they accelerate beyond reason as investors pile in to a rising market.

The actual powers of the FSOC in practice will matter, as will its approach to using them. At one end of the spectrum, there could effectively be little more than a power to warn about danger, which could be useful, but might not make much difference. At the other end of the spectrum, there would be solid authority to force changes, perhaps by raising capital standards or even limiting certain activities outright. Ironically, the stronger the power, the harder it may be to use. Bubbles grow because there is a widespread belief in the underlying thesis driving the market and investors are profiting from following that belief. Thus, there will be strong resistance to any regulator who argues against the prevailing belief, especially if they are seen as about to destroy a profitable market opportunity that will be argued to be beneficial to society at large. For that reason, there is little risk of the opposite problem, that a systemic regulator will act too strongly or too soon, although this remains a theoretical possibility.

Despite the risks of ineffectiveness, it is better to have a regulator responsible for leaning against the wind when market forces are pushing too hard in a particular direction. Warnings and the threat of specific actions may still help rein in at least some of the excesses associated with bubbles, even if the regulatory actions themselves were to be thwarted. It would be better, however, to have a single regulator play this role rather than a council. The need to win a consensus across all the regulators, with their different views, constituencies, and institutional interests is likely to make it excessively hard to achieve the desired systemic safety.


Higher capital and liquidity requirements

The current crisis has reinforced the importance of a strong level of capital at banks and other key financial institutions. Capital represents the portion of a bank’s assets on which no one has a call except the owners of the bank, whose role is to absorb any losses. Thus, it is available to pay for mistakes and misfortunes, which we have vividly seen are a real possibility in this business. The more capital is held, the greater the level of mistakes and bad luck that can be handled.

The administration supports tougher capital requirements, which are clearly needed. The key will be finding the right balance; tough and effective without overshooting. Capital is not free, for the banks or for society. The investors who provide the capital expect a return on their investment which has to be built into the price of loans and other services or taken out of the rate paid to depositors.

Similarly, the administration supports tougher liquidity requirements, since key financial institutions have been forced to the wall because they allowed themselves to become too exposed to the risk of a “run” by creditors. Within limits, it is a useful economic function for banks to borrow short-term and lend long-term, but it needs to be carefully balanced against the risk that short-term borrowings will run off without new creditors being willing to step in at a reasonable price in a time of trouble.


Tougher regulation of systemically important financial institutions

A newly designated group of Tier 1 Financial Holding Companies (Tier 1 FHCs) would be established by the Fed, in consultation with the FSOC. These entities would be required to hold more capital and perhaps bear additional restrictions not applicable to other financial institutions. The theory is that certain financial institutions are so large or interconnected with other key market players that they cannot be allowed to fail. In practical terms, this means that there is an implicit government guarantee covering those institutions and therefore a potentially large cost to taxpayers if they begin to fail. It is reasonable to take regulatory steps to reduce the risk of failure for those institutions below the risk for less significant ones. Those restrictions may also reduce the temptation for smaller institutions to find a way to become too important to fail and thereby gain the same implicit federal guarantee. Expanded “resolution authority,” discussed next, is a key element of regulation being proposed for Tier 1 FHCs.


Expanded resolution authority

Regulators have available an elaborate set of powers to deal with banks that have fallen into trouble, powers that allow intervention well short of when a bank becomes formally insolvent. There is a regime of “prompt corrective action” steps that regulators can require banks to take once they become undercapitalized or hit other severe problems. Federal regulators have much less authority to deal with troubled financial institutions of other types, with the level of authority falling to zero for insurers or hedge funds.

The administration is proposing to give the Federal Reserve and the FDIC powers over systemically important financial institutions, including bank holding companies and Tier 1 FHCs that are not bank holding companies, that are similar to the prompt corrective action powers already enjoyed by regulators of banks. The Fed would be principally responsible for using these powers while the financial institutions remain solvent, with the FDIC taking over any institutions that actually fail.

This would be a major and controversial change to existing regulation and insolvency laws. It seems clearly necessary in regard to bank holding companies, which are standard corporations covered by regular bankruptcy rules, but which are so bound together with their bank subsidiaries as to form one integral whole. My earlier paper, “Pre-emptive Bank Nationalization Would Face Thorny Problems,” discussed some of the serious difficulties in dealing with a bank and its holding company under different legal bases.

There is also a good case for extending bank-like resolution authority to insurers, finance companies, and securities firms that are affiliated with Tier 1 FHCs, although the answer is not as clear-cut as with bank holding companies. Here the arguments for resolution authority are tied quite closely to the basic premise for tougher regulation of Tier1 FHCs in general. If we establish a separate class of Tier 1 FHCs, they will be implicitly guaranteed by the government, giving the taxpayer a greater stake in their health. We therefore need to optimize the way we deal with such entities if they become insolvent, including, preferably, establishing rules and authorities that make it less likely that they will reach insolvency. The prompt corrective action requirements on banks are a sensible way of doing this.

There are two broad arguments against extending resolution authority, as well as numerous more technical concerns. First, some analysts do not think that the separate status should be established in the first place. In part this is because it makes it more likely in their view that taxpayers will have to subsidize failures and in part because it could give an unfair competitive advantage to the largest competitors, leading them to become bigger still. Second, there are fairness issues involved in changing the insolvency regime for investors who have held bonds of the affected institutions for years under the clear understanding that they would be protected by regular bankruptcy law in the event of an insolvency.

I support extending resolution authority, but it is too complex an issue to fully discuss here. I intend to issue a separate paper in the near future expanding on the brief discussion here.


Consolidation of regulatory functions

There are significantly too many bank regulators in the United States. Different banks and bank-like institutions are regulated by: state regulators; the Office of the Comptroller of the Currency (OCC); the Federal Reserve; the Office of Thrift Supervision; the National Credit Union Administration; and, for certain important purposes, the Federal Deposit Insurance Corporation (FDIC). It appeared earlier that the administration would propose significantly reducing the number of bank regulators, perhaps to as few as a single regulator. This thought appears to have died in the face of intense opposition by many in Congress and elsewhere. No one would design the banking regulatory system the way it is now if they were starting from scratch, but there are many entrenched interests who do not want the present system to change.

The Office of Thrift Supervision is the only regulator who appears to have lacked the institutional support to retain their separate existence. The administration has proposed merging them with, and effectively into, the OCC. This move makes sense, but does not provide nearly the advantages the broader consolidation would have brought. Different regulators will inevitably have different approaches, especially as they are generally given substantial independence in order to reduce the politicization of regulatory decisions. These differing approaches can reduce the effectiveness of systemic regulation, in part by opening up the possibility of “regulatory arbitrage,” where financial groups put their various activities into the affiliates which have the softest regulatory requirements. It is true that tighter regulation of consolidated groups at the holding company level will reduce the ability to arbitrage the regulators, but it is unlikely to entail supervision as detailed as that which will occur at the level of the regulated subsidiaries.

Outside of bank regulation, there are two financial market regulators, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). It makes compelling sense to combine them, but the politics are apparently too difficult. (For one thing, the Agriculture committees of the two houses strongly wish to retain authority over a robust CFTC.) Instead, there will be additional fragmentation as some of the consumer protection functions of the SEC will overlap with that of the new consumer protection regulator discussed later.


New regulations for securitizations and derivatives

Many of the losses by financial institutions and other market players came from problems with securitizations of mortgages and other assets or from problems with derivatives, particularly credit default swaps. The administration proposes greater regulation in both areas, in line with previous statements.

The biggest change to securitizations would be a requirement that the originators of the loans underlying the securities retain at least 5% of the risk. The idea of “keeping some skin in the game” is intuitively appealing and should help. However, it is important not to take excessive comfort from this change. Banks will indeed pay more attention to the quality of the assets they securitize if they retain even a small fraction of them. But, the financial incentives in a bull market for those assets will still push them towards taking greater and greater risks, since they will immediately gain most of the benefits through securitization while only having a future risk on a small fraction of the asset pools. Also, banks are not immune to the euphoria that grips the larger markets during an asset bubble. The banks, to their regret, actually retained much of the mortgage risk from the bubble period, sometimes even buying more in the open market.

The administration is also proposing other positive steps related to securitization, including: greater transparency about the assets backing the securities; clearer guidance from the rating agencies about the differences between asset-backed securities and regular corporate debt; and changes to the compensation structure for the parties involved in securitization.

On the derivatives side, the administration had already indicated that it would push for all standardized derivatives to be traded through an organized exchange or cleared through a clearing house. An exchange is a centrally organized marketplace for the purchase and sale of financial products. The best known is probably the New York Stock Exchange, but there are also several prominent exchanges that do a major business in derivatives already. Exchanges bring a real benefit from transparency about the pricing and volume of trades, as well as making it easier for regulators to track trading positions of major parties. In contrast, much of the trading volume in derivatives now takes place “over the counter,” between two counterparties who are not generally required to report details of the trade and who take each other’s credit risk in regard to the transaction. This credit risk is often mitigated by requiring collateral, but it is clear in retrospect that this process was not well-managed in many cases, leaving a large number of institutions very exposed to the credit risk of AIG, for example.

The major exchanges dealing in derivatives use central clearing houses that act as the counterparty to both sides. If A sells an option to B on the exchange, the clearing house would interpose itself, buying from A and selling the option on to B. The sole purpose of this interposition is to eliminate B’s credit exposure to A. If the option becomes valuable over time, B needs A to make good on its promise. If A doesn’t, the clearing house would make good, protecting B. Such clearing houses can also handle trades that were done off of an exchange, which will be an allowed alternative in certain cases.

It should be noted that using a clearing house does not eliminate counterparty risk altogether. The clearing house could become insolvent itself if enough of its counterparties fail to meet their obligations. This should still represent a diminution of the total credit risk in the system, since clearing houses are well-capitalized and operate in a clearly defined business that is easier to manage than a broader business, but there could be extreme circumstances where a government rescue would be required.

The big controversy with derivatives is what to do about customized derivatives. The use of derivatives to manage risk by sophisticated corporations is pervasive. Sometimes those derivatives are significantly cheaper or more effective if they cover the exact risk rather than using one or more standard derivatives to approximate the desired protection. It would be a great shame to lose those efficiencies altogether by banishing customized derivatives, but there is also a fear that financial firms will deliberately sell slightly non-standard derivatives in order to avoid the tougher rules on standardized ones.

This is another area where the devil is in the details. The trick will be to provide incentives or requirements to use standard derivatives where possible, while leaving the ability to use customized ones where they serve a genuine need. The administration’s proposal attempts to strike this balance. It will be interesting to see what comes out the other end of the legislative process, given the combination of a high degree of public anxiety about derivatives combined with a lack of understanding of this complex topic by many who are voicing opinions about the proper course of action.


Stronger consumer protections

The administration has proposed creating a Consumer Financial Protection Agency (CFPA), responsible for all aspects of regulation of mortgages, credit cards, and other consumer-focused financial products, with a few exceptions, such as mutual funds, which are left with the SEC. This appears to be a fairly powerful agency, with the power to set binding regulations, impose fines, etc. It will specifically be authorized to impose an obligation to offer “plain vanilla” products, such as a standardized 30-year fixed rate mortgage, with the possibility that consumers who wish to make another choice will have to specifically waive their right to have the standardized product.

There have been many bad practices that developed in the bubble period which harmed consumers, especially related to sub-prime mortgages. It will be useful to have a clear regulatory focus on eliminating those problems and avoiding others in the future. The critical issue will be the extent to which the CFPA is able to find the right balance between promoting consumer safety and allowing innovation. Everyone can agree on the need for transparency. What is harder is when there are both risks and rewards to a given product, from the consumer’s viewpoint. How much will the CFPA try to protect consumers from taking risks that might actually be legitimate in light of the potential rewards?

Another key issue that will be determined by a combination of legislative wording and regulatory choices over time is the extent to which the CFPA will move out of products that are clearly consumer products into a wider range of financial products. For example, would the CFPA ever find itself imposing regulations on derivative products, perhaps on the basis that some individuals do invest in them? This appears not to be the intent of the proposal, but there will doubtless be gray areas in practice.


Greater international coordination

Finally, the administration has also highlighted the need for greater international regulatory cooperation. This would indeed be useful, particularly if the United States develops tougher rules in some areas than currently exist elsewhere. However, it is not likely that there will be a large effect on U.S. policy from this international cooperation. As has already been seen with the failure to propose significant regulatory consolidation, financial regulation in the United States is a very parochial affair, with entrenched interests fighting their corner with relatively little regard for what is going on in the rest of the world.


Summary

The proposals are generally quite sensible. The unfortunate aspect is that political constraints have caused the administration to stop short of a full solution in certain areas, most notably in the consolidation of regulatory functions into fewer hands. Nonetheless, the country should be better off if these proposals are passed than if we were to remain as we are now.

Does the "Smart Grid" Have a Smartest-Guys-in-the-Room Problem?

Does the "Smart Grid" Have a Smartest-Guys-in-the-Room Problem? By Ken Maize
Master Resource, June 19, 2009

[...]

However politically incorrect my conclusion, I’m convinced that the “smart grid” is not smart and even dumb. It diverts attention from what is a more important objective–a strong grid. And it politicizes in the very area where we need more consumer-driven, free-market incentives.

Following the Northeast grid collapse of 2003, the Electric Power Research Institute (EPRI) popped out the smart grid concept, largely the brainchild of then EPRI’s CEO Kurt Yeager. The blueprint was for an interconnected intelligent network reaching from the generating station to your toaster, able to talk up-and-down the line, matching supply and demand seamlessly.

Sounds cool, but doesn’t stand up to analysis in my judgment.


Where Did ‘Smart Grid’ Come From?

The idea of a smart grid has been laying around in bits and pieces for many years. I recall visiting Southern California Edison (SEC) in the 1980s where a group of us energy reporters visited the utility’s “smart house.” It kinda reminded me of the Betty Furness advertisements for Westinghouse kitchens when I grew up in Pittsburgh in the 1950s and 1960s. SCE assured us that the smart house, connected to the utility over phone lines (this was pre-World Wide Web) and through radio signals, would dominate home construction in the coming years. (Enron would have a ’smart house’ a decade later to awe visitors to 1400 Smith Street in Houston, but that’s another story.)

Didn’t happen, for lots of reasons, most of them good. It didn’t make economic sense for consumers (although it did for the utility — remember all-electric “gold medallion” homes?). It was way too technologically optimistic, assuming communications protocols that really didn’t exist, and appliances that weren’t remotely ready to talk to each other and the utility. Heck, this was largely before cell phones were making a big impact in the market.

Fast forward to the 21st Century. The grid has shown that it is in trouble. The Internet has demonstrated the utility of Vint Cerf’s IP communications protocol. EPRI is facing an existential moment (what the heck is our role here?). Presto! The smart grid. It controls power flows, adjusts supply demand on the fly, instantly corrects for frequency and power imbalances. It slices, it dices, it’s the latest, biggest, best Ronco product of all time. We can get Billy Mays (no relation, he spells it differently) to peddle it on late-night cable.


Rescuing Dumb Renewables

The concept of the smart grid (if not the reality) also fits into the allegedly new paradigm of renewables. We want lots of power from the wind and the sun (water doesn’t count). But the places where the winds blows a lot and the sun shines a lot are a long way away from where there are a lot of people.

Hence proposals to build a transcontinental, high-voltage (AC and DC) backbone grid on top of the existing transmission and distribution network (which former energy secretary Bill Richardson famously and erroneously called a “third world” grid following the 2003 grid collapse). What’s a trillion dollars or so to bring unreliable power to market?

So here is the Big Green Grid Dream: tie renewables to consumers, with a smart grid to govern (Big Brother?) usage. We could imbue the entire grid — high-voltage transmission and lower-voltage distribution with smarts, from the generator to the substation to the refrigerator. It’s the Big Rock Candy Mountain–or Dream Green Machine.


Another Problem: Cybersecurity

Another problem with the concept of a smart grid (which most advocates assume will use IP/TCP communications protocols) is cybersecurity. It’s hard to bring down a dumb but strong grid in a cyber attack. The smarter it is, the more vulnerable it becomes. There was a report in the Wall Street Journal not long ago that hackers from China and Russia had successfully penetrated the U.S.”grid,” which was undefined in the article.

I don’t believe it, and no other mainstream media outlet backed up the story. But the “smarter” the grid becomes, the more likely such hacking becomes. That’s a real problem.


The Legacy Problem

The U.S. transmission grid (and I’m talking about the big pipes — 365 kV and above) has clear weaknesses. We don’t have a U.S. grid, but loosely-interconnected regional grids. East and West don’t meet very easily. Texas is an island unto itself. Florida is aspiring to the same. Without strong physical interconnections, it’s impossible to dispatch and control a national grid. So a lot of “smart grid” is putting the cart before the horse.


Color Me Skeptical

I don’t buy any part of it, and it ain’t going to happen. It’s what I have described elsewhere as lemon-meringue pie-in-the-sky. Among other problems, the costs are simply unknown, and who will bear them is also unknown. Most of what I’ve seen implicitly suggests that taxpayers will get the check, since customers would revolt if the costs showed up on their monthly bills.

I’ve tuned into recent FERC discussions about grid issues, and heard what I think is a lot of nonsense about smart grids. I’d rather our regulators and policy makers were focusing on muscle, not brains. It’s heavy lifting we need, not heavy thinking.

—————————————
Ken Maize is executive editor of MANAGING POWER magazine and editor of POWER Blog. He was the founder and editor of Electricity Daily (1993-2006) and a reporter and editor at The Energy Daily for a dozen years, starting on March 28, 1979, the date of the Three Mile Island problem. Contact address: kmaize@hughes.net.

The Potential Gas Committee has raised its gas resource estimate for the US

U.S. Gas Resources: Julian Simon Lives! (Malthus, Hotelling, Hubbert are wrong again). By Michael Lynch
Master Resource, June 22, 2009

The Potential Gas Committee has issued its new biennial gas resource estimate for the United States and once again raised its estimate, this time by 15%, or from 1,321 trillion cubic feet (Tcf) to 1,525 Tcf. This equates to a 70-year domestic cushion, given annual U.S. consumption of 20 Tcf. The evaluation of available shale gas, production of which is now soaring, played a major role in this re-evaluation and potently demonstrates how new technology (aka human ingenuity, what the late Julian Simon called the ultimate resource) creates resources, refuting the static fixity/depletion view of the mineral-resource world.

Few realize that the PGC has been raising the estimates of conventional resources throughout history, even as the United States has consumed large amounts of natural gas. Thus gas has been and is an expanding resource, not a depleting one.

In 1966, the PGC’s estimate of ultimately recoverable resource (i.e., including cumulative production) was 1,283 Tcf, versus the current estimate of approximately 2,600 Tcf, including 1,100 Tcf of cumulative production. While that includes several hundred Tcf of shale gas and coal-bed methane (CBM), conventional gas resources have surpassed 2,000 Tcf and are far beyond even the most optimistic estimates of a quarter century ago.

An excellent summary of those estimates can be found in the Office of Technology Assessment’s U.S. Natural Gas Availability: Conventional Gas Supply Through the Year 2000, which noted that the pessimistic projections for production in 2000 were about 9 Tcf. Total production that year proved to be over twice that amount, at 18.7 Tcf, of which less than 2 Tcf were shale gas and CBM.

In fact, resource estimates from that era have proved wildly pessimistic. A review of URR estimates from 11 different sources, including M. King Hubbert and Richard Nehring, found none that came close to current levels, with the highest at 1,800 Tcf. Indeed, five of the nine estimates of lower-48 remaining undiscovered resources came in below 200 Tcf, whereas production since then has been 500 Tcf.

Against this background, we have any number of pundits decrying the optimists arguments that resources will be sufficient for our needs, pointing to a few years of elevated prices, and encouraging the building of numerous—now idle—LNG import terminals. Even more, arguments that global gas resources are somehow constrained should be put to bed.

How to Get The Fed Out Of Its 'Box'

How to Get The Fed Out Of Its 'Box'. By FREDERIC S. MISHKIN
A commitment to fiscal discipline could enable expansionary monetary policy.
The Wall Street Journal, Jun 22, 2009, p A15

When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma.

Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around 70 basis points (0.70%), with the result that the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates is particularly worrisome, because it has the potential to choke off economic recovery and lead to further deterioration in the housing market. That would put an already weakened financial system under stress. Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?

To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause of the rise in long-term rates is the more positive economic news of the past couple of months, particularly in financial markets. The bad news is that long-term interest rates are higher because of concerns about the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. To fund these budget deficits, the Treasury has to sell large quantities of bonds both now and in the future, causing bond prices to fall and interest rates to rise. The increased supply of Treasury debt puts pressure on the Fed to buy it up.

Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, want to make it easy for the Treasury to sell its debt and thereby be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.

The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy to lower long-term interest rates through the purchase of Treasurys. The fiscal situation argues against this policy action, because it would weaken the Fed's inflation-fighting credibility.

How can the Fed get out of the box and pursue the expansionary monetary policy that is needed right now? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions when tax revenue undergoes a substantial decline. In addition, fiscal stimulus to promote economic recovery when the economy is in a severe recession is a sensible prescription.

However, the failure to take steps to get future budgets under control is a recipe for disaster. Not only does it make it difficult for the Fed to take the actions needed to promote economic recovery, but it may even make the fiscal stimulus package less effective. After all, if you know that the government is issuing a lot of debt that has to be paid back someday you can expect to pay much higher taxes in the future. With the prospect of higher taxes, you will be less likely to spend today.

How can the Obama administration and Congress help the Fed do its job and help the fiscal stimulus package work? It needs to address exploding spending on entitlements -- Social Security and particularly Medicare -- which are causing future deficit projections to be so bleak.

One possibility is to establish a nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s. It produced recommendations that for a time helped put Social Security on a more solid footing. Another is taxing health-care benefits as part of any package to reform health care. Taxing health-care benefits would not only generate large amounts of revenue. It would also increase the incentive for people to lower the costs of their health care. There are surely many other ways to promote more fiscal responsibility.

The Fed can assist this process. It could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past. In the current extremely difficult economic environment, we surely need such a deal now.

Mr. Mishkin, an economics professor at Columbia University, is a former member of the Board of Governors of the Federal Reserve and the author of "Monetary Policy Strategy" (MIT Press, 2007).

Treasury's reform plan gives the credit raters a pass

A Triple-A Punt. WSJ Editorial
Treasury's reform plan gives the credit raters a pass.
The Wall Street Journal, Jun 22, 2009, p A14

If world-class lobbying could win a Stanley Cup, the credit-ratings caucus would be skating a victory lap this week. The Obama plan for financial re-regulation leaves unscathed this favored class of businesses whose fingerprints are all over the credit meltdown.

The government-anointed judges of risk at Standard & Poor's, Moody's and Fitch inflicted upon investors the AAA-rated subprime mortgage-backed security. They also inflicted upon the world's nest eggs the even more opaque AAA-rated collateralized debt obligation (CDO). Without the ratings agency seal of approval -- required by SEC, Federal Reserve and state regulation for many institutional investors -- it would have been nearly impossible to market the structured financial products at the heart of the crisis. Yet Team Obama suggests only that regulators reduce the agencies' favored role "wherever possible."

It's a revealing phrase, implying that there are situations when it's appropriate to rely on ratings from the big three instead of actually analyzing a potential investment. Can anyone name one? Probably not, which makes one wonder how the ratings-agency lobby could be so effective.

The truth is that the strongest defenders of this flawed system are mutual funds, state pension administrators and the federal regulators now managing the various bailout programs. Digging into the underlying assets in a pool of mortgages or judging the credit risk in a collection of auto loans is hard work. But putting taxpayer or investor money in something labeled "triple-A" is easy. Everyone is covered if the government's favorite credit raters have signed off.

The Obama plan also calls for regulators to "minimize" the ability of banks to use highly-rated securities to reduce their capital requirements when they have not actually reduced their risks. Minimize, not eliminate? Does the Treasury believe that some baseline level of fakery is acceptable in bank financial statements? To review, a critical ingredient in the meltdown was the Basel banking standards pushed by the Federal Reserve. Among other problems, Basel allowed Wall Street firms to claim that highly-rated mortgage-backed securities on their books were almost as good as cash as a capital standard.

The Obama plan does make plenty of vague suggestions, similar to those proposed by the rating agencies themselves, to improve oversight of the ratings process and better manage conflicts of interest. The Obama Treasury has even adopted the favorite public relations strategy of the ratings agency lobby: Blame the victim. "Market discipline broke down as investors relied excessively on credit rating agencies," says this week's Treasury reform white paper. After regulators spent decades explicitly demanding that banks and mutual funds hold securities rated by the big rating agencies, regulators now have the nerve to blame investors for paying attention to the ratings.

Even the Fed, which until recently would accept as collateral only securities that had been rated by S&P, Moody's or Fitch, has lately acknowledged the flaws in this approach. The New York Fed has anointed two more firms, DBRS and Realpoint, to judge the default risk of commercial mortgage-backed securities eligible for the Term Asset-Backed Securities Loan Facility (TALF). Since the passage of a 2006 law intended to promote competition, the SEC has also approved new firms to rate securities that money market funds and brokerages are required to hold.
But inviting more firms to become members of this exclusive club isn't the answer. As long as government requires investors to pay for a service, and then selects which businesses may provide it, it's unlikely investors will get their money's worth. History says it's more likely that investors who use the agencies' "investment-grade" ratings as a guide will be exposed to severe losses -- ask people who went long on Enron and WorldCom.

It's time to let markets decide how to judge creditworthiness. One lesson of the crisis is that the unregulated credit default swap (CDS) market provided a more accurate measurement of the risk of financial firms than the government's chosen ratings system. Apparently even the largest provider of these government-required ratings, S&P, has taken this lesson to heart. The company recently introduced a new "Market Derived Signals" model that incorporates the prices of CDS contracts "to create a measure that facilitates the interpretation of market information."

This looks like a signal that even the prime beneficiaries of a government policy believe that the policy failed. So why won't the Obama Administration embrace real reform?

Is Government Health Care Constitutional? The right to privacy conflicts with rationing and regulation

Is Government Health Care Constitutional? By DAVID B. RIVKIN JR. and LEE A. CASEY
The right to privacy conflicts with rationing and regulation.
The Wall Street Journal, Jun 22, 2009, p A15

Is a government-dominated health-care system unconstitutional? A strong case can be made for that proposition, based on the same "right to privacy" that underlies such landmark Supreme Court decisions as Roe v. Wade.

The details of this year's health-care reform bill are still being hammered out. But the end result is sure to be byzantine in complexity. Washington will have immense say over how, when and through whom Americans are treated. Moreover, despite the administration's public pronouncements about painless cuts in wasteful spending, only the most credulous believe that some form of government-directed health-care rationing can be avoided as a means of controlling costs.

The Supreme Court created the right to privacy in the 1960s and used it to strike down a series of state and federal regulations of personal (mostly sexual) conduct. This line of cases began with Griswold v. Connecticut in 1965 (involving marital birth control), and includes the 1973 Roe v. Wade decision legalizing abortion.

The court's underlying rationale was not abortion-specific. Rather, the justices posited a constitutionally mandated zone of personal privacy that must remain free of government regulation, except in the most exceptional circumstances. As the court explained in Planned Parenthood v. Casey (1992), "these matters, involving the most intimate and personal choices a person may make in a lifetime, choices central to personal dignity and autonomy, are central to the liberty protected by the Fourteenth Amendment. At the heart of liberty is the right to define one's own concept of existence, of meaning, of the universe, and the mystery of human life."

It is, of course, difficult to imagine choices more "central to personal dignity and autonomy" than measures to be taken for the prevention and treatment of disease -- measures that may be essential to preserve or extend life itself. Indeed, when the overwhelming moral issues that surround the abortion question are stripped away, what is left is a medical procedure determined to be "necessary" by an expectant mother and her physician.

If the government cannot proscribe -- or even "unduly burden," to use another of the Supreme Court's analytical frameworks -- access to abortion, how can it proscribe access to other medical procedures, including transplants, corrective or restorative surgeries, chemotherapy treatments, or a myriad of other health services that individuals may need or desire?

This type of "burden" analysis will be especially problematic for a national health system because, in the health area, proper care often depends upon an individual's unique physical and even genetic history and characteristics. One size clearly does not fit all, but that is the very essence of governmental regulation -- to impose a regularity (if not uniformity) in the application of governmental power and the dispersal of its largess. Taking key decisions away from patient and physician, or otherwise limiting their available choices, will render any new system constitutionally vulnerable.

It is true, of course, that forms of rationing already exist in our current system. No one who has experienced the marked reluctance to treat aggressively lethal illnesses in the elderly can doubt that. However, what may be permissible for private actors -- including doctors and insurance companies -- is not necessarily lawful when done by the government.

Obviously, the government does not have to pay for any and all services individual citizens may desire. And simply refusing to approve a procedure or treatment under applicable reimbursement rules, as under the government-run Medicare and Medicaid, does not make the system unconstitutional. But if over time, as many critics fear, a "public option" health insurance plan turns into what amounts to a single-payer system, the constitutional issues regarding treatment and reimbursement decisions will be manifold.

The same will be true of a quasi-private system where the government claims a large role in defining acceptable health-insurance coverage and treatments. There will be all sorts of "undue burdens" on the rights of patients to receive the care they may want. Then the litigation will begin.

Anyone who imagines that Congress can simply avoid the constitutional issues -- and lawsuits -- by withdrawing federal court jurisdiction over the new health system must think again. A brief review of the Supreme Court's recent war-on-terror decisions, brought by or on behalf of detained enemy combatants, will disabuse that notion. This area of governmental authority was once nearly immune from judicial intervention. Over the past five years, however, the Supreme Court (supposedly the nonpolitical branch) has unapologetically transformed itself into a full-fledged, policy-making partner with the president and Congress.

In the process, the justices blew past specific congressional efforts to limit their jurisdiction and involvement like a hot rod in the desert. Questions of basic constitutionality (however the court may define them) cannot now be shielded from judicial review.

It is, of course, impossible to predict how and when the courts will ultimately rule on the new health system. Much depends on the details and the extent to which reasonable and practical private alternatives to the national plan remain. In crafting the law, however, its White House and congressional sponsors must keep privacy -- that near absolute right to personal autonomy they have so often praised and promoted -- squarely before them. The only thing that is certain today is that the courts, and not Congress, will have the last word.

Yes, We Can Expand Access to Higher Ed

Yes, We Can Expand Access to Higher Ed. By PETER MCPHERSON and DAVID SHULENBURGER
More college degrees will be good for the economy.
The Wall Street Journal, Jun 20, 2009, p A11

For generations, the United States has led the world in higher education. But today the U.S. has fallen to ninth in the proportion of young adults (age 25-34) who attain college degrees among the countries belonging to the Organization for Economic Cooperation and Development. In Japan, Korea and Canada, more than 50% of young adults hold college degrees. Only 41% do in the United States. The question is: Should we do more?

Our nation's economic future depends on it. Our educational advantage made us the world's leader in discovery, invention and innovation. Our labor force has been able to perform better and receive higher wages because of its intellectual capital. But as that capital lags behind that of its competitors, our country's prominence is at risk.

The bottom line is that education affects economics. The more educated a work force is the more value it adds to society. We can chart this by looking at the way income levels vary with educational degrees. Since 1980, the gap between the earnings of those with bachelor's degrees and those with just high-school diplomas has widened. The ratio between the median earnings of men with the former and men with the latter grew to 1.99 in 2007 from 1.43 in 1980.

In today's harsh economy, there is a strong correlation between education and employment. In May 2009, those with bachelor's degrees have an unemployment rate of 4.8%; associate's degree, 7.7%; high-school degree, 10.0%; and less than high-school degree, 15.5%.

Given the impact education has on the economy, the U.S should set a goal of college degrees for at least 55% of its young adults by 2025. This is in line with President Barack Obama's statement that "by 2020, America will once again have the highest proportion of college graduates in the world." This goal would require graduating an additional 875,000 students per year -- a 42% increase of people with at least an associate's or bachelor's degree.

History suggests higher education can meet this goal within the next 15 years. In the 15 years following World War II, post-secondary enrollment expanded by 82%. And in the baby-boomer period of 1962-76, enrollment expanded by a whopping 174%.

The path we foresee resembles what happened during the baby-boomer period. Then, in the heat of the Cold War, the imperative to make technological progress led the nation's universities to expand. As the nation's youth came to understand that they needed more education, the government made education a priority. The sobering lessons from the current economic situation could contribute to a similar pattern of thought and action.

We propose to: 1) enroll a higher percentage of high-school graduates, now 64%; 2) increase the number of adults returning to college; and 3) increase college graduation rates while maintaining educational quality.

To realize these goals, the historic partnership between higher education and the state and the federal government should be re-established. It is the only way that this country will increase its number of degree holders by 42%, a task that will obviously require more resources than public universities and colleges currently have.

The administration and Congress have taken the first steps to expand the number of degree holders, including increasing Pell Grant funding and GI educational benefits. These steps will help more low- and middle-income students attend college.

Figures suggest that the goal is attainable and important for the competitiveness of our people and country. Though some states are currently cutting funding to education, higher education needs help now. Our goal should not wait for better times.

Mr. McPherson, former chairman of Dow Jones & Company, is president of the Association of Public and Land-grant Universities, where Mr. Shulenburger is vice president.

Our revolutionary leaders wanted the best from their children

Founding Fathers. By Barbara Dafoe Whitehead
Our revolutionary leaders wanted the best from their children.
The Wall Street Journal, June 20, 2009, p A13

Barack Obama is a doting father who says that one of the greatest pleasures of his presidency is eating dinner with his daughters on the nights when he is in town.

Some of the nation's Founding Fathers were not so lucky. Doting dads though they were, patriotic service forced them to live apart from their families for years at a time. Benjamin Franklin, John Adams and Thomas Jefferson, the three Founders who spent the most time abroad, missed milestone events. Franklin was a no-show at his daughter's wedding and his wife's funeral. Adams was in Philadelphia when his wife, Abigail, gave birth to a stillborn daughter. While in France, Jefferson received word that his 2-year-old daughter had died of whooping cough. The news came seven months after her funeral.

Trans-Atlantic separations proved too painful to bear. Whenever possible, the Founders took their children with them or sent for the children once they had established a household abroad. John Adams set off on his maiden voyage to England accompanied by his 9-year-old son, John Quincy. On a second crossing he brought along sons John Quincy and Charles. His teenage daughter, Abigail, arrived in France with her mother a few years later. Benjamin Franklin's son, William, and his two grandsons, Temple Franklin and Benny Bache, were part of the Franklin overseas ménage at various times. A new widower, Jefferson took his elder daughter, Patsy, along with him on his diplomatic mission to France and later sent for his younger daughter, Polly.

The children were not always thrilled to go. Charles Adams sobbed inconsolably as he boarded the ship with his father. Eight-year-old Polly begged her father to let her remain at home in Virginia with her beloved aunt: "I am very sorry you sent for me," she bravely wrote. "I don't want to go to France." Still she went, accompanied on the journey by a 14-year-old babysitter named Sally Hemings. Upon arrival in London, the homesick girl spent the next month in the temporary care of Abigail Adams until her father sent a French-speaking manservant to fetch her. Abigail pointedly reminded Jefferson that the experience was traumatic for the child who, once again, was faced with separation from a mother figure and sent off to live with a father she did not know.

Nor was the arrangement a piece of cake for their fathers. In addition to the all-consuming diplomatic responsibilities of winning allies and funders for the Revolution, these lone fathers had to raise Revolutionary Kids. Chief among their responsibilities was securing an elite European education for their young offspring while protecting them from the temptations and dissipations of living abroad. The Founders' children and grandchildren kept company with an aristocratic power elite, savored Continental fads and fashions, and learned to speak fluent French.

It was all too easy, their fathers worried, for the Revolutionary Kids to abandon the republican virtues of industry and frugality and, even worse, to lose their native language. "It is a mortification to me," John Adams wrote to John Quincy, "that you write better in a foreign language than in your mother tongue."

To protect their children from corrupting influences, therefore, the Founding Fathers had to part with them again. Franklin dispatched his 9-year-old grandson, Benny Bache, to school in Switzerland for five years. The Adams sons attended schools in Holland. The Jefferson daughters were placed in a convent in Paris.

Yet no matter how devoted, the Founding Fathers were not inclined, as today's parents are, to lavish their students with praise. "Good job" was not in their vocabulary. "Take care you never spell a word wrong," Jefferson admonished his younger daughter. "Remember too . . . not to go out without your bonnet because it will make you very ugly and then we should not love you so much."

Nor did the Founding Fathers leave it up to their children to "make good choices." Instead, they moralized endlessly on the perils of indolence, time-wasting and thriftlessness. Jefferson reproved Patsy: "If at any moment, my dear, you catch yourself in idleness, start from it as you would from the precipice of a gulph." John Adams lectured John Quincy, hardly a slouch of a student, to "lose no Time. There is not a moral Percept of clearer Obligation or of greater Import."

When Benny Bache asked his grandfather for a gold watch, Franklin responded tartly: "You should remember that I am at a great Expence for your education . . . and you should not tease me for things that can be of little or no Service to you."

Even the profligate Thomas Jefferson embraced the virtue of frugality. When Patsy appealed for extra money, her father refused: "The rule I wish to see you governed by is of never buying anything which you have not money in your pocket to pay for. Be assured that it gives much more pain to the mind to be in debt, than to do without any article whatever which we may seem to want."

Judged by today's psychological standards, these 18th century fathers sound harsh and unfeeling. Yet to see the Founding Fathers as flesh-and-blood dads, to glimpse their struggles to rear their children at a time of grave uncertainty and peril, is to appreciate their service and sacrifice anew. Founding a nation meant more than winning a war. It also called upon the nation's Founders to pass on the passion for freedom, educational excellence and civic virtue to their children and grandchildren.

John Adams said it best in a letter to Abigail: "The education of our children is never out of my Mind . . . Fire them with Ambition to be useful and make them disdain to be destitute of any useful or ornamental knowledge or accomplishment. Fix their Ambition upon great and solid objects."

Ms. Whitehead is director of the John Templeton Center for Thrift and Generosity at the Institute for American Values and co-editor of "Franklin's Thrift: The Lost History of a American Virtue," just published by Templeton Press.

A warning from Copenhagen

A warning from Copenhagen. By stefan
Real Climate, Jun 21, 2009

In March the biggest climate conference of the year took place in Copenhagen: 2500 participants from 80 countries, 1400 scientific presentations. Last week, the Synthesis Report of the Copenhagen Congress was handed over to the Danish Prime Minister Rasmussen in Brussels. Denmark will host the decisive round of negotiations on the new climate protection agreement this coming December.

The climate congress was organised by a "star alliance" of research universities: Copenhagen, Yale, Berkeley, Oxford, Cambridge, Tokyo, Beijing - to name a few. The Synthesis Report is the most important update of climate science since the 2007 IPCC report.

So what does it say? Our regular readers will hardly be surprised by the key findings from physical climate science, most of which we have already discussed here. Some aspects of climate change are progressing faster than was expected a few years ago - such as rising sea levels, the increase of heat stored in the ocean and the shrinking Arctic sea ice. "The updated estimates of the future global mean sea level rise are about double the IPCC projections from 2007″, says the new report. And it points out that any warming caused will be virtually irreversible for at least a thousand years - because of the long residence time of CO2 in the atmosphere.

Perhaps more interestingly, the congress also brought together economists and social scientists researching the consequences of climate change and analysing possible solutions. Here, the report emphasizes once again that a warming beyond 2ºC is a dangerous thing:

Temperature rises above 2ºC will be difficult for contemporary societies to cope with, and are likely to cause major societal and environmental disruptions through the rest of the century and beyond.

(Incidentally, by now 124 nations have officially declared their support for the goal of limiting warming to 2ºC or less, including the EU - but unfortunately not yet the US.)

Some media representatives got confused over whether this 2ºC-guardrail can still be met. The report's answer is a clear yes - if rapid and decisive action is taken:

The conclusion from both the IPCC and later analyses is simple - immediate and dramatic emission reductions of all greenhouse gases are needed if the 2ºC guardrail is to be respected.

Cause of the confusion was apparently that the report finds that it is inevitable by now that greenhouse gas concentrations in the atmosphere will overshoot the future stabilization level that would keep us below 2ºC warming. But this overshooting of greenhouse gas concentrations need not lead temperatures to overshoot the 2ºC mark, provided it is only temporary. It is like a pot of water on the stove - assume we set it to a small flame which will make the temperature in the pot gradually rise up to 70ºC and then no further. Currently, the water is at 40ºC. When I turn up the flame for a minute and then back down, this does not mean the water temperature will exceed 70ºC, due to the inertia in the system. So it is with climate - the inertia here is in the heat capacity of the oceans.

From a natural science perspective, nothing stops us from limiting warming to 2ºC. Even from an economic and technological point of view this is entirely feasible, as the report clearly shows. The ball is squarely in the field of politics, where in December in Copenhagen the crucial decisions must be taken. The synthesis report puts it like this: Inaction is inexcusable.


Related links

Press release of PIK about the release of the synthesis report

Copenhagen Climate Congress - with webcasts of the plenary lectures (link on bottom right - my talk is in the opening session part 2, just after IPCC chairman Pachauri)

Nobel Laureate Meeting in London - a high caliber gathering in May that agreed on a remarkable memorandum which calls for immediate policy intervention: "We know what needs to be done. We can not wait until it is too late." The new U.S. Energy Secretary Steven Chu participated over the full three days in the scientific discussions - how many politicians would have done that?

The crisis reveals the weakness of nation-based regulation

We Need Greater Global Governance. By Peter Mandelson
The crisis reveals the weakness of nation-based regulation.
The Wall Street Journal, Jun 19, 2009, p A13

Fingering the villain in the banking crisis of 2008 turns out to be tougher than it looks. Was it the banker with the skewed incentives and the poor grasp of risk? Was it the over-indebted consumer with the 125% mortgage? Was it the politicians and regulators who failed to see the risks in both?

The answer, of course, is that it was all three, and any number of other contributing factors. But what enabled the banking crisis to happen was a structural imbalance in the growth model of the global economy over the last two decades.

That model has produced unprecedented global growth, but it also developed a serious weakness at its center. Unless we address that weakness, any other counter-recessionary strategy is palliative at best. The risk is that as the global economy slowly returns to growth, the urgency to address this fundamental problem will recede.

Reduced to its crudest form the problem was this: Credit was too cheap in the developed world. It was kept cheap by a number of factors. The commitment of China to an export-led growth model, matched by a willingness from rich-world consumers to keep spending, created persistent surpluses in China in particular.

Those surpluses were invested in developed-world debt, particularly the U.S., pushing down interest rates. That encouraged investors to look for riskier and riskier investments to increase their yield. It also encouraged people to buy houses they couldn't afford with the help of people who probably shouldn't have lent them the money in the first place. That debt was sold around the world. The end of the housing bubble revealed the risk in the system.

The precise detail of this process matters less here than the simple problem it represents. The stability or otherwise of the global economy is the sum of sovereign national macroeconomic policies. There is no mechanism to mediate between those policies or insist on action that would counter systemic risk. Similarly, national financial regulators have a clear enough remit for national market stability, but financial markets are now regional and global. Nobody was asleep at the wheel of globalization because there is no wheel to speak of.

If these imbalances are to be unwound in an orderly way, China will have to build a social welfare system that reduces huge levels of precautionary saving and thus boost domestic demand. It will need to continue to move towards greater currency flexibility. The export-led growth models of other surplus economies such as Germany and Japan are also both going to have to give way to greater domestic demand. Both consumers and governments in the U.S. and Britain are going to have to repair their balance sheets. We are going to have to save and invest more and export more.

Is any of this actually possible? Is it possible to preserve the benefits of open trade and an open global economy, addressing macroeconomic risk while totally respecting the choices of sovereign governments?

The answer has to be: not really. No government in the global economy, and certainly not economies on the scale of the U.S., China, Japan and the European Union, can claim a prerogative over domestic action that entirely ignores the systemic affects of its policies. The only way forward is a totally renovated approach to international coordination of economic policy.

We need to strengthen and depoliticize the International Monetary Fund and give it a new surveillance role that covers all aspects of systemic risk. It needs to be mandated to make recommendations on weaknesses in the system, and countries should be obliged to take these recommendations extremely seriously. Peer pressure is going to be vital -- just as it has been in keeping trade barriers at bay over the last year.

We need much greater global coordination of financial regulation, facing up to systemic risk and ensuring that market participants are not able to play one regulatory jurisdiction against another. The Group of 20 leaders have taken the first steps down this road.

Free-market true believers will resist the conclusion, but the only way to preserve a global growth model based on the huge benefits of dynamic markets is to regulate it better. The bill for the benefits of an open global economy has arrived, and it can only be paid in greater global governance.

Mr. Mandelson is Britain's business secretary and was EU Trade Commissioner from 2004 to 2008.

WSJ Editorial Page: The NEA's Latest Trick

The NEA's Latest Trick. WSJ Editorial
Trying to deny military families.
The Wall Street Journal, Jun 19, 2009, p A14

Public school teachers are supposed to teach kids to read, so it would be nice if their unions could master the same skill. In a recent letter to Senators, the National Education Association claims Washington, D.C.'s Opportunity Scholarships aren't working, ignoring a recent evaluation showing the opposite.

"The DC voucher pilot program, which is set to expire this year, has been a failure," the NEA's letter fibs. "Over its five year span, the pilot program has yielded no evidence of positive impact on student achievement."

That must be news to the voucher students who are reading almost a half-grade level ahead of their peers. Or to the study's earliest participants, who are 19 months ahead after three years. Parents were also more satisfied with their children's schools and more confident about their safety. Those were among the findings of the Department of Education's own Institute of Education Sciences, which used rigorous standards to measure statistically significant improvement.

If you call that "failure," no wonder the program has been swimming in several times as many applications as it can accept. They come from parents desperate to give their kids a chance to get the kind of education D.C.'s notorious public schools do not provide. That's the same chance the Obamas have made by opting for private schools and Secretary of Education Arne Duncan has taken by choosing to live in a Virginia suburb with better public schools.

Contrary to the NEA's letter, the D.C. voucher program isn't magically expiring of its own accord. In March, Congress voted to eliminate the vouchers after the 2009-2010 school year unless it is re-approved by the D.C. City Council and . . . Congress. The program, which helps send 1,700 kids to school with $7,500 vouchers, was excised even as the stimulus is throwing billions to the nation's school districts.

The NEA's letter was a pre-emptive strike against the possibility that 750,000 students in military families would benefit from vouchers. That idea was raised in a Senate hearing this month, when military families explained that frequent moves and inconsistent schooling was harmful to their children. "The creation of a school voucher program should be considered," Air Force wife Patricia Davis dared to say.

President Obama pledged to support whatever works in schools, ideology notwithstanding. But neither he nor Mr. Duncan have dared to speak truth to the power of the NEA. Military families can join urban parents on the list of those who matter less to the NEA than does maintaining the failed status quo.

CBO on Federal President's health plan

ObamaCare Sticker Shock. WSJ Editorial
A $1.6 trillion deficit boost, and the uninsured will still be with us.
The Wall Street Journal, Jun 19, 2009, page A14

This was supposed to be a red-letter week for national health care, as Democrats started the process of hustling a quarter-baked bill through Congress to reorganize one-sixth of the economy on a partisan vote. Instead it was a fiasco.

Most of the devastation was wreaked by the Congressional Budget Office, which on Tuesday reported that draft legislation from the Senate Finance Committee would increase the federal deficit by more than $1.6 trillion over the next decade while only partly denting the population of the uninsured. The details haven't been made public, but the short version seems to be that President Obama's health boondoggle prescribes vast new spending without a coherent plan to pay for it even while failing to meet its own standards for social equity.

Finance Chairman Max Baucus postponed the health timeline, probably until after Congress's July 4 vacation. His team will try to scale down the middle-class insurance subsidies and make other cuts to hold the sticker shock under $1 trillion. (Oh, is that all?) Mr. Baucus also claims he's committed to a bipartisan consensus, yet most Republicans have been closed out of the negotiations, and industry lobbyists have been pre-emptively warned that even meeting with the GOP will invite retribution.

Useful to emphasize amid the mayhem is that CBO's number-crunching is almost always off -- predicting too much spending for market-based policies and far too little for new public programs, especially on health care. The CBO score for a new entitlement is only the teaser rate, given that the costs will inevitably balloon as the years pass and more people mob "free" or subsidized insurance.

Mitt Romney pitched his 2006 health reform -- which Democrats view as a model for universal coverage -- as modest and affordable, yet already its public option is annihilating the Massachusetts fisc. The original cost estimate for last year was $472 million; final spending came in at $628 million. Spending this year is at least $75 million over initial budget, while projections for next year range as high as $880 million -- and even those are probably too low.
Capitol Hill's entitlement Democrats are determined too press ahead, despite this cost detour. Still, this week's lesson is that ObamaCare might not be inevitable once Americans figure out the astonishing price tag.

New Bisphenol A Study is of Very Limited Relevance to Human Health

New Bisphenol A Study is of Very Limited Relevance to Human Health. By Steven G. Hentges
ACC, Jun 18, 2009

The following statement can be attributed to Steven G. Hentges, Ph.D. of the American Chemistry Council’s (ACC) Polycarbonate/BPA Global Group. Dr. Hentges’ comments are in regard to a study from researchers at North Carolina State University (NCSU) and the National Institute of Environmental Health Sciences (NIEHS). The study, "Neonatal bisphenol-A exposure alters rat reproductive development and ovarian morphology without impairing activation of gonadotropin releasing hormone neurons," was funded by NIEHS and published online June 17 by the journal Biology of Reproduction. The study was co-authored by Heather B. Patisaul and Heather B. Adewale of NCSU and Wendy N. Jefferson and Retha R. Newbold of NIEHS.

ARLINGTON, VA (June 17, 2009) – “The American Chemistry Council (ACC) and its member companies have long-supported research to advance scientific understanding about chemicals and promote public health. To achieve these goals with limited resources, including limited use of laboratory animals, study designs should be based on sound scientific principles and data so as to be directly relevant to human health. This new study fails to meet these basic study design principles and practices.

“It is a continuing disappointment to see that researchers – including scientists from National Institute of Environmental Health Sciences (NIEHS) – conduct studies that involve injection of laboratory animals with bisphenol A (BPA). This experimental technique has recently been acknowledged by the NIEHS to have very limited value for assessing human health effects since people are orally exposed to BPA, not by injection. It is well-known that BPA is efficiently metabolized and rapidly eliminated from the body after oral exposure.

“The researchers also state, incorrectly, that their study is significant because it used a dose equal to the EPA reference dose for BPA, which is a science-based lifetime daily intake level determined to be safe by EPA. However, the EPA reference dose is specifically applicable only to oral exposure, not to injection exposure. Consequently, this study does not call into question the validity of the EPA reference dose.

“Although the researchers correctly note that ‘the research was done on rats, making it difficult to determine its applicability to humans...’, the study is of very limited relevance to human health, according to the NIEHS guidelines, due to these inherent study design flaws.

“Eleven regulatory bodies around the world have recently assessed the science on bisphenol A (BPA) and uniformly determined that BPA is safe for use in food contact products. In February, the U.S. Food and Drug Administration (FDA), in regard to their ongoing review, stated: ‘With regard to BPA generally, based on all available evidence, the consensus of regulatory agencies in the United States, Canada, Europe, and Japan is that the current levels of exposure to BPA through food packaging do not pose an immediate health risk to the general population, including infants and young children.’ ”

Learn more about BPA.

Views from India: Why Manmohan Singh is in Yekaterinburg?

Talking Heads: Why Manmohan Singh is in Yekaterinburg? By P. Stobdan
IDSA, June 16, 2009

Prime Minister Manmohan Singh is attending a slew of Russian hosted high profile meetings including those of the SCO and BRIC in Yekaterinburg which would be viewed keenly by most international watchers. The SCO, keenly nurtured by Russia and China as an exclusive nucleus, had hitherto excluded those with observer status from its core deliberations. The forum became popular as an embryonic counterpoise to the United States after 2005 when it bluntly issued a quit notice to the US from Central Asia and decided to salvage an assortment of autocrats being ostracized by the West. Since then, even Iran has been seeking shelter under the SCO auspices.

Why has Russia changed the summit format this time around to include Iran, India, Pakistan and Mongolia in the core deliberations? While it reflects the changing international realignment, the spin now emerging clearly indicates that Russia is counter-strategizing to deal with global issues or at the least it is unwilling to concede the challenges being posed by NATO. The rift with the trans-Atlantic alliance continues as Moscow has rejected the idea of exerting pressure on Iran over its nuclear programme in exchange for the US abandoning its planned missile defense system in Eastern Europe. For its part, NATO has not abandoned its quest to bring Ukraine and Georgia within its fold. The standoff over Georgia also continues.

It is also clear that Russia’s showdown with Georgia has changed the rules of the game. Moscow had lost diplomatic face not only in Europe but also in Asia. Many of Russia’s friends including SCO members were incensed by its adventurism towards former-republics, including the way in which it had been using gas as an instrument for arm-twisting. China and the Central Asian states were wary of Russia’s action and as such they did not endorse Moscow’s call for recognizing Abkhazia and South Ossestia during the last SCO summit in Dushanbe. The adroit Chinese were certainly not keen to pick a fight at the risk of ruining relations with the West. Moscow has also perhaps realized that it is fast losing influence in the Eurasian space, especially given that the global meltdown has made Central Asian states more dependent on China. The former Soviet republics are relying more on Chinese driven institutions than moribund organization led by Russia. Unlike Russia, China has showed no inclination for prematurely confronting the West. Instead, it was cautious about admitting Iran into the SCO as a full member and may have moderated Central Asian behavior to the chagrin of Moscow.

It is against the backdrop of this trend of Russia losing economic, political and cultural attractiveness vis-à-vis China that we should see Moscow’s attempt to bring India fully into the Eurasian space. Another reliable partner is Russia’s old trusted ally - Mongolia. India’s inclusion is also linked to the global financial crisis. Both Russia and China have been attempting to evolve a fresh financial architecture, including a proposal for a new global currency to replace the dollar as a way to preempt another financial meltdown. Russia hopes that Brazil, India and China would join hands as part of the BRIC forum to push the idea further.

The SCO meeting would be significant especially since it is being held against the backdrop of the new American Af-Pak Plan and Obama’s attempt to muster the support of regional powers to make his Afghan policy a success. The SCO, under Russia’s presidency, has been talking about Afghanistan more seriously than before mainly because the focus of geopolitics has shifted from Iraq to Afghanistan – Russia’s traditional backyard. In fact, the high profile March 2009 Conference in Moscow clearly set the stage for the SCO to play a stepped-up role, when it announced a roadmap to deal with increasing security concerns emanating from Afghanistan. It called for comprehensive cooperation against terrorism, drug trafficking and organized crime. The Russians suspect that the global economic downturn may have had an impact on the Taliban as well and thus strengthen the drugs trade. But SCO efforts are being hampered by the NATO presence in Afghanistan. The Russians claim that Afghan opium production increased 44 times after NATO and US troops were deployed in the region and since the withdrawal of Russian border guards from Tajik-Afghan border in 2005.

Moscow has shown willingness to provide transit routes for NATO shipment across Russia and Central Asia to Afghanistan. But this is being downplayed by the US which prefers to rely upon Pakistani supply routes. Attempts would be made by the SCO to bring Afghanistan within its fold this time. As the US intends to deal with and not confront the Taliban, Moscow fears that there will be a power vacuum in Afghanistan upsetting the existing balance. Some SCO declarations may come as music to Indian ears, since they would be a contrast to the NATO’s military approach and are likely to insist upon Pakistan stopping terrorism emanating from its soil. For New Delhi, the SCO may provide a useful platform to counter the negative fallout for Indian interests emerging from the Af-Pak plan. India had earlier pushed for a policy that integrates development projects in Afghanistan with security initiatives and has also insisted that there are no ‘good’ or ‘bad’ Taliban.

It is also likely that Russia is once again trying to use its leverage to soften India with regard to ongoing tension with Pakistan. Putin made a failed attempt earlier to bring together Vajpayee and Musharraf at a similar summit held in Almaty in 2002. Vajpayee did not relent.

The SCO carries a range of ambitious goals under its charter as letter of intent, including the development of an energy club, an inter-bank consortium, and cultural centres to set up an SCO university. But all in all, its strength is slightly exaggerated. The grouping suffers from nebulous internal contradictions. Everyone plays a game under the SCO template. There are internal discords and competing interests. Behind the SCO façade both China and Russia are competing for energy deals with Central Asian states. And like in Africa, Chinese firms are buying resource mines by befriending the region’s corrupt regimes, and in the process is fuelling corruption and undermining a host of environmental and labour standards.

The importance of India is occasionally aired by the SCO members, but in reality Russians and Central Asians only pay lip service while China effectively scuttles anything positive involving India in the Eurasian space. Decades of Indian efforts for an energy deal with Central Asian states remain frustrated. Except on security issues there is little that India can achieve in the SCO. The danger is that though the SCO is not a military block, it is increasingly getting securitized due to stepped-up co-operation to fight terrorism through intelligence consultations and large-scale military exercises. Many have dubbed it as an Asian NATO.

There is nothing wrong in Manmohan Singh attending the Yekaterinburg meeting even if it is a low diplomatic parade. It is also alright if the Prime Minister wants to dispel the myth that he only cares for Washington. In any event, India stands to gain by being courted by other centres of power rather than placing all its eggs in the American basket.

Prof. P. Stobdan is Senior Fellow at the Institute for Defence Studies and Analyses, New Delhi

Too Big to Fail, or Succeed: Everyone will want to become big enough to enjoy 'systemic risk' protection

Too Big to Fail, or Succeed. By Peter J Wallison
Everyone will want to become big enough to enjoy 'systemic risk' protection.
The Wall Street Journal, Jun 18, 2009, page A17

In a speech at the White House yesterday, President Barack Obama outlined what he envisions for future regulation of the financial system. He called his plan "a new foundation for sustained economic growth . . . a transformation on a scale not seen since the reforms that followed the Great Depression." Indeed it is.

His plan, if adopted, will fundamentally change the nature of our financial system and economy. The underlying concerns and assumptions are clear, and they are made clearer by considering other ways that his administration has dealt with the consequences of competition -- particularly the faux bankruptcies of General Motors and Chrysler and the impending change in antitrust policy. Although the president said in his speech that he supports free markets, these initiatives confirm that the administration fears the "creative destruction" that free markets produce, preferring stability over innovation, competition and change.

According to the administration white paper circulated prior to the president's speech, the Federal Reserve would be authorized to create a special regulatory regime -- including requirements for capital, leverage and liquidity -- for any firm "whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed." In addition, if a large financial firm is failing, the Treasury is to be given the power -- in lieu of bankruptcy -- to appoint a conservator or receiver to "stabilize" it.

Designating particular financial firms for this kind of special regulatory treatment clearly signals to the markets that these institutions are too big to fail. It will reduce the perceived risk of lending to them, enabling them to raise funds at lower cost than their smaller competitors.

In other words, the administration's plan would create what are essentially government-sponsored enterprises like Fannie Mae and Freddie Mac in every sector of the financial economy -- insurers, securities firms, finance companies, bank holding companies, and hedge funds -- where these specially regulated firms are to be designated. The result will be devastating for competition. Larger firms will squeeze out smaller ones and aggressive small companies will have less opportunity to overcome the government-backed winners.

Moreover, the administration's proposal to provide a special bailout mechanism for large firms confirms the likelihood that these firms will never be closed down or liquidated. Citing the market turmoil that followed Lehman's collapse, the administration will argue that failures like this are "disorderly." But failure comes from risk-taking -- the very source of our economy's strength -- and it is ultimately risk-taking and its consequences that the administration's plan is intended to prevent.

The turmoil following Lehman's failure occurred because market participants expected, after the rescue of Bear Stearns, that any larger firm would also be rescued. When Lehman wasn't, all market participants were required to recalibrate the risks of dealing with all others, causing a freeze-up in lending and hoarding of cash. Lehman's failure itself did not cause any substantial losses, and within two weeks of its bankruptcy filing Lehman's trustee sold its brokerage, investment banking, and investment management businesses to four different buyers.

Contrast this with AIG, the administration's paradigm, which was saved by the government because it was allegedly too big to fail. That firm is gradually wasting away under government control, with the taxpayers footing the bill.

The administration's fear of competitive outcomes is not reflected solely in financial-sector policies. Consider General Motors and Chrysler. They were defeated in the marketplace. Simply put, they failed to build automobiles enough Americans wanted to buy.

Their disappearance would not have threatened the stability of the financial system, although it would undoubtedly have been disruptive for suppliers, dealers and employees. Yet the administration wouldn't allow them to fail, either. Despite all the talk about credit priorities, the fundamental point is that the administration used taxpayer money to overturn the market's verdict. If we want a preview of what the administration will do with the resolution authority it wants for large financial companies, we need look no further.

The same pattern with regard to competitive markets can be seen in the Justice Department's new antitrust policy. Christine Varney, the new assistant attorney general in charge of antitrust policy, has said that U.S. policy should be more like Europe's. Until now, U.S. antitrust policy has tried to protect competition. Europe attempts to protect competitors. Protecting competitors means blunting the skills of superior players, allowing inferior managers and business models to remain in business and thus preventing better managements and business models from emerging. Again, stability wins out over change and progress.

The president has said on several occasions, including in yesterday's speech, that "I've always been a strong believer in the power of the free market." But his administration's prescriptions tell a different story. In AIG, GM, Chrysler, Fannie Mae and Freddie Mac we can see the future that the administration envisions for our economy -- a sclerotic and unchanging structure of big companies working with, protected by, and relying on big government.

Mr. Wallison is a senior fellow at the American Enterprise Institute.

On the New CCSP Report

Obama's Phil Cooney and the New CCSP Report. By Roger Pielke, Jr
Prometheus, Jun 16, 2009

Imagine if an industry-funded government contractor had a hand in writing a major federal report on climate change. And imagine if that person used his position to misrepresent the science, to cite his own non-peer reviewed work, and to ignore relevant work in the peer-reviewed literature. There would be an outrage, surely . . .

The Obama Administration has re-released a report (PDF) first issued in draft form by the Bush Administration last July (still online PDF). The substance of the report is essentially the same as last year's version, with a bit more professionalism in the delivery. For instance, the photo-shopped picture of a flood appears to be removed and the embarrassing executive summary has been replaced by something more appropriate.

This post is about how the report summarizes the issue of disasters and climate change, including several references to my work, which is misrepresented. This post is long and detailed, which is necessary to support my claims. But stick with it, or skip to the end if you've seen the details before (and long-time readers will have seen them often), there is a surprise at the end.

Here is the relevant paragraph of the CCSP report, found on p. 105:

While economic and demographic factors have no doubt contributed to observed increases in losses,346 these factors do not fully explain the upward trend in costs or numbers of events.344,347 For example, during the time period covered in the figure to the right, population increased by a factor of 1.3 while losses increased by a factor of 15 to 20 in inflation-corrected dollars. Analyses asserting little or no role of climate change in increasing the risk of losses tend to focus on a highly limited set of hazards and locations. They also often fail to account for the vagaries of natural cycles and inflation adjustments, or to normalize for countervailing factors such as improved pre- and post-event loss prevention (such as dikes, building codes, and early warning systems).348,349
Lets take it sentence by sentence.


Sentence #1

While economic and demographic factors have no doubt contributed to observed increases in losses,346 these factors do not fully explain the upward trend in costs or numbers of events.344,347Reference 346 is to a paper I co-authored:

Pielke, Jr., R. A., Gratz, J., Landsea, C. W., Collins, D., Saunders, M., and Musulin, R., 2008. Normalized Hurricane Damages in the United States: 1900-2005. Natural Hazards Review, Volume 9, Issue 1, pp. 29-42. (PDF)

In that paper we did indeed conclude that economic and demographic factors have contributed to losses related to hurricanes. In fact, we concluded that these factors accounted for all of the increase in hurricane losses over the period of record:

The lack of trend in twentieth century normalized hurricane losses is consistent with what one would expect to find given the lack of trends in hurricane frequency or intensity at landfall.

The CCSP report however, says the opposite, that these factors do not explain the upward trend in costs or numbers of events. To support this claim they provide two citations. Lets consider each in turn, first #344:

Mills, E., 2005: Insurance in a climate of change. Science, 309(5737), 1040-1044.

If you go to Mills, and I have, you will find that it is a commentary that does not offer any new research. Instead, its assertion that societal factors cannot explain the increase in disaster losses is based on a further reference; here is what Mills says:

Global weather-related losses in recent years have been trending upward much faster than population, inflation, or insurance penetration, and faster than non-weather-related events

You will see in my comprehensive discussion of Mills that he relied on two sources to support this claim. The first source actually refers to the second, so there is only one source. That one source is a 2000 Munich Re report, which for reasons I explain in the previous link does not actually support its claim.

But more problematically, why is a report characterized by Science Advisor John Holdren as being the "most up-to-date, authoritative, and comprehensive" analysis relying on a secondary, non-peer source citing another non-peer reviewed source from 2000 to support a claim that a large amount of uncited and more recent peer reviewed literature says the opposite about?

The second citation referred to is #347:

Rosenzweig, C., G. Casassa, D.J. Karoly, A. Imeson, C. Liu, A. Menzel, S. Rawlins, T.L. Root, B. Seguin, and P. Tryjanowski, 2007: Assessment of observed changes and responses in natural and managed systems. In: Climate Change 2007: Impacts, Adaptation and Vulnerability. Contribution of Working Group II to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change [Parry, M.L., O.F. Canziani, J.P. Palutikof, P.J. van der Linden, and C.E. Hanson, (eds.)]. Cambridge University Press, Cambridge, UK, and New York, pp. 79-131.

Which is of course Chapter 1 of the 2007 IPCC AR4 WGII report. That report relied on a single study to make the following claim (at p. 110):

A global catalogue of catastrophe losses was constructed(MuirWood et al., 2006), normalised to account for changes that have resulted from variations in wealth and the number and value of properties located in the path of the catastrophes . . . Once the data were normalised, a small statistically significant trend was found for an increase in annual catastrophe loss since 1970 of 2% per year.

Muir-Wood (2006) is of course the white paper prepared in advance of the Hohenkammer Workshop on disaster losses that I organized along with Peter Hoeppe (of Munich Re) in 2006. I called the IPCC out on this cherrypicking/misrepresentation when the report was first released. Even though Muir-Wood et al. (2006) found no trends from 1950, and more importantly the Hohenkammer Workshop resulted in a consensus finding that such attribution was not possible, the Muir-Wood et al. study has been cherry-picked by the IPCC and before that the Stern Review and now, indirectly, again by the CCSP.

So to summarize: sentence one is not supported by the citations provided, which lead in both cases to selectively chosen non-peer revied sources, and the citations that are peer reviewed on this subject come to an opposite conclusion and are ignored.


Sentence #2

For example, during the time period covered in the figure to the right, population increased by a factor of 1.3 while losses increased by a factor of 15 to 20 in inflation-corrected dollars.That figure appears to the right and its problems are many.

That figure appears to the right and its problems are many.

1. The figure includes a major earthquake and 9/11.
2. The figure and the text neglect the effects of increasing wealth.
3. Published peer reviewed studies show no long-term trends in flood or hurricane losses once adjusted for societal change, yet those data are included.


Sentences #3 and #4

Analyses asserting little or no role of climate change in increasing the risk of losses tend to focus on a highly limited set of hazards and locations. They also often fail to account for the vagaries of natural cycles and inflation adjustments, or to normalize for countervailing factors such as improved pre- and post-event loss prevention (such as dikes, building codes, and early warning systems).348,349

I have to think that that the third sentence is referring to at least some of my work. Places that have been looked at include the United States for floods, hurricanes, and tornadoes (I'll ignore other studies outside the US since this CCSP report is referring only to the US). So what does that leave remaining? Not much.

The fourth sentence cannot be referring to my work, since it explicitly considers variability, inflation, and mitigation. Strangely enough that sentence is supported (reference #348) by a letter to Science (PDF) that I wrote on the Mills (2005) paper. In that letter I stated:

Presently, there is simply no scientific basis for claims that the escalating cost of disasters is the result of anything other than increasing societal vulnerability.

So it is strange to see it cited suggesting something that it does not.

Finally, #349 goes to a new paper by Mills which can be found here in PDF. Mills 2009 offers nothing related to the subject of this sentence, so it is strange to see it cited as a source here.

How can we explain how such a patently bad paragraph full of misrepresentations appeared in a U.S. government report?

One answer might lie in the fact that Evan Mills was a co-author of the report (p. 159). Do you think that had anything to do with it? His list of consulting clients is positively Phil Cooney-esque. Here are a few businesses and organizations that he lists under Consulting & Advising in his resume:

* Armstrong/Energyn (US)
* Barakat, Howard & Chamberlin, Inc. (US)
* Better Energy Systems (UK)
* Ceres (US)
* CMC Energy Services (US)* Integrated Process Technologies (US)
* Investment Research, Inc. (US)
* Teton Energy Partners (US)

So a person responsible for misrepresenting science in a government report has ties and presumably financial interests with companies that have an interest in climate policy outcomes? No, couldn't be. Could it?

For those wanting a more rounded picture of extremes in the United States, here is what an earlier CCSP report concluded about extreme events in the United States, but which was uncited by this new CCSP report in this paragraph:

1. Over the long-term U.S. hurricane landfalls have been declining.
2. Nationwide there have been no long-term increases in drought.
3. Despite increases in some measures of precipitation (pp. 46-50, pp. 130-131), there have not been corresponding increases in peak streamflows (high flows above 90th percentile).
4. There have been no observed changes in the occurrence of tornadoes or thunderstorms
5. There have been no long-term increases in strong East Coast winter storms (ECWS), called Nor’easters.
6. There are no long-term trends in either heat waves or cold spells, though there are trends within shorter time periods in the overall record.

'Public Option': Son of Medicaid

'Public Option': Son of Medicaid. By Daniel Henninger
Lard atop lard that only a politician or bureaucrat could love.
The Wall Street Journal, Jun 18, 2009, page A15

In his speech on health care to the American Medical Association, President Obama explained why the U.S. has "failed" (yet again) to provide comprehensive reform that "covers everyone." He had a list of the failing people, who "simply couldn't agree" on reform: doctors, insurance companies, businesses, workers, others. And "if we're honest," he said (ergo, disagreeing with this is dishonest) we must add to the list "some interest groups and lobbyists" who have used "fear tactics."

It seems to me, if we're honest, that one other contributor to the health-care morass should have been on the president's list: Congress. Indeed a close reading of Mr. Obama's speech suggests he holds the political class innocent insofar as he blames everyone else but them. Can this be true?

Back before recorded history, in 1965, Congress erected the nation's first two monuments to health-care "reform," Medicaid and Medicare. Medicaid was described at the time as a modest solution to the problem of health care for the poor. It would be run by the states and "monitored" by the federal government.

The reform known as Medicaid is worth our attention now because Mr. Obama is more or less demanding that the nation accept another reform, his "optional" federalized health insurance program. He suggested several times before the AMA that opposition to it will consist of "scare tactics" and "fear mongering."

Whatever Medicaid's merits, this federal health-care program more than any other factor has put California and New York on the brink of fiscal catastrophe. I'd even call it scary.

Spending on health and welfare, largely under Medicaid, makes up one-third of California's budget of some $100 billion. In New York Gov. David Paterson's budget message, he notes that "New York spends more per capital ($2,283) on Medicaid than any other state in the country."

After 45 years, the health-care reform called Medicaid has crushed state budgets. A study by the National Governors Association said a decade ago that because of "new requirements" imposed by federal law -- meaning Congress -- "Medicaid has evolved into a program whose size, cost and significance are far beyond the original vision of its creators."

In his speeches, Mr. Obama makes the original vision of his "public option" insurance plan sound about as simple as driving through toll booths with an electronic pass on your windshield. It's going to be all about "best practices" with patients "reimbursed in a thoughtful way," as if the federal government is about to become just another big Google.

Medicaid is a morass. Since the program's inception, Congress has loaded it up every few years with more notions of what to cover, shifting about 43% of the ever-upward cost onto someone else's tab, mainly the states. A 1988 congressional mandate requires local schools to pay for schooling and related services for disabled children, but because Congress underfunds its mandates, the states pay the rest through Medicaid.

The list of add-ons is endless, and there's little about it that is thoughtful. Why shouldn't one think that, as with Medicare and Medicaid, the Obama Public Option in time will become an impossible fog for patients to navigate? But unto eternity the program's administrative complexity will provide work for bureaucrats, Members of Congress, their staffs, lobbyist spouses and the "health-care" establishment of foundations and economists.

Oh, and the courts. The fact that this is a public program ensures not just congressional meddling but also makes it vulnerable to litigation. Over time, the Sotomayors of the federal bench will make it bigger. One piece of California's incredible budget mess flows from a federal judge's 2006 decision to seize control of the state's prison-health system and make the state pay billions for new health spending imagined by his appointed federal overseer.

Medicaid alone didn't put California and New York on the brink. Add in spending on public education and you've accounted for about 60% of their budgets. This drives the deficits and gets all the ink, but not least among the casualties of bigness is the idea of governance.

The elected legislatures of California, which holds 36.7 million American citizens, and New York, with 20 million, are essentially falling apart as governing bodies. The whole country has witnessed the spectacle of the comic "coup" in New York's Senate in Albany the past two weeks.

With collapse comes a truth: The bigger the government, the smaller the politicians. As mandated entitlements grow, the spending "crowds out" the need or obligation to think or to govern. Legislators with nothing very real to do become lazy, slack and corrupt. They become Albany. Or Sacramento. Or Trenton.

Mr. Obama's plan is intended to "guarantee" health insurance for all. Whatever the truth of that, its outlays -- larded atop Medicaid, Medicare and Social Security -- guarantee that Congress will become more like the states' clown shows. But they are expensive clowns.

In his speech, Mr. Obama said the cost of the Public Option won't add to the deficit: "I've set down a rule for my staff, for my team -- and I've said this to Congress -- health-care reform must be, and will be, deficit-neutral in the next decade." If we're honest, that means tax increases are inevitable. Sounds scary to me.