I often find Krugman a little over the top -- it seems so hard to be a pundit and maintain perceptions of objectivity -- but he has done a fair job addressing some of my doubts about the stimulus in his 9/3/2010 column. To wit:
1. We do not (yet) see the most watched-for harbingers of strain that we would expect to see if the markets regarded U.S. fiscal policy as excessive, rising interest rates and inflation. What we are seeing, in fact, are the telltale signs of deflation. Whether or not the appearance of deflation calls for more fiscal stimulus may be an open question, I think, but it certainly isn't obvious that fiscal restraint is called for.
2. The claim I've seen recently that Germany's experience shows that fiscal restraint is the better salve is laid to rest by Krugman, in my opinion. One could as easily claim that their more robust safety net, unions, and labor-management relationships has pulled them through. These features, common to some degree in other European countries, give their economy more potent automatic stabilization a priori, so that less explicit stimulus may be warranted. Oh, and their GDP has fallen further than ours in percentage terms, anyway, according to Krugman. 
[Interestingly, Krugman does not mention the fact that conditions in foreign exchange markets are extremely favorable to European exporters in his rebuttal. A recent article on the Times Business pages describes the large devaluation of the Euro relative to the U.S. and Japanese currencies, and the boon that this has been for Germans doing business in China.]
3. It's a fair argument that the second dip (as in "double dip recession") threatens because the fiscal stimulus that has already been dealt is wearing off, and more of the same is warranted. I wouldn't dare to be a strong proponent of that, but the story is internally consistent, at least with respect to the timing of events.

So OK, Professor Krugman, some good points... but more spending? Are you sure?
[For the record, I'm for the status quo. (That is, extend the tax cuts, at least for the middle class; no draconian program cuts; allow for some modest stimulus, if that's what soothes the polity; etc.) What's been accomplished by various monetary and fiscal stimulus measures has been effective. We have thwarted financial calamity. But the debt matters, and I don't think the second dip poses the same danger that sense. Financial markets seem to have accepted the stimulus up to now, but that can change in a hurry. I think that improving business confidence is the only think that will lead us the rest of the way out of the darkness.]

What is Quantitative Easing?

James Bullard essentially states that quantitative easing differs from standard OMO in that it operates on longer term securities. Thus, it acts to affect long-run interest rates, whereas standard operations act upon short term rates (precisely, the Fed Funds rate). This is a useful way to think about QE that had not dawned on me previously.

Thoughts about the notion of a "bond market bubble"

What is a "bond market bubble"? Some recent articles (*) have appeared suggesting that we are observing such a thing at the moment. 

I don't think there can be a bubble in the bond markets (in accord with a recent post by Elliot Turner at Seeking Alpha), but the run-up of bond prices seems ominous nevertheless. To identify a bubble, I think we need to find an asset offering sustained unsustainable returns; bonds will not do so. In particular, prices have risen, offering great returns to those who have bought bonds in the past. But the price of a bond is bounded in theory and practice by the restriction that nominal interest rates will never drop below zero; so bond prices will never reach a level that cannot be justified by some rational interpretation of the world. (Literally, the simple sum of promised payments is an upper bound on the price of the bond... or more precisely, only an abject fool would pay more.)

What worries me is not the run-up in Treasuries prices, so much as the run-up of the price of private issues. (See the article on J&J linked below -- how can one lend to any public company at 5% for 30 years!?!) This is flight to quality, surely. But again, I will argue that the corporate debt market itself cannot exhibit a bubble. Rather, that market may facilitate bubbles in other markets.

This is something we have seen before. Earlier in the decade, rates were similarly low, and the money was being funneled into the housing market. Similarly, I think that investors need to watch out for that kind of phenomenon this time around, as well. More precisely, investors need to be conscious of what corporations are doing with that leverage.

(*) Some related articles: "J&J Sells $1.1 Billion of Debt at Record-Low Rates," By Sapna Maheshwari and Tim Catts, Bloomberg, Aug 12, 2010. "Guarding against the Bond Market Bubble," by Andrew Leckey in the Chicago Tribune. Note that most of these do not go so far as to claim that we are experiencing a "bond market bubble".

What's all this about taxes?

I stumbled into a TEA party event this past weekend (8/7/2010; the event was adjacent to a really cool playground I frequent), and I was informed by its participants of an impending fiscal assault. My informant, despite her animation, seemed only imprecisely informed. But as I was mostly uninformed myself, I resolved to assemble at least a wide angle view of the facts.

Here I will assemble some facts pertaining to the near term outlook for taxes. With respect to the long-term, it is much harder to be precise. Indeed, in agreement with the TEA party philosophy, I think that the long term outlook for taxes is inseparable from the behavior of the fiscal deficit.

1. The Bush tax cuts.

(a) The Economic Growth and Tax Relief Act of 2001 (EGTRRA 2001) provided for reductions of income, estate, and capital gains taxes phased in over time. (It also included some lump sum rebates to taxpayers of record in 2000.) The cuts are scheduled to "sunset" or expire after 2010; that is, rates revert to pre-EGTTRA levels in 2011 if no other action is taken. [Wikipedia entry on EGTRRA]

(b) The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA 2003) accelerated the phase-in of the previous act, and provided for further reductions of capital gains tax rates (to a maximal rate of 15% for long-term gains). Again, the cuts are scheduled to expire and revert after 2010. [Wikipedia entry on JGTRRA]

2. What happens without further action?

In 2010, we have a maximal marginal rate of income taxation of 35%, a maximal rate of taxation of long-term capital gains of 15%, and no taxation of inherited estate property. If no other action is taken, income tax rates, capital gains tax rates, and estate tax rates will all be higher in 2011. In particular, without some action, the maximal rate of taxation on income will rise to 39.6%, that on long-term capital gains will rise to 20%, and the estate tax will revert to the 2001 levels specifying a rate of 55% with exemption for the first $1 million of wealth. [See the Wikipedia entry on the capital gains taxes in the U.S. or USA Today article, 7/23/2010 for the details on that the capital gains tax.]

3. What are people fighting about?

(a) According to an FT article, 7/25/2010, the Obama administration has favored extending the cuts as they apply to those earning less than $250K/year, while allowing expiration of cuts as they have applied for the wealthiest 2-3% of Americans. Under this plan, the highest marginal rate of taxation of income will rise from 35% to 39.6%, and the (maximal) rate of taxation of capital gains will rise from 15% to "at least" 20%.

Obama has proposed resetting the estate tax rules to the 2009 terms, 45% after exempting the first $3.5 million of wealth. This is higher than the current level (zero), but low by the standards of recent history. It is also much more generous than the terms to be applied without legislative action (see above). [USA Today article, 7/23/2010]

(b) As much as I can see, the opposition simply wants to see the 2010 tax environment extended. My sense is that the consensus of expectations of political observers holds that the Republicans will hold out until after the November elections by continuing to propose extension of the whole package, and that they will refuse to allow only partial extensions to go through. In particular, they will oppose the proposals coming from Democrats to extend only the parts that apply to the "middle class".

This seems likely to be a fight that hinges on spin, since both sides want the middle class part, and because that part is very popular (applying, as it apparently does, to 97-98% of Americans). The key, I think, will be the portrayal of the other side as the side that held up the extension of the part for the middle class. Another part may be the currency of the Republican argument (c.f., Jim Nussle's characterization on CNBC) that high income households are not really "households", but small businesses.

In short, it seems that (i) both sides want to reduce taxes relative to what the laws on the books would say should apply for 2011, but (ii) each side wants to blame the other for "allowing taxes to rise". Thus, (iii) each side will be willing to see policy drive off a cliff if it means that the other side may be more injured by the crash.

Fear of Commitment and of Being Committed

Myron Scholes (at least I think it was Scholes), in an article in the AER P&P in 1998 or so claimed that the shockwaves that followed the Russian default resulted from a policy failure of the IMF. In particular, he claimed (or at least hinted) that the IMF should have mitigated the contagion by some form of bailout. I think that this mentality is analogous to the idea that the decision of policymakers to prevent the Lehman bankruptcy in September of 2008 was a failure of policy. (A regular NPR reporter -- I've forgotten who, exactly, but he was reporting on from Spain, I think, on the expanding crisis in Europe -- recently accurately claimed that the concensus opinion among economists was now that this decision was a mistake; I believe this claim is right.)

My view is that the idea that these decisions represented failure of policy is exactly wrong. What these episodes show is, in my opinion, exactly the defining moment of strategy. Economic theory shows very clearly that optimal policy requires commitment to follow a path that may be viewed as short-term suboptimal. If this theory holds any lesson for practice, and I think it does, then this means that we citizens of the real world are destined to observe enlightened policymakers making some hard choices that may be interpreted as wrong ones from some short-run point of view.

So let's go deeper: What is the objective function of our policymaker? Well, the objective of the long-term policymaker that defines "optimal" or "first-best" policy is long-run societal welfare. But in practice, it may be that the objective function of the policymaker in power in 2008 considers, at best, only welfare form 2008 on. And his objective function may be even more different: it may consider only his own tenure in power. Moreover, his own longevity in power is closely connected to public opinion. If, in fact, the policymaker has committed to maximization of long-run societal welfare, then his hands are tied; his decision is very likely to be quite painful in the short-run. The long-run gain would come in the form of reinforcing (or perhaps even establishing) in the minds of other players in the economy that the policy to be followed is, in fact, the optimal time-inconsistent one, that our policymaker has long-run welfare in mind.

So here is my claim: the popular perception that the policymakers failed in 2008 is perfectly consistent with the fact (as I believe it to be) that the decision to allow Lehman to fail was the optimal one. The short term pain felt by the public and the policymakers may be exactly the pain of following a time-inconsistent policy. The benefit, however, may come in the form of establishing in the minds of other players that our policymaker has the ability to commit.

[A sensible formalization of this claim may go further: the game I seem to be describing entails some private information available to the policymaker as to his own type distinguished by the nature of his ability to commit or perhaps the nature of his objective function. ]

To Misters Cayne, Schwartz, Fuld: shut up.

The idea that Bear Stearns, Lehman Bros, and possibly other investment banks came under "speculative attack" as a result of some inability of market regulatory institutions to control such attacks (exhibited, for example, in the absence of an "uptick rule") is crap. Your businesses imploded because they were built on the precarious business model of borrowing to the hilt in short term markets to buy risky illiquid assets. Your cries of conspiracy serve to underline the point (obviated in 2008, I think) that you don't understand the markets well enough to operate these things prudently. Where regulation may have failed is in preventing you and your ilk from getting into that position in the first place!

Surely, your accumulated bonuses save you from the economic consequences you deserve to suffer; the (low, low, low) reputation you have earned through the episode is some consolation to those of us who firmly believe that you brought this on yourselves. In the end, it is very little consolation: given a chance, I have no doubt that any of you would do it all again if you were given the chance. In fact, I don't blame you for that. Given the same opportunities and incentives, I would do the same. But what I wouldn't do is bitch about how the market screwed me over. It's time for you to pretend to some humility!

How big is the derivatives market?

This article in Slate offers a readable answer to the question. International Financial Services London, an industry group, offers a useful digest of this data. Some sources of cited data are the Bank for International Settlements and the International Swaps and Derivatives Association (ISDA).

The BIS estimates had the "notional value" exceeding $600 trillion in 2008, undoubtedly an eye-catching number. The important thing to remember is that the "notional value" of derivative securities is not all that useful for judging the obligation or value to the counterparties under the contracts, though it may be useful for comparing the size of the market across years in relative terms. As such, notional value is not particularly useful for assessing the market's contribution to systemic risk.

The market value of the securities would surely be a useful number. But this measure has at least two problems attached. First, for derivatives traded bilaterally in the dark, it may be difficult to establish objective market values. This argument is similar, in some ways, to one posited by Accountants and executives who resisted attempts to bring about more transparent accounting for stock options in the 1990s. As in that case, however, the fact that it is hard to do doesn't mean that we shouldn't try to do it. On the other hand, there may be some danger that assignments of market value to dark market contracts will be manipulated to effect sinister purposes. In any case, where money has changed hands, a historical book value can surely be established, and this would be useful.

Second, the market value of derivatives securities can change incredibly fast. This property is basic to the nature of the securities, of course; you can understand this phenomenon by thinking about the market value of a fire insurance policy on the morning after your house has burned down. Similarly, the value of CDS contracts insuring various actors against default by Lehman changed significantly after September, 2008.

Slate's Explainer tells us:

"Gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007, less than one-fortieth of the $596 trillion estimate. (That number shrinks to about $3.3 trillion once you take into account contracts that directly offset one another.)"